Erkki Liikanen: On the digitalization of financial services -
opportunities and risks
Speech by Mr Erkki Liikanen, Governor of the Bank of Finland, at the 2017 RiskLab/BoF/ESRB
Conference on Systemic Risk Analytics, Helsinki, 28-30 June 2017.
* * *
1. Introduction
Advances in information and communication technologies have shaped the development of
financial services already for several decades. Digitalization of financial services is a new name
for this development. But undoubtedly the new name also reflects significant turns in recent
developments, which have opened entirely new avenues.
A central phenomenon is that digitalization of information has recently been spreading to almost
all areas of human activity. One result of that is the availability of 'Big Data', to use the well-known
catchword. It is possible to combine information between sectors and activities more efficiently,
often in surprising and productive ways. This is having an impact on all areas of economic
activity from production and working patterns to leisure.
At the same time, techniques to handle and analyze the vast new data resources are in
increasing demand. Prospects for technological applications which were once considered
utopian, are coming a real possibility.
All this has opened new opportunities also to financial services. Both the incumbent institutions
and new players are seizing these opportunities. Great benefits are available, but not without
risks. Ideally, new technologies and players can increase competition which may lead to better
and cheaper financial services to the end users: households, companies, and the public sector.
Today I want to share with you some thoughts regarding digitalization and financial services. I
want rather raise questions and leave the search for answers to you, researchers.
Given that this is a conference on systemic risk analysis, I will discuss risks that might be
gathering strength as digitalization continues. But I will start by discussing the benefits available,
which will help us understand the drivers of new developments in financial services.
Second, I will discuss the role of regulation. Important regulation has already been launched to
help reap the benefits made available by digitalization. New legislation needs to be
technologyneutral.
To safeguard the benefits, regulation also needs to keep pace with the potential new risks. But
therein lies a challenge: the speed of development has become so fast that it may easily exceed
the speed with which regulation can adapt. So this is a new paradigm also for the legislators.
Finally, and what might come closest to the concrete issues dealt with in this conference, I will
consider the potential role of new data and data analytics in helping us measure and manage the
risks - both old and new - to financial stability.
2. Outlook for the future: digitalization
Fundamental shift in consumer expectations
Let us start with consumer expectations. How are they shaping financial services?
Customers, especially, expect that services are available when they are needed. They are used
to 24/7 world. The immediacy of services is the new normal.
As to the user experience provided by a bank, consumers no longer necessarily use other banks
as a benchmark. User experiences provided by tech companies in other services also shape
expectations in banking services.
These shifts pose a challenge to traditional banks' infrastructure and organizational setup,
perhaps even their mindset. In contrast, the opportunities opened up by digitalization has
spawned fintech start-ups that strive to be customer oriented, providing immediacy of services,
and being available 24/7 by design. Many banks try to meet this challenge, not without difficulty.
Fragmentation in payment services
Payments are an area where the new products and players are already quite visible.
If a decade ago we had the choice of whether to pay with credit card or cash, now we also have
mobile apps for making payments, and in some rare cases even virtual currencies. Similarly for
a merchant, the choice, what payment methods to accept has become more complex. At least in
the short run this fragmentation of payment choices will likely continue.
Another phenomenon is that payment becomes embedded into other services. This
emphasizes the need for sufficient financial literacy as it may become more difficult for
customers to keep track of their spending. This is coupled with the fact that instant consumer
credit decisions can be incorporated into these services.
Regulators need to stay alert at least from two perspectives: first, to ensure sufficient consumer
protection, and second, to monitor the development of consumer credit aggregates from the
viewpoint of financial stability.
It is worth noting that most of the new applications are still based on the existing infrastructure.
This may impose restrictions on what can be achieved in terms of innovation. It also stresses the
importance of thinking about the current systems in the background.
New business models
Fintechs typically challenge the most profitable parts of banking business by offering targeted
services and using lean organizations. Competition may hence lead to lower margins in banks. In
the short run, this may put a strain on profits in some incumbent institutions, given their heavier
organizational structures.
In the longer run, the entry of fintechs could induce a change of business models also in the
incumbent institutions. Who will eventually provide the new services? Synergies between
different services would seem to be the key question. If there are no synergies between two
services, then they will not necessarily be offered by the same institution. This could even have
implications for bank structures.
A separate question is: How many companies which are providing payments services alone, will
be profitable.
3. Regulating the digitalizing financial industry
3.1 Regulation as a catalyst to reaping the benefits
The changing landscape in the financial industry raises the question how the new digitalized
financial services should be regulated. The goal is always to provide efficient but safe services
for households and businesses. Regulation should facilitate this and not be an impediment. It can
help reap the benefits available from new technologies.
Comparison with regulatory development in telecom and payments
As a background, it can be useful to look at another industry that has experienced a similar
change not too long ago. The telecommunication industry went through such a process in the
early 2000s.
