In this chapter we explore how digital banking could replace the traditional banking system and will examine some of the most significant recent financial innovations, such as microcredit, crowd lending, peer-to-peer lending, and crowdfunding. We will also offer a broad and analytical view of the “uberization” of retail banking; specifically, how the evolution of banking has affected the costs and risks associated with financial transactions, and how fintech has synergistically boosted economic productivity within the finance industry and beyond.
In the West, three “industrial revolutions” paved the way for our present era—an era of digital, Internet revolution. A brief history of these three socioeconomic disruptions can help us comprehend the ways in which fintech innovation is situated in history, and how fintech might impact the future.
The first industrial revolution occurred in western European economies during the eighteenth century. Abundant and cheap coal, combined with a supportive institutional environment, were critical conditions for this era’s mechanization advancements. These conditions, together with financial reforms, led to the emergence of large factories and corporations, such as the Marshall Mill in Leeds, and the stock market that financed companies.
During the second industrial revolution, in the late nineteenth and early twentieth centuries, the United States led the way in mass production, which was energized by the invention of the combustion engine, electricity, the telegraph, and production assembly lines. World-renowned companies such as Ford, Goodyear, ExxonMobil, and Edison International emerged. During this period, railroads in the United States sparked an unprecedented social upheaval. They fueled a consumer economy and facilitated a massive population movement from rural areas into increasingly crowded cities. They connected the country from coast to coast and made the transportation of people and freight easier and cheaper. Railroads also reshaped the agricultural system, and eventually farmers found other work.
In the long run, however, the explosive growth of the railroad industry also yielded considerable new opportunities. Waves of new, well-paying jobs emerged for an expanding working class and spurred the rapid growth of other industrial sectors. For instance, the metallurgy industry boomed to meet the demand for iron rails and coal-powered steam locomotives. The coal mining industry grew exponentially. The labor demand for laying thousands of miles of track and staffing trains, depots, and company offices also grew rapidly.
The third industrial revolution, which was characterized by automation and computerization, began in the mid-twentieth century. Deep capital markets and intellectual property rights, established by the World Intellectual Property Organization in the 1960s, facilitated the creation and global expansion of firms like IBM, Microsoft, Apple, and Google.
After the train and the telephone, perhaps the most powerful innovation to disrupt and improve our modern world has been the Internet. In little more than a generation it has completely reshaped or even replaced most traditional communication platforms, including the telephone, radio, television, the print media and especially paper mail and the conventional postal system. The Internet has given rise to a set of entirely new communication services, such as blogging, social networks, and video-streaming websites. Online shopping has grown exponentially for major retailers, small businesses, and entrepreneurs. This has enabled firms to extend beyond their “brick and mortar” presence to serve a larger, often global market, and even to sell goods and services entirely online. More recently, online marketplaces and peer-to-peer platforms have disintermediated entire industries, matching buyers with sellers on a massive scale.
This fourth industrial revolution, which is still under way, has enabled the rise of gigantic transformational companies like Google, Amazon, Facebook, Apple, and Alibaba. While these examples are the largest and best known of the new tech companies, CBInsights reports that over 700 privately held Internet “unicorns” valued at $1 billion or more have emerged as of July 2021.
Today’s digital revolution is driven by advances in data collection and management, and artificial intelligence (AI). At the heart of the digital revolution are new financial technologies. Also known as fintech, these technologies are profoundly transforming the way businesses, governments, and individuals interact economically.1
With that broad historical context in mind, it is important to focus on how the 2007–2008 financial crisis increased fintech’s influence in the global economy. That financial crisis transformed the banking sector and shook the foundations of the financial industry. The market capitalization of several large financial institutions and insurance companies plummeted, forcing them to merge or go bankrupt. Governments responded to the crisis by imposing new banking regulations, and banks responded with innovations to serve consumers. As a result, the crisis upended old ways of organizing and operating banks.
Seeing cracks in the traditional system, some investors turned to new financial technology companies. We will further address the reasons they pursued fintech solutions later in this chapter. For now, it is important to say that the 2008 pivot toward fintech has since propelled another wave of disruptive fintech innovations, such as Stripe (online payments), SoFi (a lending platform), and Alipay (online payments in China). In part because of fintech, the financial industry has discovered new vistas.
The swell of economic turmoil, new regulations, and innovation during and after the crisis has perhaps revealed a deeper transition in the financial sector. That transition is driven by unprecedented industry innovations, including the rise of digital payments, cryptocurrencies, and alternative forms of banking—all of which pose systemic risks to the financial sector.
Prior to the financial crisis, the markets peaked in the early 2000s. The five major investment banks—Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns—also experienced significant market cap increase. These investment banks and others were involved in “securitizing” mortgages. They pooled mortgages distinguished by default risk into tranches and then traded these securities to other investors. Large insurance companies also participated in this kind of lending practice. The underlying justification was the belief that pooling high-risk mortgages into one asset would reduce risk and therefore make the asset more valuable. In retrospect, it is hard to comprehend how this could have occurred, but few believed that all the underlying mortgages could default. Tragically, the unfathomable occurred. The countless assets contingent on those mortgages became worthless.
The mortgages underlying those securities did, in fact, collapse in 2007 when house prices stabilized. Because the mortgage-backed securities constituted a significant portion of many banks’ balance sheets, the systemic consequences were far reaching. In 2008, Bear Stearns and Lehman Brothers, two of the five Bulge Bracket Banks, went bankrupt, as did American International Group (AIG), the largest insurance company in the United States. On the weekend when Bear Stearns went bankrupt, Bank of America acquired Merrill Lynch. Within a month, Goldman Sachs and Morgan Stanley became regulated commercial banks. By November 2008 none of the Bulge Bracket investment banks remained. The world experienced the largest economic downturn since the Great Depression.
