LO 78.3: Examine the implications for financial stability in the event that FinTech credit grows to account for a significant share of overall credit.
Benefits
The growth of FinTech credit could result in greater financial inclusion. There are two key underlying points here: (1) investing in FinTech loans could diversify an investment portfolio, and (2) borrowers such as self-employed individuals or small businesses, who have historically been restricted in the amount of financing obtained from traditional banks, may now have access to sufficient capital to grow their businesses.
With all credit services being transacted electronically rather than with paper and the traditional branch banking, FinTech could bring out lower transaction costs that will benefit borrowers in the form of lower financing costs and benefit lenders in the form of higher risk-adjusted returns.
Additionally, because the use of FinTech could result in lower transaction costs and greater convenience for customers, it may incentivize traditional banks to compete more directly by innovating (i.e., establish or acquire FinTech platforms) and/or operating more efficiently (i.e., discontinuing outdated IT systems and adopting newer online IT systems). Another possibility is for banks to cooperate with FinTech platforms by establishing partnership agreements to potentially improve risk analysis or target certain underserviced areas in the market (i.e., self-employed individuals), for example.
FinTech credit may offer newer and a greater variety of lending options (beyond those of traditional banking), some of which may be more appropriate and tailored to the needs of certain borrowers.
The emergence of FinTech as a major player would reduce the level of credit situated in the banking sector. It would serve as a backup source of credit in the economy. For example, if there are negative effects that are specific only to the banking sector (i.e., unsystematic risks) that significantly reduce its ability to lend during an economic crisis, then FinTech could potentially come to the rescue.
Assuming that FinTech platforms and traditional banks remain relatively separate in their operations, it should shield the FinTech industry from risks specific to banks. However, some banks are starting to provide operational, loan origination, and referral services to FinTech platforms, which increases their dependence on banks and may make the FinTech industry more vulnerable to the same risks as banks.
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Unlike traditional banks, the FinTech industry is not exposed to maturity mismatch with its lending so it may serve as a source of credit should the economy otherwise be subject to a major liquidity shock. FinTech platforms tend to lend almost exclusively in the domestic market so compared to banks, they will be far less impacted by international shocks.
Like traditional loans, FinTech credit loans may be securitized, which allows for active trading of the resulting securities and funding to borrowers from a wider range of investors.
Risks
With more competition in the lending market with the growth of FinTech, it may significantly cut traditional banks revenue and profits, which would lower their access to capital. It may force them to take on more risk to maintain market share or compensate for losses, which could be demonstrated by weaker overall lending standards (in well-developed credit markets), for example.
Banks may be taking on incremental operational and reputational risk by working with FinTech platforms, using electronic credit models, and outsourcing IT to third-parties. The operational risk is already there for many banks but would be exacerbated as a result of FinTech. Some banks may be involved in loan origination for FinTech platforms and then involved in subsequent FinTech loan sales to investors, all of which would be largely unregulated. Should borrowers or investors suffer significant losses due to those transactions, the banks could suffer from reputation risk for being viewed as operating outside of proper credit regulation.
The growth of FinTech may also promote procyclical credit provisions. It would manifest itself in more credit being available (i.e., weaker lending standards) when it is needed less in an economic upturn, but less credit being available when it is needed more in a downturn.
Should there be a reduction in FinTech lending, there is the issue of replacing the credit within the FinTech sector or through traditional banks. Regarding the FinTech sector, FinTech credit tends to be very concentrated within domestic markets so it would likely be challenging to find replacement credit on a timely basis. Regarding traditional banks, borrowers that are likely to access FinTech are often those who would not normally be able to obtain sufficient credit through traditional banks (i.e., small business owners or self- employed individuals) so it is not likely that they will be able to find replacement credit outside of FinTech.
The nature of FinTech credit would make it more difficult for regulators to properly monitor activities given the likely lack of reporting requirements and supervision. Because FinTechs activities may largely be unregulated, government policy actions related to strengthening the credit industry during an economic downturn, for example, may be ineffective. FinTech lenders would not be able to take advantage of public safety measures such as emergency liquidity (from the central bank) that would be available to traditional banks.
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With securitization, the dependency between FinTech and the rest of the financial markets increases, thereby reducing FinTechs protection from risks faced in the general financial markets (and vice versa). In addition, the repackaging of FinTech loans could make the financial markets even less transparent from both an investing and a regulatory perspective.
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Ke y Co n c e pt s
LO 78.1 The FinTech industry may develop due to the following supply reasons:
FinTech lenders are likely to go further beyond conventional lenders in their use of technology, ultimately resulting in stronger client service.
The use of an online business model for FinTech platforms typically has small upfront
costs. FinTech lenders may be able to operate in very much the same way as conventional lenders, yet avoid their large fixed costs as well as the regulatory constraints. FinTech lenders may benefit from some market opportunities left untapped by traditional lenders and potential tax and regulatory incentives.
