The Future of Retail Financial Services

What Policy Mix For a Balanced Digital Transformation?

Sylvain Bouyon

• Publisher: Centre for European Policy Studies
• Year: 2017
• ISBN:
  9781786604811
• Edition: 1
• Topic: Politica e relazioni internazionali
• Subtopic: Politica pubblica

In recent years, the digitalisation of retail financial services – retail payments, current/savings accounts, consumer/housing credit, car insurance, property insurance and health insurance – has accelerated significantly. While policy-makers are gradually creating the necessary conditions to strengthen this digital transformation, there remain numerous policy issues and unanswered questions to resolve. Against this background, CEPS-ECRI formed a Task Force to explore four specific core questions:

• What type of level playing field is needed to ensure a successful transitions to the digital transformation?
• What are the opportunities and risks related to big (alternative) data and increasingly sophisticated algorithms?
• What kind of regulatory framework is the most appropriate for pre-contractual information duties in a digital era?
• How can the regulatory framework for digital authentication be improved?

This report presents the findings of the Task Force, based on discussions among the members, led by the Chairman Kim Vindberg-Larsen, a FinTech entrepreneur. These findings are substantiated and elaborated via in-depth research carried out by Sylvain Bouyon, CEPS-ECRI Research Fellow.

1.WHAT TYPE OF LEVEL PLAYING FIELD FOR THE DIGITAL TRANSFORMATION?

The objective of this chapter is to analyse what is the most adequate policy framework for monitoring the digital transformation of retail financial services. In order to achieve this goal, analyses are first provided on the main types of actors involved in the digitalisation of retail banking and non-life insurance. Next, different versions of the level playing field are defined, in order to contribute to the development of a balanced policy framework. This conceptual framework is then applied to two different types of policy questions: How should regulatory sandboxes) be structured? How can the regulation of P2P platforms be improved? How can efficiency and fairness be ensured in both cases?

Recommendations

1.Following a case-by-case approach when assessing the regulatory needs of each segment of product, by placing financial stability and an effective protection of consumers at the core of any policy, and by combining both versions of the level playing field (‘similar product, similar regulatory treatment’ and ’equal chance for anyone to succeed).

2.Creating core European guidelines for the development of domestic regulatory sandboxes around the six following points: transparency, welfare of consumers at the core, access for all suppliers, list of core regulations that cannot be relaxed, a clear exit strategy and ex-post evaluation for each project.

3.Developing further prudential rules for P2P platforms that focus on four elements: risk communication, orderly resolution of platform failure, early warning schemes and control of liquidity risks.

1.1Three main types of actors with differentiated regulatory burden

As emphasised in the study conducted by CEPS, UCC and LIST for the European Commission DG FISMA on “the role of digitalisation and innovation in creating a true single market for retail financial services and insurance” (2016), there are three types of players involved in the digital transformation of retail banking and non-life insurance:³

-Established suppliers: These include traditional banks (and their suppliers, e.g. consumer credit agencies, etc.) and non-life insurers that have already made significant innovations in their products and processes in order to face more demanding consumers, heightened competition and increasing compliance requirements.

-New companies: Often defined as FinTech start-ups,⁴ these new entrants are typically start-ups created in recent years, which develop and distribute new processes for banks or insurance companies and/or new products for consumers (see Table 1 for a detailed classification).

-Companies that have traditionally been active in other sectors: These companies are examining the possibilities of disrupting retail banking, insurance, investment, capital raising, market provisioning, etc.

Companies in each of these groups possess strengths and weaknesses. While established suppliers can leverage both their extensive experience in providing financial services (notably with regulations) and their broad network of consumers, they also have to cope with significant legacy issues that markedly slow their digital transformation (a vast network of branches, a management philosophy that often does not match with the systematic innovative approach of the digital era, etc.) and high regulatory pressure. Owing to their small size, new companies are more flexible than established players and are more adaptable to digital changes. Furthermore, as they typically do not have banking licences, their compliance burden is much lower than for established players. Nevertheless, they also have to cope with numerous difficulties, including uneven access to funding.

Finally, companies that have been traditionally active in other sectors are showing greater interest in entering the market, in particular large information and technology organisations that can benefit from their global brands and prestige with millions of consumers (such as GAFA), as well as from their vast amounts of personal data and their technological expertise in data analytics, (open) APIs and digital interactions with consumers. Nevertheless, so far they still have low expertise in the sale of retail financial services and, should they opt to enter the market, will most likely have to comply with a vast range of banking regulations, requiring large amounts of time and resources.

1.2‘Similar product, similar regulatory treatment’ versus ’equal chance for anyone to succeed’?