One root of the problem was that lenders granted mortgages to people who had little or no means of paying the mortgage, especially if housing prices fell. As house prices steadily climbed in the early 2000s, banks lowered their lending standards. Some waived income verifications or down payments. NINJA loans (no job, no income, no assets) became common. Banks, investment banks, and rating agencies all accepted large fees to create securitizations. The repurchase agreement “repo” market, traditionally based on US Treasuries, grew so fast that it began to run out of securities. Public policy encouraged, even demanded, lenders to grant more loans to lower-income borrowers. These risky mortgages were employed to “support” the value of the tranches of securities.
In retrospect, we can identify three main contributing factors behind the 2008 crisis: falling capital risk, rising repo haircuts, and increased counterparty risk. As people in the financial sector saw danger ahead, the market responded with four mechanisms by which the global crisis unfolded.
The first mechanism relates to liquidity spirals. As the assets on banks’ balance sheets decreased, lenders restricted credit. This, in turn, pushed asset prices down and caused a downward spiral. Second, risk-averse banks began to increase reserves and restrict lending access to capital markets. Third, Lehman Brothers and Bear Stearns faced “bank runs” as investors rapidly withdrew massive amounts of capital. That resulted in a multiplier effect that shook public confidence in the overall banking system. Finally, concerns over counterparty risk—defined as the likelihood or probability that one of those involved in a transaction might default on its contractual obligation—led to systemic gridlock. The ensuing panic had consequences beyond subprime bonds. It created “genuine fears about the location of subprime risk concentrations among counterparties.”2
In response to the financial crisis, governments chose to provide bailouts to financial institutions they deemed “too big to fail.” They believed that these bailouts would prevent further deterioration of the entire financial system and spare citizens from greater harm. In the United States, bailouts were offered to AIG, Fannie Mae, and Freddie Mac. The US government also created the Troubled Asset Relief Program (TARP) and passed the 2008 Emergency Economic Stability Act to purchase $700 billion of impaired bank assets. Through one new program or another, the Federal Reserve eventually supported nearly every major financial institution. Even foreign banks received indirect bailouts. The Federal Reserve rapidly went from a simple balance sheet and a very conservative policy to unprecedented interventionist measures. The Fed’s balance sheet also grew 500 percent to $4.5 trillion. The balance sheet, at the time of this writing, remains close to this level.
The government then increased spending, as part of its expansionary fiscal policy, to stimulate a GDP rebound. It also enacted further policy measures to prevent a future crisis. In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Among other things, this act gave the Financial Stability Oversight Council the ability to break up banks that contributed to systemic financial risk. The act also stipulated the Volcker Rule, which restricted a bank’s ability to engage in speculative trading.
All of this had a profound impact on the financial industry. Banks never regained their former power.
As a result of banking and financial services having been debilitated by the financial crisis, many new fintech players saw an opportunity to disrupt the financial sector. These firms have used digital technology to improve efficiency and reduce costs. In the last ten years, private investment in global fintech has multiplied (Figure 2.1). The top fintech investment destinations are led by China and the United States.
Investment in Asian fintech companies grew steadily to a record $8.6 billion in 2016. Within that context, fintech investors have focused mostly on China, in part because of China’s influence in all of Asia. China has a chance to lead in AI because it adopts new technologies quickly;3 traditional financing and investment opportunities are rather limited, both in China and abroad, which opens the door for fintech companies; a steady increase in housing prices has made investment in traditional risk assets riskier; and Chinese firms face limitations when investing overseas.4
Interestingly, more than half of China’s total fintech investment so far has come from a single deal: the $4.5 billion funding round of Ant Financial (Alibaba’s payment and lending division). Thus, while most countries have experienced investment declines, China’s fintech investment doubled in 2016, earning them a central place in the fintech market.
Data sources: CBInsights, “The State of Fintech Q2 2020 Report: Investors and Sector Trends to Watch,” 2020, https://
Note: From 2010 to 2015, we used the data representing “deal value.”
FIGURE 2.1 Global investment activity in global fintech companies
If we look beyond questions of geography, we see that fintech companies have been targeting four key technological areas: artificial intelligence, cybersecurity, blockchain, and disruptive insurance technologies (insurtech).
Many menial tasks performed by financial professionals will soon be handled by computer algorithms. This will likely result in lower costs, higher quality, and more diverse financial product offerings. Entrepreneurs are creating new fintech companies that use machine learning and Big Data. These new online banking products include trading automation (high-frequency trading) and more efficient customer services, sometimes using robo-advisors.
AI has also exposed cybersecurity vulnerabilities, a reality that became particularly salient following the 2016 bank heist of Bangladesh’s central bank via the Swift payment system. Criminals stole $81 million, which at that time was the largest successful bank robbery in history. The financial sector’s justifiable fear of losses has continued to drive increased investment in cybersecurity. In 2017, cybersecurity start-ups raised a record $7.7 billion across 552 deals, including a record of ten mega-deals worth more than $100 million. Among other deals, ForgeRock, the identity management start-up, announced an $88 million Series D investment. Cybereason, a Boston cybersecurity firm specializing in endpoint detection and response to digital security breaches, announced it had secured $100 million in funding. Signifyd, which specializes in preventing e-commerce fraud, closed a $56 million Series C investment.
