Sound Practices: Implications of Fintech Developments for Banks and Bank Supervisors

After completing this reading, you should be able to:

• Differentiate between the Basel Fintech scenarios and the roles participants perform and risks they are subject to in each scenario.
• Discuss the impact of Basel disintermediated bank scenario on incumbent banks’ present business models identifying areas of existing product and funding risks.
• Distinguish practical instances of the Basel Committee’s Principles for sound management of operational risk (PSMOR) as applied to Fintech.
• Distinguish the implications for bank supervisors and regulatory frameworks as a result of Fintech along with existing licensing regimes and regulatory responses.

Basel Fintech Scenarios, the Roles Participants Perform and Risks they are Subject to in each Scenario

Financial technology has proliferated in recent years with banks and venture capital funds making sizeable investments in Fintech. The Basel Committee on Banking Supervision put in place a task force to provide insight into this development and explore the implications for banks and bank supervisors. The following are the five Fintech scenarios reported by the committee in 2018:

Scenario 1 – “Better bank”

In this scenario, the incumbent banks digitize and modernize themselves with the goal of retaining customer relationships and the core banking services. They leverage enabling-technologies to improve their current business models. The enabling technologies considered include cloud computing, big data, artificial intelligence (AI), and distributed ledger technology (DLT). Banks may innovate payment services and digitize the lending process through some of these efficient interfaces and processing tools to enhance their current products, services, and operations.

Elements Scenario 1 – “Better bank”

1. The use of technologies, including chatbots and AI, among others, may assist banks in creating sophisticated capacities to maintain a value-added remote customer relationship at the same time mitigating fraud and other risks.
2. They are employing innovative payment services to support a better bank scenario. The development of branded mobile payments services by most banks are more acceptable to customers than the non-bank alternatives.
3. Banks are pushed to offer partially or fully automated Robo-advisor services, digital wealth management tools, among other services, to be able to compete in the retail banking market, retain customers and also attract new ones.
4. Digitizing the lending processes is becoming increasingly essential to meet the consumer’s growing expectations of speed, convenience, and low cost of credit decision-making.

There are signs of incumbents adding investment in technological advancements and change of business models. However, this scenario is not yet thoroughly dominant.

Key Risks Under Scenario 1 – “Better Bank”

Execution risk

This relates to the implementation of the new strategy, which relies on the bank’s ability to efficiently manage and effectively implement technological innovations as well as the business model change. There is a potential competition among the incumbent banks to select the winning strategy and the right time to market it.

Operational risk

This may result from the increased reliance on third parties and thus the emergence of cyber-risks. The incumbent banks may rush the transition from legacy infrastructure to the new digital platforms, which may be accompanied by cyber-security risks.

Strategic risk

The incumbent firms could lose a substantial amount of market share due to the rapid unbundling of bank services to digital giants, Fintech, or Bigtech. This will, therefore, increase the individual banks’ risks to reduced profitability. Moreover, incumbents could fail to efficiently use innovation or deliver less expensive services to meet customer expectations. This lack of agility and anticipation may lead to the banks’ reduced profitability.

Systemic-operational risk

Fintech has led to increased interdependencies among the market players and market infrastructures. These interdependencies may lead to an IT risk that may escalate into a systemic crisis.

Idiosyncratic operational risk

Lack of sufficient adaptability of legacy bank IT systems or inadequate implementation practices may result in some banks using greater numbers of third-parties, either through outsourcing or other Fintech partnerships, thereby reducing the transparency of the end-to-end operations. The increased use of partnerships and third-parties increases risks such as cyber-crime, data security, and privacy, money laundering, among others.

Scenario 2 – “New Banks”

In this scenario, incumbent banks may not survive the wave of technology-enabled disruption, and thus new technology-driven banks such as neo-banks, or banks created by Bigtech companies may replace them. These banks will have full service digitalized banking platforms utilizing advanced technology to provide banking services cost-effectively and innovatively.

We have seen the emergence of neo- and challenger banks, for example, Monzo bank and Atom banks in the United Kingdom, and WeBank in China among others, However, there are no clear signs of the predominance of the new bank scenario.

Key Risk Under Scenario 2 – “New Banks”

Soundness

Many incumbent banks are large in size and scale, making it difficult to efficiently and cost-effectively achieve the required level of modernization and digitization of their current processes within an acceptable timeframe.

Scenario 3 – “Distributed Bank”

In this scenario, financial services become increasingly modularized, allowing the incumbent banks to carve out enough of a niche for survival, while other financial service providers “plug and play” on the digital customer interface. The provision of financial services may be made by the incumbents, Fintech, or Bigtech providers who utilize modern technology. There may be an emergence of a large number of players providing specialized services without attempts of being integrated banks or competing for the entire customer relationship. Banks will, however, compete to own customer relationships and provide the core banking services. An example of the distributed bank scenario is where consumers adopt mobile wallets developed by third-party technology firms such as Apple Pay, Samsung Pay, or Android Pay.

