The Digital Economy And Financial Innovation
BIS PapersNo 109The digital economy andfinancial innovationMonetary and Economic DepartmentFebruary 2020
The views expressed are those of the authors and not necessarily the views of the BIS.This publication is available on the BIS website (www.bis.org). Bank for International Settlements 2020. All rights reserved. Brief excerpts may bereproduced or translated provided the source is stated.ISSN 1682-7651 (online)ISBN 978-92-9259-337-7 (online)
ForewordThe 18th BIS Annual Conference took place in Zurich, Switzerland, on 28 June 2019.The event brought together a distinguished group of central bank Governors, leadingacademics and former public officials to exchange views on the topic “The digitaleconomy and financial innovation”. The papers presented at the conference arereleased as BIS Working Papers No 841 and 842.BIS Papers No 109 contains Panel remarks by Claudia Buch (Vice President,Deutsche Bundesbank), Norman Chan (former Chief Executive, Hong Kong MonetaryAuthority) and Jon Cunliffe (Deputy Governor, Bank of England) and a resulting Paneldiscussion between Agustín Carstens and them.BIS Papers No 109i
ProgrammeThursday 27 June 201918:00Welcome cocktail and informal barbecueFriday 28 June 201909:00–09:10WelcomeHyun Song Shin, Bank for International Settlements09:10–10:30Session 1:Technological advances and the financial systemChair:Veerathai Santiprabhob, Bank of ThailandAuthor:Susan Athey, Stanford Graduate School of BusinessDiscussants:Franklin Allen, Imperial College Business SchoolCecilia Skingsley, Sveriges Riksbank10:30–11:00Coffee break11:00–12:20Session 2:Machine learning and central bankingChair:Mario Marcel, Central Bank of ChileAuthor:Hélène Rey, London Business SchoolDiscussants:Francis X Diebold, University of PennsylvaniaLuiz Awazu Pereira da Silva, Bank for InternationalSettlements12:20–14:00Buffet lunch14:00–15:20Session 3:Financial innovation and changes in financialintermediationChair:Pablo Hernández de Cos, Bank of SpainAuthor:Thomas Philippon, New York University, SternSchool of BusinessDiscussants:Manju Puri, Duke University, Fuqua School ofBusinessDavid Dorn, University of Zurich15:20–15:50BIS Papers No 109Coffee breakiii
15:50–17:10Session 4:The real effects of financial innovationChair:Olli Rehn, Bank of FinlandAuthor:Antoinette Schoar, MIT Sloan School ofManagementDiscussants:Thorsten Beck, Cass Business SchoolJanice Eberly, Northwestern University, KelloggSchool of Management17:10–18:20Wrap-uppanel:Financial innovation in the digital age:implications for central banksChair:Agustín Carstens, Bank for InternationalSettlementsPanellists:Claudia Buch, Deutsche BundesbankNorman Chan, Hong Kong Monetary AuthorityJon Cunliffe, Bank of England18:45–21:30Conference dinnerSaturday 29 June 201907:30–10:00ivBuses depart for BaselBIS Papers No 109
ContentsForeword .iProgramme . iiiContents . vPanel remarks – Claudia Buch . 1Panel remarks – Norman Chan . 7Panel remarks – Jon Cunliffe . 11Panel discussion . 13Previous volumes in this series . 16BIS Papers No 109v
Panel remarks – Claudia BuchClaudia Buch1After the global financial crisis, central banks were assigned a crucial role incontributing to a stable financial system. In this regard, monitoring and assessing risksto financial stability is a core responsibility. Assessing the financial stabilityimplications of digital innovations requires an understanding of how vulnerabilitiesemerge and how they change over time. This includes assessing the risks of individualinstitutions, connections with other institutions, and exposure to common shocks. Tothe extent that new providers of digital financial services such as fintechs and bigtechs change the value chains of financial activities and cooperate with financialinstitutions, disruptions of value chains might become systemic.Digital innovations affect vulnerabilities and the resilience of thefinancial systemObtaining reliable information on the activities of fintechs and big techs fromtraditional statistics and reporting systems is difficult. Hence, mappinginterconnectedness in the financial system – so far – focuses mainly on “traditional”financial institutions (see graph). Given the patchy knowledge base, it is crucial tomonitor the resilience of institutions to assess whether emerging vulnerabilities willultimately endanger financial stability. In this regard, it is interesting to note that somenew providers of digital financial services, such as big techs, are not funded throughdeposits and are well capitalised. This may – a priori – mitigate financial stabilityconcerns. However, these companies might venture into the realm of “traditional”financial services such as deposit-taking and lending or innovatively bundle existingservices and products to create a new product. In this case, fintechs and big techsmay assume the same risks or even greater risks than regulated financial institutionsdo. Hence, assessments of resilience and of the related risks may change, whichrequires first and foremost adequate coverage of these institutions in official statistics.1Vice-President of the Deutsche Bundesbank.BIS Papers No 1091