Blockchain, a nascent technology, works like a digital ledger that records financial (or other types of) transactions across a decentralized, openly shared network of computers. We will address blockchain’s functions more in subsequent chapters. For now, it is important to know that opinions about blockchain are mixed. In 2016 the entire financial industry seemed euphoric about blockchain technology, but the hype has been increasingly replaced by a cautious and studious approach. Most large financial groups believe blockchain has the potential to revolutionize the financial industry. A few central banks have considered creating digital currencies based on blockchain technology. Several banks—including HSBC, Deutsche Bank, Rabobank, and Société Générale—have agreed to collaboratively develop blockchain technology for financial trading. One of the most successful initial digital coin offerings was Filecoin, a blockchain-based cryptocurrency and digital payment system located in the United States. It raised $257 million in 2017. Tezos, a new blockchain currency aiming to be more reliable than Bitcoin or Ethereum, raised $232 million in 2017. Sirin Labs, a Switzerland-based company that plans to build a blockchain-based smartphone, raised $157 million in 2017.5
The term insurtech, denoting the combination of insurance and technology, designates all services and innovations that combine digital and insurance activity. Insurtech firms aim to serve the B2C segment (individuals, companies, professionals) and B2B (insurers, insurer banks, mutual, social protection groups). Insurance companies rely on digital technologies to introduce innovations that drive the emergence of new economic models, new processes, and new products. These models and products have the capacity to modify the behavior of all market players, policyholders, insurance intermediaries, insurers, and reinsurers—a profound transformation.
Digital disruption in the insurance sector lags behind the changes in other financial sectors. However, start-ups like so-sure, Friendsurance, Lemonade, Guevara, and Brolly have emerged with transformative sectoral models. Other companies have focused on operational efficiencies and cost-effectiveness. Further investment in insurtech is expected to continue as start-ups identify new needs and solutions.
We mentioned above that China has gained a leading role in developing and implementing fintech innovations. So next we look more closely at China’s influence.
The United States and China together host more than 80 percent of the world’s unicorns. Late in 2019, China surpassed the United States to become the world’s biggest hub for unicorns, becoming the fintech equivalent of Silicon Valley. The tech firms Xiaomi, Baidu, Didi Chuxing, Meituan, and Toutiao are all headquartered in Beijing. China’s e-commerce giant, Alibaba, is based in Hangzhou. Shenzhen is home to Tencent, a multinational conglomerate that is investing heavily in AI. Despite its relative youth, Tencent already has market capitalization higher than General Electric, and Baidu is larger than General Motors.6 The two largest unicorns are Ant Financial, valued at about $200 billion, and Lu.com.
China’s meteoric economic catch-up is often attributed to its ability to leapfrog innovative technologies, but this explanation does not account for China’s impressive progress in finance and technology. Important cultural factors seem to be driving China’s recent expansion. These include its ability to quickly adopt new technologies, its massive centralized business platforms, and its relatively weak privacy norms. Ironically, internal investment is aided because it is so difficult for Chinese firms to make international investments.
China’s ability to rapidly adopt new technologies may secure its spot as the global AI frontrunner. Just as millions of Indians skipped over landlines and flip phones to immediately adopt smartphones, Chinese consumers are bypassing older technologies and jumping directly to new technologies. For example, Chinese shoppers have skipped credit cards to embrace e-payment platforms. Although Apple Pay has not yet gained full momentum in the United States, its Chinese equivalent, Tencent, facilitates more than 600 million cashless transactions every month.
Tencent and other Chinese firms’ massive, centralized platforms give them an edge in AI research and development. They have huge stores of data to train machine-learning algorithms. These platforms enjoy near-monopolistic power that will help China monetize applications in the future. Tencent’s many services include social media, music, e-commerce, mobile games, Internet services, payment systems, smartphones, and multiplayer online games—all of which are among the world’s biggest and most successful in their respective categories. Offerings in China include the well-known instant messenger Tencent QQ and one of the world’s largest web portals, QQ.com. Its mobile chat service, WeChat, has helped bolster Tencent’s continued expansion into smartphone services and has been credited as one of the world’s most powerful apps. It also owns most of China’s music services (Tencent Music Entertainment), which has more than 700 million active users and 120 million paying subscribers, making it one of the world’s largest and most profitable music services.
Moreover, Chinese firms benefit because Chinese citizens are not very concerned about privacy. In the West, privacy is regarded as a personal right, which restricts the ability of companies to collect consumer information. By contrast, in China privacy is generally associated with being suspicious or secretive. People assume that an honest person has nothing to hide from the public domain. Thus, Chinese consumers are often willing to give up their data. While India is adopting a “right to information” and the European Union has codified a “right to be forgotten,” China allows its technology firms to collect a wide range of user data for many purposes, such as for credit-scoring systems like Alibaba’s Sesame Credit.
Still, limited financing and investment opportunities—at home and abroad—could slow China’s momentum in AI and related fields. Chinese savers have little incentive to park money in Chinese banks because the inflation rate is higher than the real rate of return on deposits. This, coupled with China’s high consumer-price volatility, feeds resistance to locking up savings. There is little reason to invest in the Shanghai Corporate Index because economic growth rates outpace stock-market performance. Investors still have the market turbulence of 2015 fresh in their minds. They keenly recall how this turbulence led to government intervention, sharply falling prices, and several trading stagnations.