Elements Showing the Relevance Scenario 3 – “Distributed Bank”

1. Fintech firms provide Robo-advisory or automated investment advisory services through a bank or as part of a partnership with a bank.
2. Lending platforms can partner and share with banks the marketing of credit products, the approval process, funding, and compliance management. Lending platforms may also acquire licenses, enabling them to do business without the need to cooperate with banks.
3. There is an emergence of innovative payment services with joint ventures between banks and Fintech firms. Consortiums supported by banks are seeking to establish mobile payment solutions and business cases based on DLT for enhancing the transfer processes between participating banks.

Key Risks Under Scenario 3 – “Distributed Bank”

Operational risk

The involvement of Fintech firms as service providers or business partners presents third-party risks. Banks will, therefore, require processes in place for due diligence, ongoing control assurance, and monitoring of the outsourced services to safeguard themselves and their customers.

Security risks

The banks involving Fintech firms as partners may imply that they process transactions on behalf of the Fintech firms. This may pose some security issues as they do not fully understand the customers as they would their own. Therefore, banks will require an effective AML/CFT monitoring in place.

Scenario 4 – “Relegated Bank”

In this scenario, incumbent banks provide commoditized services and surrender the direct customer relationship to other financial services providers. The Fintech and Bigtech companies use the incumbent banks’ banking licenses to provide the core commoditized banking services such as deposit-taking, lending, among other banking activities. Moreover, the relegated bank’s decision to keep the balance sheet risk of these activities would depend on the contractual relationship with the Fintech or the Bigtech firms.

The following are some examples of a modularized financial services industry where banks are relegated to the provision of only specific services to another player who owns the customer relationship:

1. Payment platforms have grown over the years, leaving banks to provide back-office operations support in areas such as treasury and compliance functions. Fintech firms will be engaging with the customer and managing the product relationship. However, the licensed bank would provide authentication for the customer to access funds.
2. Online lending platforms become available to the general public as a financial service provider. It may also extend the range of services provided from lending to become a new intermediary between customers and financial institutions to intermediate all types of banking services.
3. Banks belong to many financial vehicles to which the Robo-advisor directs customer investments and financial needs.
4. Social media leverage customer data to provide its customers with tailored financial products and services from third parties such as banks and others. For example, WeChat, an instant messaging mobile application, offers mobile payment features.

Key Risks Under Scenario 4 – “Relegated Bank”

Concentration risk

This comes in as a result of the number of new platforms, the Bigtech firms gaining a significant market share leading to “too-big-to-fail” issues.

Systemic risk

In a relegated bank scenario, banks become back-office service providers for front-office customer-facing platforms. The front-office customer platforms will lead to increased competition between banks accelerating customer mobility, aggressive pricing on loan offers, and deposit transfer speeds.

Privacy and security risks

Customer relationship is handled by the new platforms based on automated processes and innovative use of customer data. There is a potential for the emergence of inappropriate marketing processes.

Strategic risk

The incumbent firms could lose a substantial amount of market share due to the rapid unbundling of bank services to digitalization giants Fintech or Bigtech. This will, therefore, increase the individual banks’ risks to profitability.

Scenario 5 – “Disintermediated Bank”

In this scenario, banks are no longer significant players as they are displaced from customer financial transactions by more agile platforms and technologies that ensure a direct matching of final consumers depending on their financial needs, for example, making payments, borrowing, raising capital, among others. As such, customers may have a more direct say in choosing the services and the provider, rather than sourcing such services through an intermediary bank. Peer-to-peer lending platforms are an example of this scenario, in which particular customers can directly take on the role of the lender or the borrower.

The Impact of Scenario 5 – “Disintermediated Bank” on Incumbent Banks’ Present Business Models and Areas of Existing Product and Funding Risks

The disintermediated bank scenario may impact the incumbent banks’ present business model by either posing risks or presenting some opportunities. The following are some of the risks and opportunities as a result of this scenario.

Risks

Data privacy and data security

Customer relationship is handled by the new platforms based on automated processes and innovative use of customer data. There is a potential for the emergence of inappropriate marketing processes

Cyber-risks

Cryptocurrencies have suffered a lot of attacks in the recent past. The use of these currencies poses a substantial risk of an attack by hackers. Numerous exchanges have suffered massive security breaches, such as Coincheck, which lost $550 million worth of crypto to hackers, and Bithub, which lost about $30 million, among others.

Money laundering and terrorism financing risk

The pseudonymous nature of blockchain cryptocurrencies is raising concern since the identities of the real actors are concealed. People may engage in illicit activities such as terrorism financing, money laundering, among others.

