(The opinions expressed here are those of the author, a columnist for Reuters.)
By James Saft
The telephone, the semiconductor and the internet: all have come and been adapted and failed to make finance any more efficient.
So much for the mobile phone; so much, even, for the ATM. The unit cost of a dollar of financial intermediation, like lending, has hovered around two cents for 130 years, according to Thomas Philippon, Professor of Finance at New York University.
That’s while the rest of the economy has seen its productivity increase about tenfold.
If you can find a bigger failure of the supposedly free market, please let me know.
So it would be naive to expect the rise of financial technology - newly enabled technologies that companies make or use to make financial services more efficient, like blockchain distributed ledger payments - to do much to make the cost of finance cheaper to the end user, much less to spark an overall improvement in how capital is allocated to those who will use it best.
The likelihood is that without intervention from outside, fintech, like those innovations which came before, will be adopted, coopted or stifled by the incumbents in finance, who enjoy huge advantages from factors like too-big-to-fail status and other forms of regulatory capture.
The solution, Philippon argues in a new paper, is regulation which contains existing institutions while creating conditions in which fintech startups can grow, compete and drive down prices without raising overall systemic risks.
In other words, starve the beast of incumbent finance while encouraging new fintech companies to outcompete it.
“Finance has benefited more than other industries from improvements in information technologies. But, unlike in retail trade for instance, these improvements have not been passed on as lower costs to the end users of financial services,” Philippon writes.
“Asset management services are still expensive. Banks generate large spreads on deposits. Finance could and should be much cheaper. In that respect, the puzzle is not that fintech is happening now. The puzzle is why it did not happen earlier.”
Fintech, a mashup of financial and technology, are businesses which seek to “disrupt” traditional banking and payments models by using digital-based services usually delivered via internet or smartphone.
And it isn’t simply that finance hasn’t become any more efficient, it has become much larger to the point where it is arguably an impediment to overall growth rather than a spur. Finance’s share of overall GDP is now roughly 75 percent greater than it was in 1980 and more than double the level during most of the post-World War II economic boom.
And while there is broad agreement that poor regulation of banking and finance was one of the main causes of the financial crisis, and thus partly responsible for the subpar growth since, reform of regulation since 2008 has had only mixed success.
Yes, the capital banks must carry against risk-weighted assets is now larger, but banks remain opaque and leverage is legendarily difficult to measure, or even to anticipate once a crisis begins. The difficulties are made much worse by political difficulties due to the economic power of finance, and fears that regulation in one place will drive bad behavior elsewhere.
“The bottom line is that transforming incumbent financial firms into safe and efficient providers of financial services is an uphill battle. At best, it will be long and costly. At worst, it will simply not happen,” Philippon writes.
In comparison, fintech startups have huge advantages. Their business models, at least in theory, are less reliant on leverage. Traditional payments and checking accounts have a fixed value, but are backed by a banking system which holds assets that fluctuate in value. Real-time valuation and fluctuating accounts, like money market funds, are now conceivable in a way they were not when banking developed.
Just think about the differences between the impact of a hypothetical failure of a major clearing bank versus, for example, the failure of Amazon. Losses can easily be allocated in an orderly way and the world moves on.
A regulatory regime should be developed which encourages new entrants, controls the extent to which existing banks buy up new technologies and promotes low leverage as a feature.
This will, needless to say, face the same political hurdles that reform of the existing system faces, but the potential prize is much larger.
Regulation of the existing financial system may or may not ultimately work and definitely will face political hurdles.
If we can allow fintech startups to establish themselves alongside the existing banks and compete but not be coopted, the old flawed system will gradually wither and be supplanted by a more efficient, cheaper alternative.
(Editing by James Dalgleish)