Financial regulation treats banks as protected species. This prevents long overdue structural change. The way forward is a fintech license. But current proposals, such as the latest one by the Swiss government, are not comprehensive enough.
The digital revolution causes sleepless nights among managers of the “old economy”. Successful business models are increasingly disrupted by the geeks from Silicon Valley. People do no longer hail cabs, they Uber, and travel offices have become rare and deserted places. However, one industry has resisted successfully the disruption from digitalized competitors so far: the financial industry. The very same banks that have existed one hundred years ago still dominate the financial sector.
Banking is fragile and expensive
Is it because we cannot do without banks? The recent financial crisis certainly confirmed the view that they are “too-big-to-fail”. After the banks lost billions in risky bets on the subprime mortgage markets, politicians put tremendous amounts of taxpayers’ money at risk to save them. If it was not for this governmental support, most banks would not exist anymore.
Governments all around the world obviously consider banks as a species that needs protection. Why is this so?
Banks are crucial for today’s financial system. Had banks failed in 2008, the financial system would have lost its ability to lubricate the economy with payment services and credit intermediation. The collapse of banks would have triggered an economic disaster. Banks were saved from extinction because governments and central banks feared a collapse of the entire economic ecosystem.
But do not draw false conclusions. The banks’ enormous potential to wreak havoc does not mean that we actually need them: An inflamed appendicitis can have fatal consequences. But this does not mean that the appendix is an indispensable part of the human body.
Technology rendered banks obsolete
Banking is, just as the human appendix, an evolutionary relict from past times. The digital revolution has enabled new business models that could provide for all the services that banks provide today. Fintech companies can offer payment services, connect borrowers with lenders, and buyers with sellers. They can do all of this much better than banks ever can.
We no longer need banking.
Nonetheless, banks remain in charge. As we have seen, they can blackmail society for bailout money. Hence, they enjoy an implicit government guarantees on their liabilities, and they have privileged access to central bank liquidity. No matter how outdated they are, banks do not have to fear new digital competition. No competitive advantage in quality or cost-efficiency by young fintech companies could make up for the privileges banks enjoy.
An alternative to banking
In 2008, we were unprepared. Bailouts were a necessary evil to prevent a collapse of the system. So next time we better be prepared. The financial system needs field-tested fintech solutions of sufficient scale so that they can replace banking institutions during the next financial crisis. To this end, we need a new regulatory framework for fintech companies based on the following two principles:
Complex and expensive banking regulation should not impose unnecessary burdens on fintech companies.
Fintech companies must not create systemic risks like banks do.
The solution: regulators should introduce a fintech license as an alternative to the banking license.
A fintech license allows its holder to offer the full range of financial services without being subject to troublesome and costly banking regulation. However, one important condition applies. A licensed fintech company should not be allowed to become a source of systemic risk and a potential liability for taxpayers.
The idea is spreading. In Switzerland, the government has proposed its introduction on Wednesday. This step goes in the right direction, but many regulators have not yet fully embraced the two principles above. Also the current Swiss proposal has its flaws.
Systemic Solvency, not Narrow Banking!
The planned "Finanztechnologie-Lizenz" in Switzerland allows companies to offer financial services, but prohibits them from investing the money received from clients and engaging in maturity transformation. These rules are to enforce the principle that fintech companies must not create systemic risks. The new approach is built upon three pillars (see figure below).
People familiar with alternative monetary concepts might recognize a familiar pattern. In this regard, the fintech license mirrors the concept of narrow banking.
What is systemic solvency? One can visualize the idea with a simple analogy. Imagine a set of domino stones where each domino stone represents one financial institution. If all domino stones are placed in sufficient distance from each other, one falling domino stone will not trigger a chain reaction. If, however, one domino stone can bring down another stone, it becomes a source of systemic risk.
The concept of the systemic solvency rule requires that all domino stones must be placed far enough apart from each other (click here for more details on systemic risks and solvency).
Of course, the real financial system is more complex than a set of domino stones. Nonetheless, the systemic solvency rule effectively deals even with complex financial products such as credit default swaps (CDS), mortgage backed securities (MBS), or collateralized debt obligations (CDO), too. This is what sets the systemic solvency rule apart from narrow banking.
The new rule itself is simple, but a thorough explanation of all its aspects and implications is outside the scope of this article. In the book The End of Banking, the the systemic solvency rule is explained in great detail.
No unnecessary regulatory burden!
While the fintech license as proposed in Switzerland removes many regulatory hurdles, it still imposes capital requirements on fintech companies. But the only justification for capital requirements is to tackle systemic risks. Dear Swiss Federal Department of Finance, better deal with separating institutions that create systemic risks from those that do not, and then scrap the capital requirements for fintech companies! They undermine the spirit of the fintech license and tilt the game towards the evolutionary banking relicts from past times.
Having said this, we have to acknowledge the encouraging trend that is finally emerging in financial regulation. So far, the idea has always been to keep banks on life support and try to get a grip on them with ever expanding regulation. This is unfortunate, as the digital revolution would actually enable a better financial system without banking.
So let us continue the current regulatory initatives. Let us free young and innovative fintech companies from regulatory legacies. The introduction of a fintech license will pave the way for a new, competitive, and resilient financial sector. With such alternative to the old banking sector, the “too-big-to-fail” problem would cease to exist. Fintech companies could take over the functions of banks when another crisis hits. Finally, there would be true disruption in the financial sector, and we would no longer have to put taxpayer money at risk to bail out something we no longer need.
Fintech must lead the way to free finance: Fintech companies can bring our financial system to the next level – but only if they disrupt finance on the regulatory level as well. Here is how they should proceed.
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