The FinTech industry may develop due to the following demand reasons: Greater use of online services by many younger customers and those in certain emerging
markets.
Loss of trust in traditional lenders in the aftermath of their failures to provide credit to
borrowers during the financial crisis. FinTech loans may be appealing to investors who view FinTech lending as investing in an alternative asset class that may provide higher returns and lower risk. Possible impediments to development of the FinTech industry include: Traditional banks have been in the online banking world for many years and some
customers may not be willing to switch to an unknown digital lender.
Considerable uncertainty exists as to whether emerging FinTech lenders would survive
an economic downturn.
Regulatory requirements could severely limit the growth of FinTech in jurisdictions
where the licensing requirements are overly onerous or where interest rate limits apply.
LO 78.2 Traditional P2P lending platforms establish an online presence whereby borrowers and lenders may interact directly with each other.
The potential borrower makes an initial loan application on the online platform by providing the required information, which is reviewed and approved by the platform. From there, only the approved applications will go into the pool from which potential lenders may select the loan(s) they want. At that point, the loan contracts are established directly between the borrower and lender. From the borrower and/or lender, the platform operator takes fees such as for loan setup or loan repayments.
In general, borrowers establish the maximum rate for loans and lenders establish the minimum rate. The platform operator uses the information together with the loan amounts to match borrowers and lenders.
The majority of platforms allow for partial or full pre-payment of loans on a penalty-free basis.
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Should a borrower be potentially delinquent on a loan; at the point of delinquency, the platform may start charging additional fees to the lender. Some platforms have methods to deal with credit losses, which could be in the form of insurance or guarantee/provision funds that provide partial or full coverage of the loan portfolio.
Should lenders wish to exit their loan investments, some jurisdictions allow those creditors to do so by paying fees to the platform and on the condition that other lenders will take over those loans.
The notary model involves a partnership agreement between a fronting bank and the lending platform because the former actually originates the loans. The loans are then sold or assigned by the fronting bank directly to interested lenders or through a platform subsidiary (securitization) to institutional investors.
With the guaranteed return model, the lending platform guarantees the principal and/or interest on the loans.
The balance sheet model involves the lending platform operating much the same way as a non-bank lender; it requires capital (i.e., debt, equity, securitization) to originate loans but it also retains the loan receivables as assets.
Invoice trading platforms providing recourse factoring have become popular because they include perks such as automatic invoice processing, less delay between invoice processing and cash payment, and a lower level of business activity required.
Microfinancial benefits include: Lower financing costs for borrowers, in theory, through the extensive use of
computerization and automation. Although there seems to be a wide dispersion of interest rates.
Higher returns for lenders, in theory, because quantifying the benefit is difficult. User convenience due to the computerized environment and the very streamlined
process that may lead to extremely timely loan offers.
Assisting existing borrowers by offering additional financing when needed (i.e., invoice trading platforms), addressing the needs of forgotten borrowers such as self-employed individuals and small business owners, and reaching out to new borrowers in emerging market economies.
Microfinancial risks include: A few platforms take on leverage risk in that they use internal resources to fund loans or provide return guarantees. Some platforms are now providing investors with the ability to withdraw amounts early; there is the risk that investors may expect liquidity even though it is clearly stated that it is not guaranteed.
Operational risks such as cyber risks given the extensive use of electronic data, service
disruption risks relating to an external provider of data storage, and fraud risk (i.e., money laundering, Ponzi schemes). Potentially lower credit risk assessment quality. Many FinTech platforms likely do not have detailed borrower information such as income, assets, and liabilities, and some FinTech platforms use exclusively hard data sources and do not consider soft credit risk factors.
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Inappropriate business model incentives that may cause more loans to be granted or more high-risk loans to be granted to maximize fees earned.
Difficulty in attracting new investors for consumer loans if investor confidence in the
platforms is low due to reasons such as low returns, higher default rates, and inability to withdraw investments early.
Low barriers to entry reduce the opportunities for any individual platform to be
profitable. In addition, there is always the threat of traditional banks beginning to aggressively compete with the online platforms. Platforms have generally incurred consistent losses each year, which calls into question whether they can continue to operate in the long-term. The result may be that platforms will have to alter their operations by originating and funding their own loans, providing loan guarantees, or using leverage, for example. In such cases, the platforms may become inherently more risky.
LO 78.3 With the potential growth of FinTech credit, some of the benefits include:
Lowering transaction costs.
Introducing greater financial inclusion.
Incentivizing traditional banks to compete more directly by innovating and/or operating more efficiently. Providing newer and a greater variety of lending options.
Reducing the level of credit concentrated in the banking sector.