Limitations in the concept of ‘similar’

The concept of ‘level playing field’ can have two definitions in business: a ‘hard’ version and a ’soft’ version. The hard version entails that all players have to play by the same set of rules (see Arneson, 2002). The soft version implies a system where anyone has an equal chance of succeeding. Both definitions are about fairness, but the definition of fairness itself differs across the two versions. Within the hard version, respect for identical rules is fairer than the objective of giving a chance to anyone to succeed, no matter their initial characteristics and comparative advantages (size, etc.).

In theory, the hard version is approached via the key principle of “similar product, similar regulatory treatment”. In practice, the application of such a principle to governing a specific market of financial products proves to be rather vague, if not void. The Oxford English Dictionary defines “similar” as: “having a resemblance in appearance, character, or quantity, without being identical”. In that context, the word “similar” can be interpreted in different ways and the definition of a clear perimeter might be laborious:

-Are substitutable products systematically considered similar? For instance, as a result of higher central bank policy rates, consumers can substitute further the holding of overnight deposits with the holding of deposits with agreed maturity.

-Can products that target different segments of consumers be considered similar? For instance, as shown in chapter 2, some FinTech start-ups provide loans almost exclusively to consumers with thin credit files, while established banks focus primarily on consumers with significant financial data.

-Can similar products a priori be eventually considered not similar if they are related to markedly different processes? For example, P2P lending platforms providing loans as banks do are using markedly different processes to fund these loans.

The systematic application of the soft version of the level playing field, which holds that anyone deserves to have a chance to succeed, also presents significant limitations. The concept of ‘equal chance of succeeding’ implies that the regulatory regime can differ across providers, depending on their characteristics: size, models, etc. As is the case with the hard version, this soft approach is needed in certain circumstances, especially to prevent smaller providers from being systematically penalised due to their smaller size (smaller providers typically do not pose the same systemic risk as large providers and several research articles in recent years tend to suggest that economies of scale exist for banks in fulfilling their compliance obligations) (see Dahl et al., 2016). Nevertheless, such a softening in the regulatory burden for specific actors can only concern very specific rules.

Level playing field continuously challenged by innovation

These questions are even more challenging within the highly innovative context observed in recent years. As a result of enhanced competition and increasingly demanding consumers, both established players and FinTech start-ups are innovating continuously, and thus continuously challenging the existing regulatory framework and level playing field. In particular, in the context of the digital transformation, numerous suppliers are developing circumventive innovations on purpose (products and processes that are no longer within the scope of the regulation).

Retail payments is a typical market where the question of a level playing field has been markedly uncertain in recent years as a result of large-scale innovations in the sector. Lower barriers to entry, high technological content, a sector where many consumers are more prone to consume new products and the growing need for internet billing solutions caused by rapid growth in e-commerce are among the main reasons behind the high concentration of FinTech start-ups in retail payments (as presented by a representative of McKinsey at a Task Force meeting), 37% of worldwide FinTech start-ups that operated in retail activities in 2015 focused on payments. Against that background, one of the main purposes of the PSD2 (2016) was to review the PSD adopted in 2007 to take account of new unregulated types of payment services providers that have brought innovation and offer cheaper alternatives for internet payments.⁵

A case-by-case approach that places consumers and financial stability at the core of any policy

Overall, although a priori well-grounded within a theoretical perspective, the systematic application of the principle of ‘similar product, similar regulatory treatment’ or ‘anyone has an equal chance of succeeding’ entails significant limitations and risks. Against this background, the Task Force privileges a case-by-case approach that places consumers and financial stability at the core of any policy, and addresses each specific risk in a proportionate and adequate manner. In order to maintain fairness among providers, this approach needs therefore to combine the two versions of level playing field, depending on the given environment.

The rest of this chapter will provide two policy examples that follow such an approach.

1.3Further prudential rules for peer-to-peer lending

Specific characteristics of peer-to-peer platforms

Lending is the segment with the second-largest disruption (22% of the FinTech start-ups that focus on the retail market in 2015 according to McKinsey). One of the main drivers behind this dynamic concerns all the new models of peer-to-peer (P2P) lending: a pool of individuals (who are typically not professional investors) (ESMA, 2014) will lend money to the counterparty (a company or an individual) without a banking intermediary and all these investors bear part of the whole financial risk, by receiving interest on their investment from the company or individual in exchange.

The development of P2P platforms can favour financial innovation and, by increasing the number of choices for consumers, contribute to further economic welfare. As regards competition with traditional providers, Milne et al. (2016) showed that “P2P lending is fundamentally complementary to, and not competitive with, conventional banking”. The core intuition behind this assumption is that P2P platforms so far have not managed to attract retail depositors and/or inter...