Is traditional finance under siege?

by Katarzyna Czupa, CASE — Center for Social and Economic Research | 16.09.2015

Image for post
Image for post

Polish customers will remember 2015 as a year of fee and commission growths in Polish banks.
At the beginning of 2015 many banks informed their clients about new fees and fee rises for their daily operations such as transfers or a simple account-maintenance. According to Bloomberg Businessweek, in May PKO BP increased their debit card fee from 3,9 PLN to 6,9 PLN for customers that spend less than 300 PLN a month. Alior Bank started charging with a monthly fee those customers who do not transfer their income to the bank’s account. Clients of Bank Pekao have to pay 1,49 PLN if they withdraw money from Euronet’s ATM. These are only a few examples of a broader trend resulting from a decrease in bank profits. Banks gain lower interest rates and experience a decrease in so-called interchange fee, which is paid between banks for the acceptance of transactions made with a use of debit or credit card. Unable to make money on loans or charge merchants with extra fees, banks simply turned to their clients, knowing that sooner or later they will comply to the new rules. But will they really?

Although financial technology (fin-tech) phenomenon has not reached Poland yet, it is gaining its momentum, mainly in Western countries with well-developed financial markets, such as US and UK. Fin-tech is said to change rules of the bank-customer game. In 2014 investment in this sector reached 12bn dollars, compared to 4bn in a previous year (Economist’s Special Report). But what does fin-tech really stand for? According to Investopedia, the term initially concerned new technological solutions „applied to the back-end of established consumer and trade financial institutions”, meaning computer programs and items used by financial institutions of all kinds with the aim to speed up their operations and thus increase their volume. Currently it is used with reference to „any technological innovation in the financial sector, including innovations in financial literacy and education, retail banking, investment and even crypto-currencies (e.g. bitcoin)”. But why fin-tech is said to be a game changer? The answer is simple — it does not facilitate banks’ operations any more. Quite the contrary — it poses a threat to banks by creating services that by-pass regular banks and thus lower customers’ costs. Services offered by fin-tech companies are significantly cheaper than the standard banks’ offer. Given that currently we use Internet and apps to manage nearly every aspect of our daily life, there are many shares to gain on the fin-the market. Are you looking for investment opportunities? Go to Wealthfront, Earmark, Larky or Simplee.

Another interesting solution is Lending Club. It is a platform that matches borrowers and investors without any traditional intermediaries such as banks, trade brokers etc. (so-called peer-to-peer lending). According to the company’s website, Lending Club allow “consumers and small business owners lower the cost of their credit and enjoy a better experience than traditional bank lending, and investors earn attractive risk-adjusted returns”. How does it work in practice? Simplicity is the key. The procedure is as follows — first, customers that need a loan fill in an application at the company’s website. The form is processed with the use of cutting-edge technology which “assesses risk, determines a credit rating and assigns appropriate interest rates”. After a few minutes a potential borrower receives personalized offer and can choose the most suitable option. As for investors, if they want to allocate their money to something different that bank deposit, they simply open an account on the platform and select particular loan(s) in which they wish to engage in, bringing them regular monthly returns.

