25th March 2015

Digital Disruption: Prudent regulation is required for banks’ digital challengers

Written by Anthony Browne

Do you think we actually need banks? Bill Gates, the world’s richest man, who knows a bit about money, thinks not. “We need banking but we don’t need banks anymore” he said recently, talking about the revolution in digital technologies that can offer banking services.

In many ways, banking is inherently the most digital of industries. With financial services, it accounts for 8% of GDP in the UK, but there is virtually no physical product other than the notes that come out of ATM machines. Your bank balance is a data entry in a computer, and when you make a payment you are transferring data from one computer to another. No one really wants banks in themselves – as they might want a car or a haircut – but rather the role of banks is to help people get what they want, whether it is to buy a house, pay for a holiday or purchase tools to ply a trade. If companies other than banks can help people do what they want to do, why do we need banks?

It is not surprising that digital companies are expressing interest in financial services. Amazon has moved on from helping small business sell their goods around the world, to offering them trade finance, a role previously reserved for banks. Apple has launched Apple Pay, Google has Google Wallet, Twitter is planning Twitter Buy, and Facebook are sniffing around. Other digital firms have been set up specifically to do financial services. Paypal made its fortune by simplifying e-commerce payments; the UK’s TransferWise  was set up 4 years ago to undercut banks in foreign exchange, and is now valued at $1bn dollars (“sorry banks” runs its advertising slogan). Tech evangelists believe that crypto currencies using distributed ledgers and blockchain technology means there is no need for banks to have a central role in payments. As Jamie Diamon, the chief executive of JP Morgan put it, “the technology firms want to eat our lunch”.

The unequivocal winners of this are the consumers – competition raises standards and spurs innovation, providing better services at lower cost. But despite what Mr Gates said, it does not mean that banks are on the brink of extinction – they will always be needed for their basic functions of deposit holding and maturity transformation. But their role may change as tech firms eat into their business.

For the banks, this digital revolution is not just a threat but also an enormous opportunity, as we highlight in our report published today Digital Disruption, which was written jointly with Accenture. All banks are embracing new technologies to improve service to customers, with the most explosive being the rise in mobile phone banking, which in a couple of years has totally transformed the way we manage our money. Other innovations include Paym payments by text, biometric security and cheque imaging. But many banks are also preparing themselves of the digital revolution by rethinking the entire way they do business, with major digital transformation programmes to ensure they fully embrace the opportunities of the new technologies. Banks are recruiting senior managers from the digital world. Many are also embarking on ground-breaking partnerships with financial technology firms, knowing they need to harness their specialist expertise.

Although it is a challenge for banks, perhaps more importantly for the economy, customers and wider society, it is also a challenge for regulators and legislators.  Banking regulation has quite rightly been tightened to ensure financial stability and to prevent a repeat of misconduct, such as mis-selling or breaches of money laundering regulations. But generally, digital firms are not regulated and don’t have to abide by the same rules. The danger is that the digital revolution will simply lead to misconduct and financial instability exploding outside the regulated banking sector in the unregulated digital sector.

If you think this won’t happen, consider the salutary story of pay day lenders. High risk, high interest, short term lenders have existed since biblical times, but when they operated manually going door to door their scale was small. Banks are basically prevented from this market because they are quite rightly only allowed to lend to people they have checked can repay the loan. Payday lenders such as Wonga were essentially highly innovative digital start-ups, which embraced the internet and data mining, but were unconstrained by banking regulation. It was an explosive mixture, and tens of thousands of people ended up in high-debt misery. Politicians complained, the pay day lenders were brought under the Financial Conduct Authority, and 90 per cent went out of business. My challenge to regulators and policymakers is to learn the lesson from this. Other challenges coming down the line include virtual currencies, which offer many benefits, but are not controlled by the same anti-money laundering and counter terrorism-financing as banks, which is why they are proving so attractive to organised criminals who want to hide from law enforcement authorities. Our new payments regulator, the Payments Systems Regulator, comes into force next month, but has raised eyebrows in the industry by regulating banks, but not regulating digital payments providers such as PayPal. Digital firms offering trade finance are not subject to the same anti-money laundering controls as banks. Digital companies offering loans are not subject to the same prudential regulation as banks, but could still impact financial stability.

To protect customers, thwart organised criminals, and ensure financial stability, prudential and conduct regulators, and legislators, need to ensure that regulation is future-proofed for the digital age. The focus needs to be on regulating activities – such as payments and lending – rather than only thinking about regulating only some categories of institutions that offer them. The balance needs to be struck to ensure we protect customers and ensure stability, while not choking off innovation and competition. Only then can we be sure that the digital revolution sweeping financial services lives up to its ultimate promise.

This article appeared in the Daily Telegraph on 24 March 2015.
Digital Disruption was jointly written by the BBA and Accenture.

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