As briefly mentioned earlier, it is difficult for Chinese firms to make international investments. In addition to the Chinese government’s controls on capital, the US government has been considering tighter restrictions on Chinese investments in strategically important sectors, particularly those relating to AI and machine learning. In fact, US regulators recently blocked Alibaba’s attempt to acquire MoneyGram, citing national security concerns.
The prospect of a China-led fintech and artificial intelligence revolution poses both opportunities and challenges. From the perspective of the West, these advancements could allow for more collaboration with one of the world’s most dynamic economies. At the same time, China’s expansion will likely give rise to new clashes between Chinese firms and foreign regulators.
In light of the fintech innovations mentioned above, and geopolitical concerns, it’s reasonable to ask what bank branches will look like in the future. It is hard to imagine a city center without bank branches or insurance offices, but brick-and-mortar branches may soon be replaced by digital equivalents. This section explores how “platform” banking innovations are reshaping the retail banking landscape and leading to the dominance of online and mobile financial services.
Online banking begins with consumer trust. There would have never been an e-commerce boom without consumer faith in online payment security. Early in the rise of e-commerce, consumers may have been comfortable making small online purchases of things like books. But before long, people began to make online purchases across many product categories. They gradually became accustomed to booking hotels and plane tickets on the Internet. People are now so confident in the reliability of online purchases that everything from house sharing to ride hailing can be done with handheld devices. All payments are seamlessly integrated between banks and companies.
Online banking had its precursors. Citibank, Chase, Chemical, and Manufacturer Hanover attempted to offer home banking through videotext (Minitel in France) as early as the 1980s. However, this service was relatively unsuccessful.
In the late 1990s, big banks recognized the important role the Internet would play in the future of their businesses. By 2000, after a few significant mergers and acquisitions, 80 percent of banks offered e-banking. Bank executives saw the lucrative potential of the new online interface and realized it would help with everything from cross-selling to consumer retention.
However, consumers were still reluctant to transact online in the 1990s and, as a result, initial growth was slow. Banks did not achieve their first million digital consumers until 2001. It took Bank of America an additional ten years to reach two million consumers. It’s likely that the parallel growth of the e-commerce sector—such as ordering products from Amazon or eBay—increased consumer willingness to adopt online banking. In the early 2000s, entrepreneurs launched the following new online banks with no physical presence: ING Direct (Netherlands), First Direct (UK), PC Financial (Canada), and E*TRADE Bank (United States), among others.
However, as is often the case, new opportunities presented new threats. Inevitably, hackers targeted the banking sector. The first techniques developed to swindle consumers out of their money included phishing, a method by which hackers created fraudulent electronic exchanges to “bait” consumers. Another approach was pharming, in which hackers created fake websites that looked authentic to trick consumers into sharing sensitive information, such as credit card details. Hackers also commonly manipulated signature banking software to substituted legitimate transactions shown on the consumer’s screen with a clandestine, behind-the-scenes transaction that siphoned off money. These were the online equivalents of a Trojan horse, in this case a horse that modified the payment destination and payment amount.
Unsurprisingly, banks quickly developed effective countermeasures and improved the security of their authentication tools, such as digital certificates, SMS payment confirmations, and unique code generators. Heightened security renewed and increased consumer faith in the online banking industry.
The next revolution in online banking germinated in 2007 when Apple launched the iPhone. Online banking gradually migrated from desktop to mobile. By 2009, fifty-four million US households accessed bank accounts with phones. A 2010 survey of consumer billing and payment habits conducted by Fiserv, a financial services technology company, found that consumers were paying more bills with mobile devices and making more person-to-person payments with digital wallets. Today mobile banking is common practice. People automatically assume that every bank has an easily downloadable app that is readily accessible at the touch of a button.
A 2016 study by Bankrate confirmed that with each passing year people were less likely to visit a bank branch for basic transactional services, such as deposits, withdrawals, and wire transfers. Today, local branches remain an important channel for resolving complex issues, but individuals are increasingly turning to online solutions for standard banking transactions (Figure 2.2).
What does this mean for the future of the banking industry? In 2017 the former CEO of Barclays, Anthony Jenkins, claimed that banks were facing an “Uber moment” and that pressure from new technology-based competitors would compel banks to significantly automate their businesses. He warned that the number of frequented bank branches would soon decline by as much as 50 percent.
Data source: World Bank, https://
FIGURE 2.2 Number of bank branches for United States, number per 100,000 adults, annual, not seasonally adjusted
To date, northern Europe appears to have the most advanced online banking industry. Nordic and Dutch banks have already cut their branch numbers by 50 percent. The larger and more traditional markets of Western Europe and the United States are likely to follow suit, cutting 30 percent to 50 percent of existing branches within the next decade.
All said, banks are experiencing a massive technological transformation, one that affects more than the transition away from physical bank branches. The technological innovations responsible for this overhaul will likely impact external and consumer-facing banking services, as well as internal processes.7
Next, we look at some of these technological changes and how they are reshaping financial services for the next generation.
The term Big Data broadly refers to analytical processes that identify correlations and patterns within large datasets, drawing meaningful conclusions from them. Banking is one of the most data-intensive environments there is. In the past, banks have used Big Data to conduct individualized risk assessments and to tailor consumer offerings. While Big Data solutions have been previously applied to front office operations—trading algorithms, customer service, and call centers—consumer banking data is a huge reservoir of untapped opportunities. It comes as no surprise that banks, such as JP Morgan, have set up institutions to analyze credit card payment data with the hope of gaining fresh insights about the US economy. The first retail banks to break into consumer data will have a significant competitive advantage.