Many may wonder whether this system is safe, especially in terms of how creditworthiness is assessed. Firstly, information given by potential creditors is verified on the basis of consumer data from credit bureaus (e.g. FICO, Experian or, in Poland’s case, Biuro Informacji Kredytowej). Lending Club, or other similar companies, check whether the person applying for a loan informed the lender about all his or her financial liabilities. They also analyse client’s credit history (number and amount of loans or/and credit cards) and a credit score. At first glance this approach looks surprisingly traditional, but there are some interesting additional features behind. Entities such as Lending Club focus not only on hard data but also on information published on customers’ social media profiles and on behavioural data gained thanks to various methods (they analyse the way an online form is filled, e.g. use of capital letters). Companies claims that this unconventional data-gain helps to assess repayment probability properly. It has crucial importance in the non-banking system of lending, as deposits are not guaranteed. Those who lend money accept that they may suffer loses if the person who took the loan defaults. It might seem surprising, but we need to remember that Lending Club’s customers do not make deposits — they invest money. The solution is profitable but also involves a big dose of risk and thus investors have to be very careful while choosing a suitable option. Therefore peer-to-peer lending is beneficial not only for customers, but also for the whole economy, as only viable projects and reliable customers are supported. To ensure this system is stable, peer-to-peer lending companies are supervised by national authorities that control banks operations. In the UK this segment of financial market is supervised by Financial Conduct Authority (FCA), which in April 2014 took over the regulation of the consumer credit from the Office of Fair Trading. Firms that offer peer-to-peer lending services must be authorised by FCA. Rules adopted by the institution are not very strict, yet the companies are expected “to have appropriate systems and controls depending on their customers needs ant their business model particularities”. Furthermore, according to FCA’s rules, in the event a lending company fails, loans have to be managed to maturity within the special programmes created by operators.

There is another financial segment worth mentioning — Islamic banking. It might sound like a Middle-Eastern niche, however, it has been rapidly developing over the last years. As EY estimates, between 2009 and 2013 the value Islamic finance’s assets was growing at an annual rate of 17 per cent. Furthermore, according to Islamic Financial Services Board, in the first half of 2014 the sector’s assets stood at 1.83 trillion US dollars. Banking plays the biggest role — it constitutes 80 per cent of assets.

How this unconventional sector differs from the traditional one and how customers benefit from it? Suprisingly, it is not based on interest rate (in Arabic called riba), which is prohibited by shariah — the Islamic law. Riba is perceived as usury, unfair charge for lending money to those in need, and unjustified profit for those who provide it. It does not mean that Islam rejects the right to profit from investment. Quite the contrary — it encourages members of umma, that is Islamic society (and thus financial sector customers), to work and reap benefits not simply from operating money but from real economic activity. In Islamic banking, there are no deposits and loans as we know them in the West. Money on saving accounts, offered both to individuals and corporates is invested not in stocks or bonds but in goods, which customer can sell for a higher price (murabahah: mark-up sale) or enterprises, which, according to profit-and-loss principle if turn out to be profitable, will yield some benefits, and if not may be a source of losses (musharaka or mudaraba). As for loans, those who take it do not pay any interest. If project turns to be successful, they share profits with lenders. If it fails, losses are shared by all participating parties (musharakah) or solely by the financier (mudarabah). Contrary to traditional finance, Islamic banking offers loans only for businessmen — individuals who need a new car may use ijara (Arabic form of leasing) or murabaha (in this case bank is an investor.

Can above mentioned instruments be successful despite the fact that they seem riskier than those in conventional system, where depositors always get their money back and creditors pay for using someone else’s money? In fact, the sense of safety in traditional finance is illusive, which becomes apparent during crises, when banks sometimes highjack customers’ deposits (like it was in Cyprus’s case) and, as a result make their clients desperately want to get their money back (so-called bank runs). The truth is, banks cannot give all our money back (they simply do not have it). Moreover, they bear losses that finally have to be covered with customers’ money, either in the form of bail-outs or bail-ins (the latter is to become legal solution when EU’s Bank Recovery and Resolution Directive comes into force). Furthermore, our savings are often invested in instruments that have nothing to do with the real economy their aim to generate profits (derivatives used for speculation or subprime credits).

The idea behind peer-to-peer lending and Islamic instruments is first to support customers and then to yield benefits for the financial institution owners. The aim of these unconventional solutions is also to make customer share the risk of the investment, which, in long term helps avoiding financial crises (only sound projects are chosen). Most likely, these innovations will not deconstruct traditional system. But they show a different approach towards usury. They might influence conventional financial organisation to re-think their strategies.

CASE — Center for Social and Economic Research is an independent, non-profit economic and public policy research institution, established in 1991 in Warsaw.

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store