FinTech, Banks and Stock Markets
The modern financial sector now plays a huge role in all our lives. A hundred years ago, few would have had a bank account for saving, and practically nothing but cash to facilitate daily payments for a bottle of milk or a loaf of bread. Yet, even when individuals seemed to be loosely connected or unconnected with financial institutions, the financial sector was critical in supporting and stimulating economic development and growth.
Despite the general consensus that a well-developed financial sector helps stimulate economic growth, it is hard to find a consensus on how to measure development of the financial sector or how to compare financial sectors across countries. It is even more difficult to find agreement on how the financial sector should be best structured, organized, governed and regulated. The differences in the restructuring and the financial sector building paths that have been undertaken by the post-Soviet-bloc countries clearly illustrate how fundamental these differences can be.
To add to these difficulties, financial sectors are very dynamic, and in the last few decades their evolution has been so intense and rapid that the process seems to be more of a revolution than an evolution. This is particularly relevant at the moment when the impact of FinTech (financial technology) on financial structures and processes is growing rapidly. It is hard to predict where the FinTech revolution will take us, but one thing can be said for sure – the historical structure based on banks and stock markets is unlikely to survive in its current form.
Thirty years ago, when Poland and the neighbouring countries started to rethink their economic format, it was automatically assumed that the new financial system would have a banking sector and a stock market. The opening of the Warsaw Stock Exchange in 1991 was both ideologically and economic symbolic. For many the (re)opening of their own ‘national’ stock exchange, after more than a half a century of closure, was a significant indication that their country was breaking away from the centrally planned past. However, while Poland’s first steps on its road to a free-market future were promising, one could argue that the Warsaw Stock Exchange, with its handful of listed stocks and one trading session a week, could be viewed from an economic perspective as little more than a pet project. It is true this pet could turn into a tiger, but at the time it was sweet rather than able to roar. Nonetheless, the vision of building both the banking sector and the stock market was an important step forwards. It was an integral part of the process of getting what other developed (and many emerging) countries had and needed, to varying degrees, to support their economic development.
Countries (if they are not distorted by exotic economic experiments, such as communism) are typically classified into either a bank-based or a market-based system. In economies with banked-based systems, banks play a central role in providing finances to corporations through the mobilization of savings, allocation of capital, risk assessment, etc. In contrast, in economies with market-based systems, capital markets (that is, markets for long-term investments that have implicit or explicit claims to capital), sitting alongside banks, contribute to the provision and accumulation of financial resources. It is common to classify countries such as Germany and Japan as having bank-based systems, and the UK and the US as countries with market-based systems. While being a bit simplistic, there is some truth in these perceptions.
Historically, German and Japanese corporations have long-term and much closer relations with banks than corporations in the UK and the US. German and Japanese stock markets used to be relatively small, although this is no longer the case. The Tokyo Stock Exchange is the third largest stock market in the world, behind the New York Stock Exchange and Nasdaq. Its market capitalization (market cap) of nearly $5.7 trillion (ten times the Polish GDP) may appear to be dwarfed by the market cap of the American exchanges ($22.9 trillion and $10.9 trillion, respectively), but Japan is a much smaller country. The Frankfurt Stock Exchange, with a market cap of $1.8 trillion, takes twelfth position on the world stage, five positions behind the UK (with a market cap of $3.8 trillion). However, ranking the developed countries in isolation, the Frankfurt Stock Exchange only stands below the American exchanges, the Tokyo Stock Exchange, the Euronext (the exchange servicing several EU countries, thus not the best of comparators against single-country exchanges), the London Stock Exchange and the Toronto Stock Exchange. Thus, with Euronext put to one side, among the five biggest developed stock markets in the world, three are in market-based economies (the US, the UK and Canada) and two are in bank-based economies (Japan and Germany). Therefore, the simple ‘historical’ separation of countries into those where stock markets play an important role and those where the role of stock markets is negligible is no longer accurate or appropriate.
The growth of stock markets in bank-based markets is part of a broader trend. To emphasize this point it is worth remembering that the global presence of stock markets is a relatively modern phenomenon. For many young people, the existence of stock markets may seem as natural as the mobile phone in their back pocket. Yet, 30 years ago nearly half the world’s population lived in countries that did not have stock markets.
The creation and growth of stock markets in modern times has often been associated with economic and/or political transformation, and it has also been related to technological and cultural change. For example, the need to create stock exchanges had been deeply rooted in the growing need for openness and transparency. The collapse of communism has contributed to the creation in Europe of more emerging stock markets than there were developed ones, but this process is broader than the collapse of communism. Since the early 1990s many countries around the world have created stock markets and this trend cannot be attributed to the collapse of communism and/or abolition of the centrally planned economies. China and Vietnam are obvious examples of this.