Digital innovations could be a catalyst for structural change in thefinancial systemHistorically, structural changes in the financial system have been a consequence ofthe process of financial innovation in terms of new products or services, newproduction processes or new organisational forms.2 Financial innovation has oftenhad its roots in advances in the processing power of IT systems and lower costs fordata storage.3 In a similar vein, digitalisation has the potential to change thecompetitive advantages of providers of financial services. New market entrants mayhave superior technologies for the screening of borrowers and thus lower informationasymmetries.4 For example, big tech firms have access to a wide range of customerdata, which may be used to improve risk assessments and the screening ofborrowers.5 Additionally, big tech firms might be able to achieve economies of scalethrough network effects. As a result, the business models of financial institutions thatare based on the cross-subsidisation of different types of service may come underpressure.Financial innovations and new digital financial services may help to raiseproductivity in the financial sector. While the global financial sector has grown2S Frame, L Wall and L White, “Technological change and financial innovation in banking: someimplications for fintech”, Federal Reserve Bank of Atlanta, working paper, no 2018-11, 2018. S Frameand L White, “Technological change, financial innovation, and diffusion in banking”, in The OxfordHandbook of Banking, second edition, Oxford, 2014.3T Beck, T Chen, C Lin and F Song, “Financial innovation: The bright and the dark sides”, Journal ofBanking & Finance, vol 72, 2016, pp 28–51.4G Dell’Ariccia, “Asymmetric information and the market structure of the banking industry”, IMFWorking Papers, no 98/92, 1998. G Dell’Ariccia, E Friedman and R Marquez, “Adverse selection as abarrier to entry in the banking industry”, RAND Journal of Economics, vol 30, no 3, 1999, pp 515–34.5J Frost, L Gambacorta, Y Huang, H S Shin and P Zbinden, “BigTech and the changing structure offinancial intermediation”, BIS Working Papers, no 779, 2019.2BIS Papers No 109
significantly, it has not been one of the most innovative sectors. Relative to GDP, theassets of German banks, for example, have increased from around 50% to more than200% since the 1950s. Trends are similar for other banking systems. However, datafor the past 150 years show that financial services in the United States have beenproduced under constant returns to scale, with an annual average cost between 1.5%and 2% of outstanding assets.6 Similar trends are documented for European banks,albeit based on shorter time series.7 More recently, roughly since the global financialcrisis, the costs of financial intermediation seem to have declined as a result ofimproved technology and increased competition.8 How digital innovations affectproductivity in banking crucially depends on changes in the competitive structure ofmarkets. As in other industries, the entry of new, more productive firms and the exitof incumbent, less productive firms, can be a channel for improvements inproductivity.This process of “creative destruction” is, however, constrained by the fact thatfinancial institutions which are being restructured or are eventually resolved may posethreats to financial stability. A core objective of post-crisis financial sector reforms hasbeen to restore normal market functioning. Among other things, restructuring andresolution regimes for systemically important banks were introduced. The ongoing expost evaluation of the too-big-to-fail reforms by the Financial Stability Board can beexpected to provide useful insights in this regard as it assesses – inter alia – the effectsof new resolution regimes.9 The evaluation focuses on the implementation of reforms,and their credibility and effectiveness in terms of coping with the failure of systemicbanks.Additionally, changing patterns of competition in the banking industry can haveimplications for financial stability that go beyond those for individual banks.Insufficient exits can lead to overcapacity and excessive risk-taking by weaklycapitalised banks, weaken aggregate profitability, and limit banks’ ability to rebuildbuffers following negative shocks. Generally, the link between competition andfinancial stability depends on the nature of the shock, risk-taking incentives at thelevel of the individual firm, and the