Algorithms enable computers to learn, to make decisions, and to make predictions based on Big Data. Artificial intelligence (AI) has the potential to emulate the human capacity to learn from and respond to complex situations, make decisions, and initiate productive dialogues. Indeed, most investment trading is currently carried out by computers, not by the “wolves of Wall Street.” By some estimates, algorithmic and high-frequency trading accounts for over 90 percent of market volume today, compared to 1990 when it accounted for none of it. Computer algorithms monitor trades for fraudulent behavior patterns. In the future, innovations in AI could be applied to middle- and front-office functions.
The banking sector is looking toward the Internet of Things (IoT) for growth opportunities. The Internet of Things refers, in part, to the vast network of sensors embedded in everyday objects that are connected to the Internet. Thanks to the IoT, electric cars can communicate with each other. So can household appliances. Everyday gadgets can help us monitor health, which is why health and fitness features are often used on mobile devices today. Some telephones and smartwatches allow users to check heart rate, body temperature, blood pressure, ECG, blood oxygen level, respiration, and many other functions.
Although in its infancy, the integration of online banking with the IoT shows ample promise. It is not difficult to imagine a world in which all identification verification is accomplished using fingerprint and facial recognition technology, and in which transactions are executed effortlessly and seamlessly without cash or credit cards. It could be possible to pay for a meal with just a glance in the right direction or to pay for transportation with a fingerprint. Similarly, with owner permission, cars and household appliances will be able to order replacement parts when needed.
Computing enables IT resources to be centrally pooled and redeployed on demand. This means that fewer computers and chips are required to achieve the same outcome. It is no surprise that banks rely heavily on computer and IT services. The cloud enables banks to have centralized, up-to-date systems without an army of computers. The cloud also facilitates the quick deployment of new software. These advances can significantly boost cost-savings and efficiency, so long as the transition is done carefully with a mind toward data security and privacy. This is where blockchain comes in handy.
Blockchain was initially used for digital currencies such as Bitcoin. As a shared database of transactions distributed across a network, its application in the banking space extends well beyond cryptocurrencies and could soon include loan syndication, fraud information sharing, master data management, and asset and security issuance. This topic will be discussed later in the chapter.
Now let’s look at where technology could have the highest impact in solving the problems of financial integration and financially excluded people.
In developed markets, the financial services industry is robust and swiftly progressing. By contrast, emerging markets are vulnerable to disruption, in part because banking and insurance are not widespread, meaning that large populations are significantly underbanked.
In recent years, financial services industries in emerging markets have been “leapfrogging” traditional economic infrastructures and moving directly to new fintech models. Mobile phones have long been used as productive tools to help elevate the poorest global communities out of poverty. Starting his operations in 1997, Iqbal Quadir founded Grameenphone in Bangladesh to provide near-universal access to telephone services and to increase self-employment opportunities for its rural poor.
Grameenphone’s central social program was created to deliver microloans to impoverished women to help them grow small businesses and micro-enterprises. As the suite of social businesses connected to Grameenphone grew, Iqbal began selling low-cost phones as a productive asset to help poor families (rural and urban) communicate across long distances, improve their business supply chains, and access mobile banks. A sponsored Grameenphone “telephone lady” was placed in each village for a modest fee. She loaned her phone to residents who wished to speak to distant family members. The telephone lady found a new stream of income and the village community benefited from easy-to-access long-distance communication. Thanks to Grameenphone, 115,000 telephone ladies were offering phone services to eighty million inhabitants across 52,000 villages by 2004.
On a much broader scale, a recent telecom boom has abruptly changed the way of life for people in Africa and Asia. Cellphones are no longer luxury items for the wealthy; they are essential tools for life. Today even the poorest families have a smartphone. People can now communicate with improved broadband and without fixed landlines.
Just as emerging markets leaped from having no phone access to using smartphones, they may bypass older banking services and jump directly to the next generation of digital financial services (Figure 2.3). High mobile phone penetration across developing markets—nations with huge populations of underbanked consumers—opens the door to unprecedented financial service opportunities delivered by fintech. The lack of financial infrastructure in these developing economies means there will be less inertia and easier implementation.
Data source: Asli Demirgüç-Kunt et al., “Measuring Financial Inclusion and the Fintech Revolution,” World Bank, Global Findex Database, 2017, https://
FIGURE 2.3 Percentage of population (age 15+) with a bank account
In some cases the fintech ecosystem in emerging markets is ahead of developed markets, because advanced mobile technologies were thrust upon emerging markets without precedent. In fact, Africa has been a leader in new payment technologies. In 2007 Vodafone launched M-Pesa, a Kenyan-based mobile phone money transfer solution. This successful mobile-phone-based platform for money transfer, financing, and micro-financing has reduced corruption and lowered the incidence of tax evasion. More recently, the use of mobile payment systems and new blockchain technologies has promised to increase the rate of financial inclusion.