Technological development, and in particular the transformation of how much, how fast and how information can be transferred and stored, was fundamental to the development of stock markets. While individual banks can collect and store information about individual investment initiatives, this information is rarely shared with other banks and investors. Stock markets, if working properly, enable standardized, quick and comprehensive information to become publicly available. This, in turn, enables the creation of an investment environment in which investors can access a broad range of investment opportunities, and choose what suits them best.
Stock market investments are associated with higher risk than typical bank deposits. There are many potential sources of stock market risk including operational (for example, trading infrastructure and regulation is not adequate to prevent irregularities) and informational (for example, some investors can exploit having access to information other investors are unable to access), etc. Some risk may also come from a lack of diversification as investors do not have enough funds (or skills or knowledge) to build a diversified portfolio, that is, invest in a range of stocks that, together, have a low probability of losing money at the same time. However, the opportunity to better diversify risks is still one of the fundamental traits of stock markets. This helps investors as well as companies. As much as investors benefit from diversification, so do companies and managers, as they may be able to obtain funds for projects that would not gain the banks’ approval, or if they did, they would be much more expensive. This ability to raise extra funds with fewer restrictions increases the amount of investments, thus positively impacting economic growth.
Yet not all companies can benefit from stock markets and equity issuances. To be listed, a company must satisfy a range of, often quite tough, criteria, which themselves can be quite financially demanding. One of the main problems of stock markets is that they act as rather expensive middlemen. Moreover, their informational transparency has remained less than perfect, and typically better for the bigger players, be they the issuers or the investors, than for the little ones. So, even if special segments of well-established stock markets, like AIM at the London Stock Exchange, have been created to reach out to smaller and less viable companies, this has not been enough. In particular, this is not a solution for countries with small and relatively thinly traded stock markets, such as Poland. Thus, equity financing is typically out of reach for many entrepreneurs. Paradoxically enough, these small and medium-sized enterprises (SMEs) also find it difficult to secure funding from banks. This has been particularly true in recent years since tighter regulation of banking activities was introduced following the financial crisis of 2008.
Banks are known for discriminating against risky projects. As a result, small entrepreneurs, whose initiatives are focused on individual (non-diversified) ideas and undertakings, suffer most. Thus, when it comes to access to capital, it has been easier for the big companies than the small ones, regardless of whether the economy is market-based or bank-based, to access it. This is especially a problem for those entrepreneurs who are willing to risk trying out new ideas. This has generally been the problem and very little has improved over the years. The fact that often governments create separate funding agencies to support those who have promising ideas but cannot find capital to finance their implementation through the traditional financial institutions, indicates the urgency of such funding and the scale of the failure of traditional finance channels.
Luckily, where there is a need to support innovation, there are also now groundbreaking solutions. Technological progress has taken another turn, and this time it may be able to create solutions that may reach those who find it difficult or inefficient to seek bank loans or secure a stock market listing. The situation has changed thanks to the development of technologies that allow vast quantities of data to be cheaply stored, managed and made accessible to anyone within a system without any discrimination. FinTech platforms are beginning to revolutionize the sector for small businesses and small players generally.
Peer-to-peer lending (P2P) is relevant to funding small businesses. It avoids many of the problems associated with banking and this is one of the reasons it has grown enormously in the last few years. Although the process may look similar to banking, it is fundamentally different in critical ways.
When we deposit funds with a bank, we are formally entering into a contract with a bank that promises a set return on our money. The bank then lends to a business and there is a contract between the business and the bank. But there is no contract between the depositor and the borrower – thus lenders have little idea of where their money is going. The banking approach has many benefits but history has shown that careful regulation is needed to protect depositors and to keep banks stable. The weakening of banking regulation typically leads to cheap money followed by instability and occasionally global crises, such as the recent great financial crisis.
The P2P approach is very different: here lenders loan directly to borrowers. The P2P platform is exactly what it implies, nothing more than a FinTech mechanism that matches borrowers and lenders. The contract is between the lender and the borrower, with the P2P platform facilitating the bringing together of the two and easing the ongoing financial relationship between them. Lenders know exactly where their money is going. If the investment is a good prospect but very risky, then, if the promised return (if successful) is right, funds may well be forthcoming through the platform to enable the entrepreneur to undertake the risky project. The funds may come from a number of investors, each putting in a small amount of the total, all facilitated by the P2P platform. If a lender wishes to exit early, then the P2P platform will sell the investment to other investors via the platform. A core advantage of the P2P process is that, since lenders loan directly to the borrower, there is none of the regulation needed that surrounds more complicated banking arrangements. P2P has developed rapidly in part because it has not been encumbered by banking regulations.