Serving as a source of credit should the economy be subject to a major liquidity shock. They are also minimally impacted by international shocks.
At the same time, some of the risks include: The increased competition may significantly cut traditional banks revenue and profits,
which may force them to take on more risk to compensate and ultimately lead to weaker lending standards.
Banks may be taking on incremental operational and reputational risk by working with FinTech platforms, using electronic credit models, and outsourcing IT to third-parties.
The growth of FinTech may also promote procyclical credit provisions.
Should there be a reduction in FinTech lending, because FinTech credit tends to be very concentrated within domestic markets, it would likely be challenging to find replacement credit on a timely basis.
The nature of FinTech credit would make it more difficult for regulators to properly
monitor activities. The lack of regulation means that government policy actions related to strengthening the credit industry during an economic downturn would not be effective or public safety measures such as emergency liquidity would not be available.
With securitization, the dependency between FinTech and the rest of the financial
markets increases, thereby reducing FinTechs protection from risks faced in the general financial markets (and vice versa).
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Co n c e pt Ch e c k e r s
1.
2.
3.
4.
3.
For FinTech platforms, the extent to which the underlying financial activity may be standardized is most likely limited by which of the following factors? A. Legal framework. B. High upfront costs. C. Customer reluctance. D. Potential competition from banks.
Which of the following FinTech credit platforms is characterized by matching borrowers with lenders with the loan being originated by a partnering bank? A. Notary model. B. Balance sheet model. C. Guaranteed return model. D. Traditional P2P lending model.
In which country is the notary model least likely to be utilized by FinTech lending platforms? A. Korea. B. Canada. C. Germany. D. United States.
Compared to traditional banks, FinTech credit platforms are likely more vulnerable to which of the following risks? A. Fraud risk. B. Cyber risk. C. Liquidity risk. D. Third-party service provider risk.
For an economy with a well-developed credit market, which of the following points is a benefit resulting from the growth of FinTech credit platforms? A. Greater access to credit. B. Procyclical credit provision. C. Diversify sources of funding. D. Greater concentration of credit in one sector.
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Co n c e pt Ch e c k e r An s w e r s
1. A Examples of standardized activities include digital identification and standardized electronic contracts. The extent of standardization within a jurisdiction is primarily limited by the legal framework.
FinTech platforms typically have low upfront costs. The nature of FinTech and its digital innovations is more likely to result in customer acceptance of standardization. Potential competition from banks is not a relevant factor in determining the extent of standardization.
2. A The notary model is similar to the traditional P2P lending model in that it matches
borrowers with lenders but it requires a fronting bank to originate the loan.
3. B The notary model is the most commonly used model in Germany and Korea and it is also
common in the United States.
4. B Given that FinTech credit platforms generally rely more on new electronic processes
compared to traditional banks, the electronic processes are generally more vulnerable to cyber risk.
Fraud risk, liquidity risk, and third-party service provider risks are common to both FinTech credit platforms and traditional banks. The exposure to such risks depends on the nature of activities undertaken by each.
5. C
In diversifying the sources of funding, more alternative funding options are made available to borrowers. Some of those options may be more tailored to borrowers specific needs.
In a well-developed credit market, greater access to capital may lead to a potential decrease in lending standards. Procyclical credit provision is a risk resulting from the growth of FinTech; it manifests itself in excess credit provided in a market upturn and a deficiency in credit (when it is needed most) in a market downturn. The growth of FinTech credit platforms allows a lower concentration of credit in the banking sector, which could be beneficial if the banking sector is subject to unsystematic risk.
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The following is a review of the Current Issues in Financial Markets principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Th e G o r d o n G e k k o Ef f e c t : Th e Ro l e o f Cu l t u r e i n t h e Fi n a n c i a l In d u s t r y
Topic 79
Ex a m Fo c u s
In this topic, we describe corporate culture and the role it plays in financial malfeasance and misdeeds, drawing on an analogy to the movie Wall Street and the Gordon Gekko character played by Michael Douglas. This topic is descriptive, explaining both the role culture has played in the downfalls of several firms, as well as measures society (and regulators) should take to identify and change corporate cultures. It is not as simple as corporate culture alone though, as the environment also influences human behavior. Both corporate culture and the environment can lead to excessive risk taking and, at the extreme, fraudulent behavior. For the exam, know how culture is influenced not only from top managers, but also from the types of workers who are hired (i.e., top down versus bottom up). Also, understand how culture can lead to excessive risk taking. In addition, be able to describe the way culture influenced outcomes for firms such as Lehman Brothers and AIG. The financial crisis of 20072009 shined a light on corporate culture as firms such as Lehman Brothers failed, due in part to a corporate culture that would not acknowledge failings either to outsiders or to those inside the firm who might have objected.
In f l u e n c in g C o r po r a t e C u l t u r e