Go-Jek, Indonesia’s Uber-like transportation app, recently diversified into financial services by launching an e-wallet. Like other super platforms, Go-Jek offers a menu of services on its platform, including the ability to buy more cellphone data, pay bills, and refill prescriptions. Its competitors do not currently offer services beyond ride sharing and food delivery. Go-Jek captured its user base through an initial value proposition of low-cost ride sharing on motorcycle taxis. The company’s potential is significant in part because Indonesia is the fourth-most-populous country in the world, with 264 million inhabitants, 96 percent of whom report having no credit card.8
Citigroup’s 2017 report “Digital Disruption Revisited: What Fintech VC Investments Tells Us about a Changing Industry,” highlights the fast-growing Chinese peer-to-peer lending market. When the report was released, China’s peer-to-peer (P2P) lending market was about four times larger than the P2P lending market in the United States and more than ten times bigger than the UK’s lending market. The Bank of China now regulates China’s P2P lending system by enforcing mandatory registration, minimum capital requirements, and reporting.9
India also has great potential for developing new fintech solutions. It has a large population, relatively low historic use of banking, high penetration of mobile phones, and the government’s implementation of a biometric ID system. Moreover, in November 2016 Prime Minister Narendra Modi banned rupee notes of denominations 500 ($7) and 1,000 ($14). India’s payment solution company, Paytm (backed by Alibaba), has benefited greatly from this demonetization effort. The crackdown on cash, which has been a wonder to behold, has propelled Indians to quickly transition to mobile wallets. Paytm and Ant Financial have set the precedent.
Ant Financial, the most advanced fintech company, has demonstrated that rudimentary payment services can be complemented with loan and wealth management services as more and more people gain access to financial services. All of these trends have called into question the future of the traditional bank branch.
We have entered a digital generation that will dramatically change financial services. In this section, we will explore some of the most significant recent financial innovations, such as crowdfunding, crowdlending, and Stripe. As we will see, the traditional bank branch and large banking corporations are not the only model for financial services.
During the March on Washington for Jobs and Freedom in 1963, American activist Martin Luther King Jr. called for civil and economic rights in his famous “I Have a Dream” speech. Dreams do not always come true, and realizing a dream can be hard. That said, funding your dream can make it more achievable. And crowdfunding is increasingly a way to bring financial support to a project. Crowdfunding is project-based funding for individuals who hope to make their dreams come true.
Crowdfunding is the practice of raising small amounts of funding from a large crowd of investors, typically through the Internet. Crowdfunding developed only recently, but it has had explosive growth in several countries.
Crowdfunding first started as peer-to-peer (P2P) lending in England with the emergence of Zopac.com in 2005, as a form of private lending. Since then many similar sites, such as Indiegogo and Kickstarter (in the United States), have offered similar crowdfunding services. There have also been copycat sites that operate like a donations-to-a-worthy-cause site, as opposed to an “investment.”
Kickstarter, created in 2009, is a forerunner in the field. It gives Internet users the opportunity to finance projects that are still at the idea stage. It reduces the heaviness associated with traditional modes of investment. For investors, it is not an investment in the true sense, but a form of “support” in exchange for tangible rewards from the team or person in charge of the project. A reward could be a letter of thanks, a personalized T-shirt, a dinner with an author, or one of the first products off the production line. The reward may vary depending on amounts provided by the supporters.
The business model is relatively simple. A project creator sets a fundraising goal, a deadline, and rewards for support. If the goal is reached before the deadline, the support reward is delivered to contributors via Amazon Payments. If the goal is not achieved, nobody pays. It is therefore an “all or nothing” system that avoids unpleasant surprises. Kickstarter is financed by collecting 5 percent of the donated funds. Amazon captures an additional share of 3 to 5 percent.
We must go back to the early 2000s to understand the genesis of the project. Perry Chen, then a musician, was frustrated at not being able to invite two DJs to a jazz festival due to lack of funds, and he came up with the idea of a funding platform that would let citizens express themselves: “And if the audience of this group could go to a site and commit to buying show tickets? If there are enough of them, the show takes place, and if not, the transaction falls apart.” The concept behind Kickstarter was born.
Almost ten years later, and with the help of Yancey Strickler and Charles Adler, the Kickstarter site was launched. Success was immediate. The company quickly raised $10 million from the private equity fund Union Square Ventures and business angels such as Jack Dorsey (founder and CEO of Twitter).
Less than two years after its creation, the New York Times described Kickstarter as the “NEA of the people.” Time ranked Kickstarter as one of the “best inventions of the year 2010” and one of the “best websites of the year 2011.” The main competitors were GoFundMe, Dryrock Ventures (for start-ups), and Y Combinator.10
The site grew rapidly. In early 2011 more than $7 million per month was committed on the platform, compared to less $2 million a year earlier. By early 2019 Kickstarter reported that it received more than $4 billion in pledges from 16.2 million backers and that it successfully funded 161,000 projects.11
Kickstarter is probably the least “tech” of the fintech companies mentioned in this book, but it is no less central in this ecosystem, especially as an early player in participatory funding systems. In the early 2010s, Kickstarter and its competitor, Indiegogo, were the main success stories of the sector. They gave a major boost to the world of fintech. A very large number of entrepreneurs have been influenced by the company’s success, philosophy, and simplicity. The start-up accelerated the emergence of crowdlending platforms and pushed large organizations in different sectors to review their models for funding small projects.
Crowdfunding has several advantages that contribute to economic activation. It encourages financially unsophisticated individuals to participate in formal systems. It allows investors to broaden their asset classes and diversify existing portfolios. It encourages technological advancement by funding promising ventures. And it creates employment opportunities by funding talented individuals and their projects.
This can also happen through increasingly popular peer-to-peer lending platforms. Several platforms have developed to serve specific niches or needs. CommonBond is a simple two-sided marketplace to finance students’ tuitions. The technology offers a simple and fast process for getting a student loan and comes with increased job prospects. The CommonBond Family feature ensures that borrowers have networking opportunities, panels, dinners, and career support to help borrowers get jobs after college. CommonBond allows businesses to pay back loans, which helps students reduce debt and makes companies more desirable to the workforce.12
Other platforms, such as Kiva, focus on small businesses typically overlooked by banks. A borrower applies for a loan and once the request is verified by the platform, the business and loan details are posted on the Kiva website. Lenders can choose which businesses to lend to. After a period, borrowers can make payments to lenders via PayPal or through Kiva’s local field partners who help borrowers through the loan process.