P2P platforms usually deal with lenders who deposit money for a fixed return (which of course they may never get if the project fails). Crowdfunding platforms are somewhat similar to P2P platforms but the main difference is that typically those funding through a crowdfunding platform will expect to get a share of the project (equity) rather than a fixed return. Indeed, often funds raised on crowdfunding platforms are used to fund something where contributors do not get any financial return, for example, when funding an aid project in a developing country. So crowdfunding is typically focused on very early ventures or social interventions rather than existing small businesses. P2P and crowdfunding are the two leading components of a new investment style sometimes referred to as FinTech credit.
The global FinTech credit market has grown rapidly around the world in recent years. Between 2013 and 2016 lending in the sector is believed to have grown by over 200 per cent. Initially, the development took place in the US and the UK. The first P2P company in the world, Zopa, started in the UK in 2005. However, in recent years growth has been strongest in ex-communist and liberalizing communist countries. The chart below shows the leading countries in the world according to P2P lending as a percentage of GDP in 2016. Poland is added for comparison, as it held 58th position in 2016.
These calculations are based on the data available from the Cambridge Centre for Alternative Finance, University of Cambridge, and from the World Bank.
These calculations are based on the data available from the Cambridge Centre for Alternative Finance, University of Cambridge, and from the World Bank.
The driver behind the development in FinTech credit in ex-communist countries and countries such as China appears to be somewhat similar: the need for change outside the traditional structures. For example, almost all the banking sector in China is state owned and these banks have favoured large companies and safe investments. Although the recent liberalization in the financial sector in China has had a limited impact on the proportion of banking that is privately owned, it has had a huge impact on FinTech credit, which in volume terms is now the largest in the world by far. The P2P sector has enabled SMEs to access finance in significant volumes for the first time.
Ex-communist countries such as Latvia, Estonia and Lithuania missed out on the fast growth in financial markets in the 1980s. P2P and other FinTech approaches have been rapidly embraced by enterprises and governments in these countries as a route to developing their financial sector and fund their SMEs, particularly where financial regulation is perceived to be liberal and a little lax in comparison to those in many developed countries. Indeed, P2P platforms in the ex-communist countries where they have developed rapidly, are now targeting other ex-communist countries as markets where they can enter and grow.
All this suggests that FinTech credit could have a positive impact on ex-communist countries and such countries should seriously consider how to make use of this process. However, it is not all plain sailing: China presents a good example of how problems can quickly arise. For several years the Chinese authorities were relaxed about the rapid growth of FinTech, left the sector barely regulated and saw the benefits of it providing funds to entrepreneurial parts of the economy. However, as competition intensified, P2P platforms in China started to offer guarantees to depositors to enable the sector to maintain the enormous growth. This successfully led to rapid growth, but once things started to go wrong for some investments the platforms could not always meet their promises, particularly those that have been making leading and unreasonable promises. This led to a lack of confidence in the sector. Several platforms went bankrupt and the Chinese authorities have had to step in to regulate the sector to increase confidence. Current concerns about the financial sector in the Baltic countries are also bringing pressure to the sector.
It appears that FinTech offers more opportunities for ex-communist countries than for many others and these governments ought to be looking carefully at the sector as a way of funding SMEs and economic growth. But this needs to be done carefully. It is dangerous to sit back and leave the markets to their own devices with no regulation. Finding the balance between stringent banking regulation on the one hand and no regulation on the other is the challenge on which these countries should focus.
Centre for Governance, Regulation and Industrial Strategy,
School of Management, University of Bath, UK
Ania Zalewska is a Professor of Finance and Director of the Centre for Governance, Regulation and Industrial Strategy (CGR&IS) at the School of Management, University of Bath, UK. Having both a mathematics and economics background (she holds a PhD in Mathematics from the Polish Academy of Sciences in Warsaw, and a PhD in Economics from the London Business School), her research interests include pension reform, regulation, governance, managerial incentives, and the evolving nature of market risk. She has published in leading academic journals (e.g. Journal of Financial Economics, Economic Journal, Journal of Banking & Finance, Journal of Empirical Finance). Her opinions have also featured in Financial Times, The Times, The Economist, The Hill and many other international outlets. Ania Zalewska has advised various governmental bodies (e.g. the Competition Commission, HMRC, FSA, DECC, BEIS, the Committee on Standards in Public Life and leading international companies on financial issues).
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