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Technology sometimes evolves at breakneck speed. When it comes to innovation in financial activities, often referred to as FinTech, the world is seeing major advances. For banks, FinTech is disrupting core financial services and pushing them to innovate to stay relevant. For consumers, this means potentially wider access to better services. Such changes also raise the stakes for regulators and supervisors – while most individual FinTech companies are still small, they can grow very quickly into both riskier customers and business segments than traditional lenders. .

This combination of rapid growth and the growing importance of FinTech financial services to the functioning of financial intermediation can come with system-wide risks, which we cover in our latest Global Financial Stability Report.

Adding risk

Digital banks are gaining systemic importance in their local markets. Also known as neobanks, they are more exposed than their traditional counterparts to the risks associated with consumer loans, which generally have less protection against losses as they tend to be less collateralised. Their exposure also extends to higher risk taking in their securities portfolio, as well as higher liquidity risks (in particular, the liquid assets held by neobanks relative to their deposits tend to be lower to those held by traditional banks).

These factors also create a challenge for regulators: the risk management systems and overall resilience of most neobanks remain untested during economic downturns.

Not only are FinTech companies taking on more risk themselves, but they are also putting pressure on long-established industrial rivals. Look to the United States, for example, where FinTech mortgage originators are following an aggressive growth strategy during times when mortgage lending is booming, such as during the pandemic. Competitive pressure from FinTech companies has significantly hurt the profitability of traditional banks, and this trend is expected to continue.

Another technological innovation, which has developed rapidly over the past two years, is decentralized finance, a crypto-based financial network without a central intermediary. Also known as DeFi, it offers the potential to provide more innovative, inclusive and transparent financial services through increased efficiency and accessibility.

However, DeFi also involves the accumulation of leverage and is particularly vulnerable to market, liquidity and cyber risks. Cyberattacks, which can be serious for traditional banks, are often deadly for these platforms, stealing financial assets and undermining user trust. The lack of deposit insurance in DeFi adds to the perception that all deposits are at risk. Historically, large customer withdrawals often follow news of cyberattacks on vendors.

graph showing loss of deposits or withdrawals due to cyberattacks

DeFi activities primarily occur in crypto-asset markets, but growing adoption by institutional investors has strengthened ties with traditional financial institutions. In some economies, DeFi is helping to accelerate encryptionin which residents adopt the crypto assets instead of the local currency.

Tighter regulations

As more and more financial services activities move from regulated banks to entities and platforms with little or no oversight, the associated risks are also changing. Although FinTechs are stepping in to challenge traditional banks on their own playing field, they bring more than competition. In fact, the two often remain linked, notably through the provision of liquidity and leverage by banks to FinTechs.

These pose challenges for financial authorities in the form of regulatory arbitrage (in which firms move or locate in less regulated sectors and regions) and interconnection that may require oversight and regulatory measures. , including better consumer and investor protection.

Policies that proportionally target both FinTech companies and traditional banks are needed. In this way, the opportunities offered by FinTech are favored, while the risks are contained. For neobanks, this means stricter capital, liquidity and risk management requirements commensurate with their risks. For incumbent banks and other established entities, prudential oversight may require greater attention to the health of less technologically advanced banks, as their existing business models may be less sustainable over the long term.

The absence of governing entities means that DeFi is a challenge for effective regulation and supervision. Here, regulation should focus on entities that are accelerating the rapid growth of DeFi, such as stablecoin issuers and centralized crypto exchanges. Supervisors should also encourage strong governance, including industry codes and self-regulatory bodies. These entities could provide an effective conduit for regulatory oversight.

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