overall structure of the banking system. In a highlyconcentrated banking system, dominated by a few banks, an idiosyncratic shockhitting a large financial institution can have repercussions for the entire system(granularity effects or “too big to fail”). But a decentralised and weakly competitivebanking system populated by many small banks might also have destabilisingfeatures. If many smaller banks are exposed to the same (macroeconomic) risks, thistoo may create systemic instability (“too many to fail”).How the entry of new firms and the use of new technologies in the provision offinancial services affect financial stability is thus hard to predict. It depends onchanges in the riskiness of individual institutions and on structural features of thefinancial system such as the degree of concentration, interconnectedness andcommonality in exposure to shocks. Assessing the costs and benefits of new financial6T Philippon, “Has the US finance industry become less efficient? On the theory and measurement offinancial intermediation”, American Economic Review, vol 105, no 4, 2015, pp 1408–38.7G Bazot, “Financial consumption and the cost of finance: measuring financial efficiency in Europe(1950–2007)”, Journal of the European Economic Association, vol 16, no 1, 2017, pp 123–60.8T Philippon, “On fintech and financial inclusion”, BIS Working Papers No 841.9Information on the evaluation, including consultative and final reports, will be available oring/effects-of-reforms/.BIS Papers No 1093
technologies is, therefore, conceptually difficult, and a lack of data on new entrantsand suppliers of financial services adds an additional layer of complexity.This moves to centre stage the question of resilience against both shocks andmismeasurement of vulnerabilities. Risk assessments must take into account thestructure of asset portfolios, maturity structures, exposures to common shocks, orfunding structures. Key to a surveillance of the emerging market for financial servicesand changing vulnerabilities is thus sufficiently detailed and granular information onall relevant actors.Better statistics are needed to improve surveillanceAnswering these questions requires, first and foremost, an assessment of the businessmodels of new market entrants. If the characteristics of these firms resemble those ofregulated financial institutions in terms of risk characteristics that justify regulation,regulation should adequately address those risks.Reliable statistics are the first ingredient in any discussion on regulatoryresponses to financial innovation from a macroprudential perspective. This presentsa ”chicken-and-egg” problem: decisions on (macroprudential) regulation – includingthe decision whether or not to regulate – require good and reliable data as an inputfor surveillance work. At the same time, data on financial institutions are traditionallycollected within the context of (micro)prudential regulation and for monetary policypurposes. Hence, data would be collected after taking the decision to regulate.One key policy response to digital innovations and new providers of financialservices is thus to address what one may call the “big data paradox”. On the one hand,new technologies promise a better, faster and safer provision of financial services anda more efficient use of data. On the other hand, financial regulators are struggling tounderstand the implications of digital innovations because there is hardly anyconsistent statistical information on how those innovations change market structures.Currently, many statistics on the financial sector do not capture fintechs as mostof these firms are recorded as providers of non-financial services. Therefore, theactivities of these firms are not collected systematically, and information on theriskiness of big techs and fintechs is patchy. It is even difficult to obtain accuratefigures on the total number of firms in the market or their market shares. Therefore,globally coordinated initiatives are needed to improve the statistical reporting on newfinancial activities, including information on activities, risks and capitalisation.To close these gaps, a working group on fintech data issues was set up by theIrving Fisher Committee (IFC) to take stock of existing data sources, identify data gaps,provide guidance on fintech classification issues and develop a way forward.10 Thepreliminary results of an IFC membership survey show that central banks are closingdata gaps and gathering data from fintech infrastructure and service providers.11However, more work still needs to be done, especially with regard to the statisticalbusiness classification of fintech firms.10The IFC is a forum of central bank economists and statisticians that operates under the auspices ofthe Bank for International Settlements.11The results of the IFC survey on fintech data will be summarised in a report and published on the BISwebsite, www.bis.org/ifc/publications.htm?m 3%7C46%7C94.4BIS Papers No 109