Lending Club allows individuals to invest in consumer credit. Consumers can borrow money for personal loans, business loans, and auto refinancing from other individuals, who earn interest, thereby removing banks and other financial institutions from the lending process.13
There are many lessons to learn from these alternate financial systems and community funding ventures. The Internet makes it possible to provide nontraditional finance options based on community funding to people otherwise overlooked by traditional institutions. However, these platforms still need to build more trust with lenders to become mainstream alternatives to banks. But progress in AI should allow for better filtering of loan requests and for enforcing loan repayments.
Stripe is a ubiquitous giant in the world of online payments that is unknown to much of the public. Its European competitor, Adyen, is better-known thanks to its IPO on June 13, 2018. Stripe, based in San Francisco, launched in 2010 through the American incubator Y Combinator and the collaboration of Patrick and John Collison, two Irish brothers in their twenties.
After their first start-up sold for $5 million, the Collisons focused on the most basic problem of any economic exchange: payments. They saw that too many start-ups failed because they could not recover money quickly and simply from customers. The two young entrepreneurs decided to address the problem by offering a new payment interface that could be integrated with their customers’ websites. The company quickly became the first choice of start-ups near Silicon Valley. Then Stripe expanded its customer base to giants such as Google, Uber, Spotify, and Facebook. It is also developing new features and services, such as fraud detection, money transfers, and offline payments. Stripe aims to make it easier for companies to adapt to the regulations of each country. In this context, Stripe has opened eight offices abroad, including in Dublin, Paris, London, Tokyo, and Singapore.
Why is Stripe innovative? Faced with competitors like PayPal, Stripe’s main advantage is reduced cost and simple setup for newly launched digital businesses. Stripe charges a fixed commission of about twenty cents and a levy ranging from zero to 2.9 percent (depending on the contract) of the amount of the transaction. Stripe’s interface is also much more flexible, more discreet, and easier to use than those of its competitors.
Stripe is also offering teams of dedicated engineers to its largest customers. More than just a payment solution, the company is now at the center of business growth strategies. Stripe offers data processing and other applications that enable companies to track transaction statistics in real time, thereby simplifying management.
Stripe has been an enabler of an ecosystem of e-commerce companies. Many start-ups, particularly in the field of food delivery, owe their success, development, and growth to Stripe’s services. In addition to these young companies, the behemoths of the Internet take advantage of Stripe’s applications to acquire new customers. With Stripe, there is no need for a bank card or even a bank account to order an Uber or to buy items on Amazon. Stripe can accept payments from anywhere in the world and is available for businesses in forty-four different currencies, including Bitcoin, and through Android Pay or Alipay.
Stripe is another example of how fintech can disrupt traditional players in the financial services sector. It has pushed banks to rethink their models. This could lead to a decline in prices and improvements in banking services. Banks are suffering from aging systems and finding it increasingly difficult to recruit competent engineers, who prefer working for more dynamic companies. J. P. Morgan, with its acquisition of WePay, is one of the few traditional banks to have quickly adopted a new model. As a result, it can offer cheaper rates than most fintech firms in the sector.
All societies today face the challenge of fraud and money laundering. With a growing number of scandals in Europe and elsewhere, Stripe must focus significant resources to preserve its image and credibility. As governments continue to add layers of regulations, they are often lenient with the small fintech companies; however, governments are intransigent with companies like Stripe, whose size rivals that of international banks.
Stripe’s global ambitions present it with another challenge. In 2016, the company launched its Singapore office and plans to invest heavily in Asia. But China is not an obvious market, and many disruptive companies have already experienced great disappointment there due to local actors backed by the government.
In the short run, the answer is likely no. Credit cards are still the most popular method of payment in the United States, and it will take time to change the credit-card culture. Because most credit cards are linked to banks, the banks should be safe for now. Moreover, financial services are highly regulated, making it harder for disruptive start-ups to enter the field. And commercial banks will likely play an ongoing and important role.
However, traditional companies like banks must address consumer needs and develop digital services. Given that Apple, Google, and Facebook can collect a high volume of qualitative and quantitative data about their clients, these firms should be able to target the right clients for the right products, thereby generating a more effective distribution channel. In light of these factors, our view is that commercial banks may need to partner more with tech players to remain competitive. Otherwise they will probably be relegated to the background.
In the long term, it is possible that fintech companies could completely replace banks. Forty million Venmo users exchanged $21 billion in the first quarter of 2019, which shows that people (especially millennials) trust nontraditional financial institutions to handle their money. At a time when US banks offer depositors next-to-zero interest rates, there is very little incentive for people to put their money in banks. New technologies like blockchain make it possible for nontraditional financial institutions to function as banks, only with more security. If the digital payment system becomes more prevalent, the need for banks will diminish, as is happening in China. This does not bode well for the future of traditional financial institutions.
We are entering an era of increased competition between incumbent banks and fintech companies. Banking business models haven’t evolved significantly over the past few decades, so the services proposed by fintech firms have a relatively high potential to revolutionize the industry. There are several reasons fintech companies could see major advancements.14
First, because fintech companies have appeared only recently, the sector is less crowded and less regulated. This makes them more agile, which gives them a greater ability to develop innovative services. By comparison, banking companies are large, highly regulated, and difficult to reform.
