What’s next for banks and Big Tech?

As part of its ongoing work to monitor fintech¹ market developments and their potential implications for financial stability,² the Financial Stability Board (FSB)³ released a report titled “FinTech and market structure in financial services” (Report).⁴

The Report notes that, despite the benefits to financial stability emanating from greater competition and diversity in lending, payments, insurance, trading and other areas of financial services, heightened competition could put pressure on the profitability of financial institutions, leading to risk-taking by those institutions in order to maintain margins.

We expect Canadian authorities (including the Office of the Superintendent of Financial Institutions (OSFI)) will continue to closely monitor these developments and their financial stability implications as fintech firms, large established technology companies (Big Tech), and the markets for third-party services continue to develop.⁵ In particular, we would note that while a particular institution may satisfy all of the guidance and requirements under OSFI’s Guideline B-10 – Outsourcing of Business Activities, Functions and Processes in respect of its outsourcing arrangement with a third-party data service provider, the growing reliance on a few Big Tech data service providers may create a concentration risk, with the Big Tech firm as the single point of failure (e.g., this could occur by the combined effect of the Big Tech firm having a direct contractual relationship with financial institutions and because the Big Tech firm is frequently the subcontractor of other service providers of financial institutions).

We also note that, because of the growing importance of outsourcing arrangements, OSFI now requires federally regulated financial institutions to notify their Lead Supervisor at OSFI no later than 72 hours after determining a technology or cyber security incident relating not only to the institution itself, but also to any third-party service provider.

While technological innovation has the potential to lower costs to financial services clients, in addition to increasing market access, the range of product offerings and convenience, the FSB notes the universe of financial services providers could be materially altered by new entrants into the financial services space, including fintech firms and Big Tech firms.

As part of the Report, the FSB analyzed the link between technological innovation and market structure⁶ and produced the following considerations:

Existing landscape

Currently, the existing relationship between financial institutions and fintech firms appears to be largely complementary and cooperative in nature. For example, a lack of sufficient access to capital and/or a robust customer base has prevented fintech firms from posing a serious competitive threat to established financial institutions, and partnering has allowed fintech firms to viably operate while remaining relatively small (and in some cases, unburdened by financial regulation, while benefiting from access to the customer base of the financial institutions with which they partner). Alternatively, partner financial institutions have benefited from access to innovative technologies.

However, there are exceptions to above, as some fintech firms have made significant inroads in credit provisions and payments, which may negatively affect the profitability of financial institutions in the future to the extent that technology permits a further unbundling of profitable services traditionally offered by banks and other institutions.

Impact of Big Tech firms

While concerns relating to unregulated fintech firms have been well documented, the competitive impact of Big Tech firms, which typically have large, established customer networks and enjoy name recognition and trust, may pose a greater threat to the financial sector. Given these Big Tech firms have strong capital positions and likely access to low-cost capital (in addition to access to proprietary customer data generated through other services, such as social media) to tailor their offerings to individual customers’ preferences), the FSB notes such firms could very quickly achieve scale in financial services. However, while Big Tech firms could represent a source of increased competition, their participation in financial services may not necessarily result in a more competitive market over the longer term if Big Tech firms were to operate with lower margins (due to cross-subsidization). In particular, the FSB notes that a greater market share of Big Tech may be associated with unchanged or higher concentration, along with a change in composition away from traditional players.

The risks of third-party data service providers

While increased reliance by financial institutions on third-party data service providers for core operations (e.g., data provision, cloud storage and analytics) could reduce operational risk at the individual firm level, the Report also notes such reliance could pose risks and challenges for the financial system as a whole, and as a result, it will be important to continue to monitor these developments. As an example, if high reliance on third-party service providers were to emerge, along with a high degree of concentration among service providers, then an operational failure, cyber incident, or insolvency could disrupt the activities of multiple financial institutions.

Canadian monitoring

As discussed above, we expect that Canadian authorities will continue to closely monitor these developments and their financial stability implications, and we understand that OSFI is currently drafting a guideline on non-financial risk (with a focus on third-party risk and cyber risk). In fact, on February 7 at the C.D. Howe Institute, Assistant Superintendent Ben Gully said, “[w]ith the growth in third-party relationships, risk concentrations may result when a number of financial institutions begin to rely upon a few service providers. OSFI's concern is that the dominance of a particular supplier in one area could create a co-dependence across the financial services sector. This matters because financial system resilience would ultimately rely on the operations of a potentially small number of non-financial, technologically driven, counterparts.”

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¹ The FSB defines fintech as “technology-enabled innovation in financial services that could result in new business models, applications, processes or products with an associated material effect on the provision of financial services.”

² Also see “Financial stability implications from fintech.”

³ The FSB was established to coordinate at the international level the work of national financial authorities and international standard-setting bodies in order to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies. It was established after the G20 London summit in April 2009 as a successor to the Financial Stability Forum (FSF). The Board includes all G20 major economies, FSF members, and the European Commission.

⁴ Also see “FinTech Credit: Market structure, business models and financial stability implications.”

⁵ According to FT Partners’ 2018 Annual Fintech Almanac, global fintech financing volume in 2018 reached a record high of US$53.8 billion, doubling 2017 volume of US$26.8 billion and far surpassing the prior record high of US$28.7 billion in 2016.

⁶ “Market structure” refers to the interrelation of companies in a market that impacts their behaviour and their ability to make profits.