Outsourcing risk

In the disintermediated bank, distributed bank, and relegated bank scenarios, there are more parties involved in providing financial products and services than at present. Ambiguity may, therefore, arise regarding the functions of the various actors in the value chain. This ambiguity may potentially increase the likelihood of operational incidents. An escalation of innovative products and services from third parties within banks may surge operational complexity and risks if controls do not keep pace. The ability of financial institutions to monitor operations and risk management activities that take place outside their organizations at third parties is therefore key.

Funding risk and liquidity risk

The use of new technology and aggregators provide opportunities for customers to automatically switch between different savings accounts or mutual funds for a better return. This can affect customer loyalty and increase deposits’ volatility. This could lead to higher liquidity risk for banks or a lack of funds.

Opportunities

Lower operating costs

The intensive use of digital technologies reduces operational costs by dissolving physical branch networks and automating loan application and pricing processes as well as credit risk assessment.

Faster and efficient service provision

Fintech credit platforms, for example, provide more convenient services to customers. The online loan application process and risk assessment help speed up processes for borrowers and investors. Borrowers get an initial indication of whether they pass the lending criteria or qualify for a loan offer.

Financial inclusion

Fintechs credit platforms have enabled access for customers through enhancement of infrastructure, innovating new products, and lowering costs, that were excluded from the incumbent banks. This has enabled the provision of service to the previously underserved group.

Practical Instances of the Basel Committee’s Principles for Sound Management of Operational Risk (PSMOR) as Applied to Fintech

Fintech poses some challenges to the incumbent firms, supervisory authorities, as well as other stakeholders. Most of the challenges they pose are consistent with risk principles as in PSMOR. The following are the practical applications of these principles to Fintech.

Fundamental Principles of Operational Risk Management

Ensuring a strong risk culture

Fintech comes with lots of interdependencies, and thus firms need to ensure that an integrated risk culture is shared throughout the supply chain.

Risk management framework

New technological innovations resulting from Fintech come with new risks. Therefore, there is a need to capture Fintech-driven new risks and risk profile changes.

Governance

Effective implementation of risk policies, processes, and systems

The firm should build a framework to capture and control Fintech-driven new risks.

Setting and assessing risk appetite and risk tolerance

The firm needs to set sufficient risk appetite and appropriate risk tolerance with effective thresholds to trigger prompt remedial action.

Implementation of the policies, processes, and systems for risks control

Involves the firm in ensuring policies are in place for prompt reporting, assessment, and early risk mitigation for Fintech-driven risks.

Risk Management Environment

Identifying and assessing risks in all processes and systems

This principle involves enhancing the capacity to identify, assess, and control risks arising from extended critical processes and systems in Fintech migrations.

Assessing risks in the launch of every new product, activity, process, and system

This principle involves the firm ensuring the timely and considerable identification, assessment of risks in the launch, approval, and delivery of Fintech-driven products, processes, and systems.

Appropriate risk monitoring and proactive risk management

The firm should update the frequency of monitoring and reporting with appropriate urgency according to the size and nature of the risks.

Strong risk control environment

Firms should afford appropriate capacities and resources allocated to promptly and effectively curb Fintech-driven risks.

Business Resiliency and Continuity

Business resiliency and continuity plans for harsh business disruption

Includes incorporating business continuity and disaster recovery plan with business disruption scenarios in the Fintech-driven processes and systems.

Role of Disclosure

Public disclosure of risk management

Involves providing information to stakeholders about changes in banks’ risk management processes that reflect changes in risk profile as a result of Fintech developments.

The Implications for Bank Supervisors on Regulatory Frameworks as a Result of Fintech Along with Existing Licensing Regimes and Regulatory Responses

The increased growth of technological innovations within the financial sector has introduced efficiency in the financial sector as well as raising some concerns. Bank supervisors, however, have to work on their regulatory frameworks so as to cater to these technological innovations. The following are some of the implications for bank supervisors as a result of Fintech.

Increased Need for Cooperation

Fintech developments usually raise issues that go beyond the scope of prudential supervision since other public policy objectives are at stake. These policies include safeguarding data privacy, consumer protection, cybersecurity, fostering competition, and compliance with countering the financing of terrorism (CFT) and anti-money laundering (AML).

Bank supervisors should communicate and coordinate with relevant regulators and public authorities in charge of data protection, consumer protection, national security, among others, to ensure that banks are using innovative technologies complying with the relevant laws and regulations. This is aimed at ensuring financial stability, safety, and soundness of the technology.

Bank Supervisors’ Internal Organization and Human Resource Policies

Fintech has and continues to alter the traditional banking business models through the introduction of technology-driven business processes. This calls for changes in the supervisory models for efficient and effective oversight of the banking system. Bank supervisors should also continuously re-evaluate the necessary skill sets and appropriate approaches to supervision to keep pace with changes in the banking sector.