Panel remarks – Norman ChanNorman Chan12Today I would like to make four sets of comments. The first comment is more genericin nature. The second comment relates to distributed ledger technology (DLT) and itsimplications for central banks. The third comment relates to a topic that wasmentioned in earlier sessions today, which is about personal data protection, storageand use. The final comment is quite timely with Facebook’s recent launchannouncement for Libra. It is about the entry of big techs into finance.Financial innovation: much more than technologyThere is a lot of fuss being made about the potential for technology to change thefinancial landscape. But in my view, financial innovation is not just about technology;it is much more than that. For a long time, conventional financial institutions (FIs) andbanks have focused a lot on their product offerings. They design products, think thatthese are what customers need and ensure that the products comply with rules andregulations. However, quite often they are doing so without really understanding howto provide an easier customer journey. So in my view, in addition to new technologyapplications, we also need to re-think about the processes.I like the following analogy. Most of us have an audiovisual entertainment systemat home. I have a very nice system, perhaps one of the best available in the market.But there are 85 buttons in the remote control that comes with the system. In theolder model, there were more than 20 buttons. My wife could not manage it and shegave up. But there are now 85 buttons, so I also gave up. In contrast, for some otherproducts such as Apple TV and Android TV, there are just five or six buttons in theremote controls. They are much easier to navigate and give you a better customerexperience for the functions you need. Apparently, these companies devote hugeamount of resources trying to reduce number of buttons and clicks to enhance thecustomer experience. This analogy shows us what a customer-centric/client-centricmindset would require. In fact, a lot of problems and unpleasant customerexperiences with banks are basically about the processes, bureaucracy and legacysystems, which have nothing to do with technology.The second point I want to make is about the tradeoff of convenience and speed.If you ask customers, they almost always prefer speed and convenience at no costuntil something goes wrong. Only when something goes wrong do they become verycareful and cautious. Indeed, convenience does not provide a safeguard. Speed doesnot guarantee safety. For example, in some jurisdictions, peer-to-peer lendingplatforms are based on mobile networks. They offer some advantages such as a fastand convenient online application process, but they do not necessarily provide safety.My last point for this slide is about the blurring of FIs and fintech companies.When you talk with banks, they said they have invested millions and millions of dollars12Former Chief Executive of the Hong Kong Monetary AuthorityBIS Papers No 1097
in technology. So fintech is not the monopoly of tech firms. There is, however, a bigdifference when big techs enter into the market. I will come to that later.Implications of distributed ledger technology (DLT) for central banksIt seems clear to me that crypto-tokens without backing are unlikely to be qualifiedas money. As a means of payment, crypto-tokens are not scalable and you have tothink about something else.Then, the concept of central bank digital currencies (CBDC) has also attractedattention. For retail usage, I do not see a lot of merit because, in many jurisdictions,there are already very efficient, fast and safe retail payment systems that make use ofcommercial bank balances, not central bank balances. CBDC also poses the risk of anunclear and complicated impact on the monetary transmission mechanism andfinancial stability. In the case of a financial crisis, public demand for CBDC wouldreplace that for commercial bank deposits, and that would pose a threat to financialstability.Stablecoins require more attention as they present new benefits and risks. Thebanking system and the credit card system have been very inefficient in meeting theneed for cross-border payments and making small payments at point of sale. Libraintends to tackle that, particularly in the
Financial innovations and new digital financial services may help to raise productivity in the financial sector. While the global financial sector has grown 2 S Frame, L Wall and L White, “Technological change and financial innovation in banking: some implications for fintech”, Federal
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