From Disruption to Rebirth – The Emergence of Fintech Banking

A version of this article appeared in Caijing on August 21, 2017.

Why has fintech turned from disrupting banks to becoming banks?

On December 28, 2016, Xinwang Bank opened for business. This is China’s third internet bank, and the first one in the Southwestern region. According to the official website, the bank is “jointly created by the New Hope Group, Xiaomi and Reg Flag as well as other shareholders, aspiring to be a data-driven bank that propels itself with data and technology to demonstrate the fusion of finance and technology.”

Merely eight years ago Jack Ma declared, “If banks do not change, we shall change them” and threw down the gauntlet on behalf of Chinese internet finance. From then on, China saw the explosion of P2P platforms in 2012, and the ballooning of Yu’e Bao (Alipay’s balance based deposit-like product) from tens of billions to hundreds of billions in 2013.  From internet finance to fintech, banks were the objects of disruption – and ridicule. They are clumsy, bureaucratic and conceited, impervious to innovation. In the new era after the financial crisis, Silicon Valley shall deliver mankind more inclusive, more democratic and more humane financial services, whereby consigning Wall Street to the dustbins of history.

Is that not the script agreed upon by fintech innovators, VCs and observers?

Apparently not quite – as the final dust of fintech regulation in China (and elsewhere) settles,as P2P platforms in China (and elsewhere) “regroup and refocus”, Ant Financial has secured a nearly full suite of financial licenses, including a banking license. Has Fintech changed banking, or has it changed its heart?

If we examine the fundamental nature of banks, it is not difficult to conclude that is but the natural course of things.

What are banks, really?

Banks have existed since the dawn of modern capitalism. For centuries, financial systems crashed and rebooted, business models came in and out fashion, empires rose and fell, but banking has stayed by and large constant – raising capital, levering it up and lending it out. Its basic function of supplying credit and leverage to the real economy has barely changed. Without credit and leverage, we do not have much of a modern economy. The twentieth century saw advances in central banking theory and practice, and the birth of a modern banking model where banks connect themselves to central banks to extend leverage and central banks implement monetary policy through banks to adjust systemic leverage. This is the model in use today, and China is no exception. The capacity to access the central bank’s printing press to fine tune the economy’s leverage is an extraordinary privilege. Hence banks, in any country, are rigorously regulated and intimately connected to the government. Undoubtedly, this model has seen its fair share of financial tempest, and has been adapted to different political realities of different countries, but for the most part it has stayed intact.

In other words, banks are institutions by which the central bank (as well as the state) exerts influence to adjust the economy’s level of leverage. To disrupt banks is to disrupt the basis of the modern economic and financial order.

Since banks are heavily regulated and intimately tied to governments, they are indeed more susceptible to bureaucracy compared to other forms of enterprises, and are more likely to succumb to the common diseases of bureaucratic organizations – too haughty to customers, too stubborn to innovate, and too inefficient to operate. But such ills are common to bureaucracies and should not be ascribed to the banking license per se. Nonetheless, the rise of fintech did target banks’ weak spots and hit them hard. To paraphrase from a previous article on the three layers of fintech, on the layer of user experience, fintech firms have indeed beaten banks and forced them to react.

But things differ dramatically when it comes to alternative financing.

Take online lending as an example. Banks enjoy tremendous advantages of employing leverage and low funding costs. The greater the loan volume, the more acute the pain of high funding cost since every basis point impacts the bottom line. The case of leverage is even more transparent given its direct link to profit margins. Sophisticated data driven lending and smart risk management technology, no matter how clever, cannot defy the age-old logic of the lending business. It is all the more ironic that even though many users, especially in China, air their grievances against bank service and user experience, they regard banks as bulwarks of reliability. People instinctively believe that banks are supported by the sovereign (even though it may not be true). Hence while many fintech firms boast innovation and disruption, they are equally enthusiastic to promote their “bank level” risk management and to announce the appointment of “banking industry” senior executives. As for mobile payments, banking relationships are even more important. Without bank account connections, payments cease to function.

Instead of prophesizing that fintech revolution will wipe banks out, it is more honest to admit that fintech firms love and hate banks in roughly equal measure. One can only imagine their yearning: “We can make better products and craft superior experiences. If only we have a banking license!”

When the want has been pressing, the chance is seized as soon as it appears – when they could, fintech firms applied to become banks. Thus is the natural course of things.

The privileges and curse of banking

In the past two years, the most advanced fintech market of the developed world – the UK, and the most advanced fintech market of the developing world – China, have both chosen to lower the barriers of banking license applications, paving the way for fintech firms to secure banking licenses in an orderly manner. The details may vary from one country to the next, but there is no higher recognition and encouragement for the industry than governments and regulators opening a path to become regular banks.

