By Maria Paula Bertran, Professor of Law, University of São Paulo, and Davi Ferreira Veronese, Master Student in Political Science, University of São Paulo
Innovation brings hope for better services and products in different areas. In the financial market, innovation executed by financial technology, the origin of the portmanteau fintech, brings the expectation of lower entry barriers and more competition. In general, fintech firms have fostered change in the global banking sector. However, these changes do not necessarily mean losses for traditional banks. The banking sector’s innovation seeds face the challenge of blossoming in the arid soil of highly concentrated markets: Will fintechs flower into a new spring, or should we expect old species to suffocate the sprouts?
Financial technology allows the entrance of new actors into the banking market but also creates fresh opportunities for incumbent banks. Established banks rely on technology to access new and current clients more intimately (using a cell phone instead of visiting a bank branch, for instance). Traditional banks offer their clients both familiar and state-of-the-art products and services through the technological initiatives in their existing brands and the capabilities of the fintech companies they control, acquire or partner with.
It is quite common for economic conglomerates to keep different companies and brands. Even if the overarching business of a specific conglomerate is to sell bread, for example, marketing strategies may create a range of products to reach a segment of consumers who suddenly can’t live without natural fermentation or carrot flavor. Bank conglomerates, for good or for ill, can use the facilities involved in creating fintechs to deepen the consumer’s need for colored credit cards, ignite endless schemes of cashback or upgrade the universe of airline miles.
However, the low entry barriers, natural advantages of being an established player and possibilities of creating new strategies without compromising the image of the main brand can also cause bank conglomerates to design a range of fintechs for undoubtedly poor “achievements”. Excluding the need to protect the company’s image, what would stop a traditional bank from developing new financial company brands that feed the credit lottery for poor people with bad credit scores (who agree to provide private information and propagate the use of invasive algorithms), promote aggressive offers (sometimes for vulnerable people, such as the elderly) or support predatory lending?
Recently, there has been much discussion about the emergence of technology-intensive companies that innovate in the financial market. Many observers have emphasized the disruptive potential of financial-technology companies. However, less attention has been paid to the relevant interactions and cooperation mechanisms between these fintech companies and traditional players, such as large banks, in the financial market.
Indeed, the intensive use of technology is capable of increasing the speed of transactions, reducing bureaucratic procedures and enabling greater flexibility and personalization of financial products. Some analysts hope these characteristics will allow fintech companies to operate in the latest market niches and benefit consumers, especially in concentrated credit markets like Brazil’s. Nevertheless, this is only a partial picture of fintechs’ emergence and consequences. A comprehensive analysis should consider the potential opportunities financial technology creates for large financial groups and the relationships between new entrants and large incumbent banks. (In a 2016 article, Andreas R. Dombret explained that ‘IT-based innovations promise more than a zero-sum game’ among entrants and traditional players because traditional banks also adapt to profit from the new channels created by technology1.)
Let’s take the Brazilian context as an example.
In 2018, the Central Bank of Brazil (Banco Central do Brasil, or BCB) created the Financial and Technological Innovations Lab (Lift), an institutional arrangement to foster financial innovation. In addition, also in 2018, the Central Bank enacted Resolution No. 4,656, which aims to confront—at least partially—the regulatory challenges that arise from fintech companies. This initiative consists of harmonizing innovation, competition and safety. On the one hand, unnecessary entry barriers must be avoided so that these new and considerably smaller actors have chances to increase innovation and competition in the sector. On the other hand, the regulator should not ignore relevant concerns about consumer safety and financial stability. (Consumer safety has become a growing concern related to digital financial services, which often generate more complex environments. In 2022, the World Bank published a technical note analyzing manifestations of consumer risks across four key fintech products—digital microcredit, P2PL [peer-to-peer lending], investment-based crowdfunding and e-money—and the regulatory approaches to dealing with them2.)
Despite these challenges, it cannot be denied that improving financial technology has been seen as a development target, although not the ultimate one.