Second, fintech companies can broaden financial horizons and surpass geographical barriers, allowing them to reach a wider consumer base than most banks. They can demystify complex financial solutions, making services more accessible to a larger proportion of the population. Robo-advisors that offer investment advice via artificial intelligence, for instance, remove the traditional minimum thresholds imposed by asset managers. This significantly reduces investment costs and enables greater access to higher-quality investment services.
Third, fintech businesses are well informed about their clients. Greater client visibility gives fintech companies the ability to act discriminately and make better pricing decisions. For example, Ant Financial rates consumers through Sesame Credit. App users report that Ant Financial offers loans that are more cost-effective relative to traditional institutions. Similarly, some insurance companies provide clients with fitness trackers. This allows them to monitor exercise habits and reduce insurance premiums for physically active clients.
Fourth, fintech firms provide better client services that are most cost-effective. As a result, their cost base is typically lower than for traditional players, and their client acquisition and servicing costs are also lower. Some companies, such as Earnest, Lending Club, and Prosper, can even avoid using their own capital to offer loans by using investor capital instead.
The financial services industry may follow in the footsteps of the car industry. Over time, car dealers gained independence from car manufacturers. Some began to sell only one brand whereas others became multi-branded. Consequently, the industry split between sellers and distributors on one side and manufacturers on the other. Financial services will likely follow a similar path, with fintech taking an increasing share of distribution and sales while regulated banks act as the “engine factory” that builds and administers financial products.
The emergence of payment apps is likely to create situations in which consumers have funds in various accounts. However, traditional banks have a long history and will continue to benefit from their established reputation as solid and trustworthy places to put savings.
Fintech start-ups are alluring for clients looking for customized services. Due to the large amounts of data they collect, fintech companies have a deep knowledge of their clients’ needs and habits, which enables them to tailor relevant services to meet each need. Therefore, to remain attractive to customers, banks must seamlessly integrate their services with third-party services (ride sharing, e-commerce, and so on). To do this, banks might need to outsource their investment activities to players who know their clients better (Amazon, Alipay). With more information, banks can lend money with less risk. As a result, fintech start-ups and banks could assume complementary roles during this period of transition.
The number of alliances between fintech and traditional players continues to rise as several large institutions announce strategic alliances. For instance, in February 2018, Bank of America and Amazon announced a joint venture that offers loans to Amazon marketplace merchants.
However, the integration of banks and fintech companies could be hindered by differences in corporate cultures. Many banks seem to recognize this challenge. In response, they are setting up internal innovation labs that focus on key areas of development (Big Data, AI, cloud storage, automation, IoT, and blockchain). These developments will be scaled up if the early stages prove successful. It’s likely that the biggest worldwide “bank” at the end of the next decade will be phenomenal at technology delivery—built on delivery and not on products. As Brett King put it, “by 2025 … banks will be competing against technology players like Ant Financial and Amazon. If they are still competing as a bank, it will be like taking on these guys blindfolded.”15
Although digital-only “challenger banks” are gaining momentum, it is too early to assume that they will cast brick-and-mortar banks into an existential crisis. We should expect a transition during which banks and fintech companies collaborate. We are very much aligned with Tapscott and Tapscott. Is this the end of banking as we know it? That depends on how incumbents react. Blockchain is not an existential threat to those who embrace the new technology paradigm and disrupt from within. The question is, who in the financial services industry will lead the revolution? Throughout history, leaders of old paradigms have struggled to embrace the new. Why didn’t AT&T launch Skype, or Visa create PayPal? CNN could have built Twitter, since it is all about the sound bite. GM or Hertz could have launched Uber; Marriott could have invented Airbnb. The unstoppable force of blockchain technology is barrelling down on the infrastructure of modern finance. As with prior paradigm shifts, blockchain will create winners and losers. Personally, we would like the inevitable collision to transform the old money machine into a prosperity platform for all.16
The 2007 financial crisis took root on Wall Street, but the next financial crisis may come from Silicon Valley. A major concern in 2007 was that some banks were deemed “too big to fail.” Today banks are better capitalized and regulators conduct stress tests of large institutions. These reforms have adequately addressed the root causes of the 2007 crisis, but they might not account for new and emerging risks, including those presented by fintech.
Since 2007, fintech firms have addressed many consumer needs and reduced transaction costs, and their innovations have become increasingly appealing to consumers. This innovative energy has its positive outcomes, but it inevitably creates risks, including market instability. These risks can be summarized in three categories.
The first risk relates to the vulnerability of fintech due to rapid, adverse shocks. Because most fintech companies are undiversified, small and young, and many operate at a loss. To reach scale, they often depend on current and future capital injections. Most are unlikely to make it. This raises the question: What happens if a start-up goes bankrupt? Could consumers lose their financial investments?
Second, fintech firms are difficult to monitor. Because they function with complex computer algorithms, it is difficult for outsiders to clearly assess risks and rewards. Moreover, many new, innovative technologies fly under the radar of monitoring agencies. It is possible that some companies are creating loopholes for money laundering and fraud? It is difficult to say, for we cannot know what we cannot monitor.
The third observable trend is a lack of commonly held norms like those that guide traditional financial institutions. The fintech industry is so new and its players are so diverse that it’s difficult to envision them reaching a point of common guidance and cooperation.
The future of finance—including the risks—will likely move in the United States from Wall Street to Silicon Valley, or to Beijing, Hangzhou, or Shenzhen. As the fintech industry grows, governments and regulators will need to play catch-up to understand, monitor, and cover potential systemic risks.