A banking license comes with many privileges:

  • Connection to the central bank – In a financial crisis, access to emergency liquidity lines is open.
  • Clearing and settlement – Banking licenses normally permit clearing and settlement functions, thus enabling a direct connection into the payment network.
  • Leverage – Banks can access low cost funding through deposits and bond issuance to exercise leverage.
  • Cross-border business – Banks can conduct cross-border payment through correspondent banking relationships.

For fintech firms, a banking license means legitimizing “alternative” financing businesses, and a transition to a rational, compliant, sustainable business model with unfettered access to existing financial infrastructure. As long as they maintain the original technological edge to compress operational and risk management costs, they can enjoy better profit margins than other banks.

Some internet veterans may argue that a banking license (and ensuing regulations) will sap the creativity of a startup, and remain fundamentally incompatible to the “Silicon Valley culture” of not fearing to fail and challenging the status quo. Facts speak otherwise. UK fintech banks such as Atom Bank, Starling Bank and Monzo prove that fintech firms with full banking licenses can be as creative as other startups and can make equally impressive UX.

Nevertheless, banking licenses will pose management challenges to fintech firms. In the transformation from a platform or a quasi-financial firm to a full fledged bank, the chief challenge is not culture but managing the business itself. Banking’s curse is that the business itself is extraordinarily difficult to balance.

A bank’s income structure may be broadly divided into interest and non-income. Interest income results from bearing credit risk. Non-interest income comes from trading, investment banking, payment, etc., mostly as a result of bearing market and operational risk (in the broad sense).

A bank’s funding structure may be broadly divided into deposit and non-deposit funding. Deposits come from households and businesses, whereas non-deposit funding is generally raised from capital markets, often through bonds. Deposit owners and bondholders demand different treatment and returns, and therefore the cost and stickiness of capital vary by time.

Juggling these income and funding structures is a difficult and ancient art that has defined – and sometime destroyed banking careers over and over. What is the optimal model of a bank? How much interest income should it earn? How much deposits should it attract? How much in bonds should it issue? Academics and industry veterans have struggled with these questions in vain. Only after the great financial crisis have scholars begun to explore this question with empirical data.

In a paper published in 2009, World Bank scholars Asli Demirgüç-Kunt and Harry Huizinga[1] pointed out that from 1995 to 2007, according to a sample of 1331 banks spanning 101 countries, banks obsessively pursued capital market revenues. All the more intriguing is that non-interest income is not all evil. A certain ratio of non-interest income effectively diversifies risk, but beyond some threshold it begins to enhance risk[2]. Such risks accumulating in banks ultimately erupted in 2008. In a similar vein, a certain ratio of non-deposit funding effectively reduces risk, but excessive reliance on bond issuance in capital markets again enhances bank risk[3].  Bear Stearns was the best example of such excess. Royal Bank of Scotland was another.

The scholars confess that they fail to produce an optimal model of business and funding mix in this paper. Historical data, on the other hand, suggests that even though banks could diversify risks with non-interest income and non-deposit funding to a certain extent, a significant deviation from the traditional model of deposit and lending may deem unwise[4]. In other words, a highly mixed banking model offers limited benefits.

The outlook for fintech banks

In the days before the crisis, it was profitability pressure and savory bonus packages that enticed banks (and their employees) into non-interest income businesses, thus altering the revenue structure. In the face of immense trading gains, stable interest income is hardly attractive, but if fintech can successfully compress the operational and risk management cost base, then the margins of businesses such as SME lending will become much more appealing. Perhaps banks finally would not succumb to the seductive call of a highly mixed model again, and reduce systemic risk overall.

The nature of non-interest income may also change. Pre-crisis non-interest income was dominated by investment banking related activities, intertwined with trading and capital markets. Fintech banks, on the other hand, could feasibly earn more stable fee income from technologically driven services such as settlement and payment. Such income streams originate from services rather than risk exposures.

On the funding side, analytics on deposit stickiness is a major direction. In fintech, deposit management remains relatively unexplored because it is virtually impossible to examine without a banking license. Yu’e Bao, Alipay’s product based on payment balances, remains the closest case study to date. If data analytics models could penetrate latent psychological needs and risk preferences of various types of funding, and build wealth management products accordingly, user stickiness will increase. This would be particularly important for fintech banks in China and other emerging markets where domestic capital markets offer fewer debt financing options.

A fintech bank is a brand new financial institution without the historical burden of other banks. Aside from delivering superior user experience (UX), it would legitimize alternative financing business lines, improve banking revenue and funding structure, and could ultimately reduce systemic risk. Safer banking in a new dynamic equilibrium, not gimmicks that purport to bend financial logic, is the kind of meaningful disruption that we look forward to. It may even deserve the title of new finance. Perhaps the ancient and difficult art of banking could be rejuvenated by fintech after all.

[1] Bank Activity and Funding Strategies: The Impact on Risk and Returns, Policy Research Working Paper 4837 by Asli Demirgüç-Kunt & Harry Huizinga, February 2009

[2] Ibid, pages 14,23,29.

[3] Ibid, pages 22,29.

[4] Ibid, page 30.