However, the hope that fintech companies will cause substantial and positive changes in credit markets has led some observers to overlook how the traditional players will adapt to these changes, mimicking strategies usually associated with the so-called disruptive entrants when creating digital and personalized services. Furthermore, it is common to see a heterogeneous context that combines both the competition and cooperation of old and new players.
A good example is Digio Bank, a digital bank controlled by two of the largest financial conglomerates in Brazil: Bank of Brazil (Banco do Brasil) and Banco Bradesco.
Digio was designed to associate the solidity of the older, larger players with the agility of the newer, nimbler ones. It has all the characteristics that are expected of a financial-technology company. But its interaction with traditional banks involves more cooperation than competition. More interestingly, our recent study showed that between April 2015 and April 2020, Digio Bank charged higher interest rates than Bank of Brazil and Bradesco most of the time when comparing the three analyzed types of credit: credit-card revolving credit, non-payroll loans and payroll loans for retirees and pensioners of the National Institute of Social Security of Brazil (Brazil-Instituto Nacional de Seguro Social, or INSS)3. Although this study has no generalizing scope (it also has the limitation of not examining the characteristics of the borrowers because of the absence of data), it reveals that the entrance of fintech companies into the market may be much more complex than often believed and involves interactions that are not fully understood.
In addition, a recent study from the US market concluded that the terms offered by fintech lenders are different for similar borrowers, often involving larger average loan sizes and higher interest rates. Moreover, the research showed that fintech loans are significantly more likely to end in default. This could be caused by adverse selection, as traditional lenders would reject some higher-risk borrowers who manage to obtain loans from fintech lenders. But the study also indicates that borrowers obtain credit from fintech companies during periods in their lives when they need it most—for instance, when they lose their jobs4.
These results suggest that the insertion of fintech lenders in the credit market tends to produce changes, but these changes are not necessarily intuitive and may be much broader than simple increases in competition. They also indicate that the regulatory challenges are substantial and should consider both the complexities of financial markets and the rights and interests of consumers.
Worldwide, financial literacy for consumers is the mainstream answer to attenuating the problems created by deleterious credit for the poorest of households. Although more education is always appropriate to deal with economic affairs, allocating most of the efforts toward providing a “better” market for individuals makes the perfect recipe for ineffective results. Individuals have irrational psychological and cultural fragilities that are likely to make them worse barriers to risks than incumbent banks (and their fintech brands), which have the support of data, economic knowledge and non-biased perceptions about their futures.
The unprecedented importance of financial technology for new players and traditional banks fosters the promotion of equitable credit and fair financial products as a new frontier for social governance. In this sense, debt and poverty worsened by irresponsible credit should be a problem to be solved not only by borrowers and financial-literacy efforts but also by banks, lenders and government regulators.
In the not-very-distant past, international companies used bribery in developing countries without foreseeing any consequences. The origins of furniture wood were not a concern for producers or consumers. Equality of opportunities related to gender and race was not an issue. The new perception of problems concerning corruption, the environment and career opportunities exemplifies how it was possible to revive some of the problems of failed regulations and underestimate the repercussions of free will in several areas. The spread of fintechs is the perfect opportunity to identify the need for fair dealings in banking services as the next frontier for social governance.
1 Banque de France/Financial Stability Review: “Beyond technology–adequate regulation and oversight in the age of fintechs,” Andreas R. Dombret, April 2016, Financial Stability in the Digital Era, Volume 20, Pages 77-83.
2 World Bank Group: “Financial Consumer Protection and Fintech: An Overview of New Manifestations of Consumer Risks and Emerging Regulatory Approaches,” 2022, Washington, DC.
3 Revista Direito GV: “Fintechs and Traditional Banks: Regulation, Competition, and Cooperation in Brazil,” Davi Ferreira Veronese and Maria Paula Bertran, 2023, Volume 44 (to come).
4 National Bureau of Economic Research (NBER): “Fintech Borrowers: Lax-Screening or Cream-Skimming?” Marco Di Maggio and Vincent Yao, October 2020, Working Paper 28021.