Various agencies have included Fintech training in their programs. However, only a few review the adequacy of their human resources, for instance, hiring profiles, or direct experimentation with DLT or other network-based technologies to advance regulatory understanding of the technological changes.

Suptech Opportunities

Suptech entails the usage of innovative technology such as artificial intelligence, machine learning, and distributed ledgers by supervisory agencies to aid in supervision. This involves the realization that the technologies that offer opportunities and efficiency to the Fintech firms could also offer opportunities for the regulators themselves.

Suptech improves the effectiveness and efficiency of supervisory’s work and oversight through real-time access and automation of the supervisory process. However, there may be barriers to its implementation, including government-wide or standardized internal policies on IT procurement, restrictions on cross-border data movement, among other reasons. Moreover, there is a lack of transparency in using the new technology works and is being controlled, for example, artificial intelligence.

Continued Relevance of Regulatory Frameworks

The current bank supervisory, regulatory, and licensing frameworks are outdated due in regards to the new technology-enabled innovations. Prudential authorities’ scope, in some jurisdictions, does not cover non-banks. However, some non-banks are offering bank-like services, enjoying regulatory arbitrage – a practice whereby firms capitalize on loopholes in regulatory systems in order to circumvent unfavorable regulations. Bank supervisors should review their frameworks to cover the new financial innovations that might pose some financial stability risks.

Licensing regimes

There is a tendency for new financial products and services to be subject only to limited or even no licensing or supervisory framework precedents. A good example of this is the issuance or transfer of digital cryptocurrencies, such as Bitcoin and its exchanges; only a few jurisdictions have licensing requirements for the same. There may be differences in licensing requirements, but basic regulatory and consumer protection requirements are applicable in almost all jurisdictions.

Facilitation of Innovation

Some jurisdictions have set up various initiatives to improve interactions with Fintech players to facilitate technological innovations and business models for financial services. These jurisdictions have set up various innovation facilitation mechanisms, including innovation hubs, accelerators, and regulatory sandboxes.

These initiatives aim at helping companies navigate the supervisory regulations applicable to the fully operational financial service institutions. In particular, the initiatives offer regulatory guidance to innovative incumbent firms as well as startups.

Innovation hubs

These are information exchange schemes on Fintech matters that support, advise, or informally guide regulated or unregulated innovative firms to prepare and make an application for authorization or new products.

Accelerators

These are fixed-term programs, usually, founded and run by experienced private sector participants. They include mentorship or education from the sponsoring partners. Accelerators select a few young firms and invite them to public pitch events, startup boot camps, where they are provided with mentorship, resources, and industry connections. Accelerators may involve projects or programs by supervisors or central banks who involve private sector firms to address specific problems and explore new technologies.

Regulatory sandboxes

These are schemes put in place by competent authorities to provide regulated and unregulated entities with a live testing opportunity of new products or services in a controlled environment. The main aim of the sandboxes is to provide a monitored space for competent authorities and firms to understand the opportunities and risks resulting from innovations and their regulatory treatment through a testing phase.

In summary, it is crucial that banks and supervisors anticipate the risks and opportunities arising from financial technologies and innovation. The Basel Committee pinpointed ten vital implications and considerations on the below supervisory issues:

1. Possible opportunities for supervisors to use innovative technologies (“suptech”).
2. The key risks for banks that accompany fintech developments, including strategic/profitability risks and operational, cyber, and compliance risks.
3. The need to ensure safety and soundness and high compliance standards without inhibiting beneficial innovation in the banking sector.
4. Cross-sectoral cooperation between bank supervisors and relevant authorities.
5. The insinuations for banks of the use of innovative enabling technologies.
6. The implications for banks of the exponential use of third parties, via outsourcing and/or partnerships.
7. International cooperation between bank supervisors.
8. The need to tweak the supervisory skill set.
9. The importance of existing regulatory frameworks for new innovative business models.
10. Key elements of regulatory initiatives set up to facilitate fintech innovation.

Practice Question

Which of the following is a true statement about an innovation hub?

A. It involves the provision of mentorship and industry connections to young firms

B. It involves the provision of a live testing opportunity of new products or services

C. It involves the provision of advice to innovative firms to prepare and make an application for the authorization of new products

D. None of the above

The correct answer is: C).

The innovation hub is an information exchange scheme on Fintech matters that support, advise, or guide innovative firms to prepare and make an application for the authorization of new products. 

A is incorrect: Accelerators are responsible for the public pitch events, startup boot camps, mentorship programs, provision of resources, and industry connections.

B is incorrect: Regulatory sandbox is responsible for the provision of a live testing opportunity for new products or services.