In Europe, one of the most important steps was to unbundle services from infrastructure. Until
then, whoever owned the copper wire going into the household, had monopoly over the services
offered to that household. New EU regulation ensured that new market entrants were given the
possibility to offer services regardless of who owned the infrastructure.
The effect that this regulatory reform together with technological development had on households
was truly significant. The prices of both devices and of services decreased significantly. As data
connections became faster, cheaper and more common, also the demand for devices and
services grew at a rapid pace. To use Finland as an example, 20 years later, 95% of households
now have an internet connection, 90% have a computer, and 85% have a smart phone.
The industry structure and business models also changed. Telecom operators had to choose
between becoming pure infrastructure providers or to widen their service offerings. Regardless
of how each company chose, the industry consolidated. Companies were bought and merged,
and there was a surge of investments. Occasionally investments resulted in failures: for
instance, some technologies turned out to be victims of hype. For handset makers, value
creation moved from devices to ecosystems.
Standardization played an important role in this development. Standards accelerated innovation
and encouraged competition within the market.
Open banking (Payment Services Directive 2)
The telecom industry provides a useful learning case for the financial industry, especially
payments. Telecom and payments are both network industries and share many similarities. EU
regulation in payments, of which the Payment Services Directive 2 (PSD2) is the most recent
case, is similar in spirit to what was done in telecoms earlier.
Regulation and de-regulation are needed to enable competition and innovation. This means
opening markets to new entrants and reducing monopolistic market power. It also means that
common standards are needed. The goal should be better and cheaper services for consumers
and households. Everyone should have access to financial services at reasonable prices.
But PSD2 is not only about payments. It affects the financial industry more widely, since
payments and other financial services are intricately connected. For banks, payments are the
most frequent touchpoint to their customers. PSD2 forces banks to open their payments
infrastructure to all kinds of service providers. Customers are free to choose, and will retain
control of, who can access their accounts.
3.2 New types of risks - regulatory and macroprudential challenges
Let me next consider examples of risks, which need special attention as the digitalization
process goes along.
Competition and financial stability
First, it is essential to facilitate competition, as I described above. But we must also mind the
potential trade-off between competition and stability. It is much debated and researched. In
particular, when profit margins get tighter, the incentive for risk-taking may rise. One way to
control such adverse incentives is to insure sufficient capitalization of financial institutions, so
that their owners have sufficient 'skin in the game'. In this regard, regulators have done much
after the Global Financial Crisis. But supervisors need to stay constantly alert.
Cyber security
Second, there is the issue of cyber security.
The European financial system is highly interconnected and interdependent. This constantly
keeps the potential for financial contagion at the center of financial stability considerations. But
the highly interconnected network of institutions also implies that cyber-attacks may pose an
increasingly serious concern to the Eurosystem's financial stability.
The issue with cyber-attacks is further accentuated due to its dynamic, constantly evolving
nature and because cyber-attacks are borderless. We may still lack sufficient pan-European law
enforcement capability to fully monitor the potential for cyber-attacks. However, work has been
started to enhance cyber resilience of the Eurosystem. For instance, promoting cyber best
practices for financial market institutions, conducting cyber surveys to monitor progress, and
establishing a framework for testing procedures would be important operational objectives in the
short term.
Shadow banking, shadow markets and new unregulated players
Third, are there specific macroprudential issues that the digitalization development would raise?
One implication of the new technologies is that they may provide a way to move financial
activities to less regulated areas. This would clearly be counterproductive because the goal of
regulation should be to safeguard financial stability in the broad sense. It is therefore important
that sufficient macroprudential measures are available to counteract potential excesses
regardless of where they originate within the financial system. (Bank of Finland and SUERF are
co-organizing a conference on shadow banking in September in Helsinki, which will provide a
forum to discuss these issues further.)
4. Contribution to macroprudential analysis
My final question today is whether the new ample data resources and techniques to analyze
large-scale data can help us tackle financial stability risks in general. For instance, are new
powerful early warning indicators to be discovered by utilizing these data and techniques? This is
clearly a question for which you in the audience can provide better answers. I hope that also this
conference has given you opportunities to discuss these issues.
I believe that after the Global Financial Crisis there is an emerging consensus on a few
principles. One is that so called nonlinearities matter much for understanding and modelling
crises.
As an example of a nonlinear relationship, a shock to asset values of a certain size may not
cause much harm if leverage in financial institutions is moderate. However, the same shock can
lead to a devastating feedback effect on asset prices if the initial leverage is high.
Consequently, there is a high demand for innovative modelling of nonlinearities. Regarding the
early development of such techniques using data-intensive analysis, we have an interesting
history in Finland. Professor Teuvo Kohonen is a key developer of a well-known type of neural
network algorithms, the Self-Organizing Maps (SOM). Professor Kohonen is widely cited for that.
What are the challenges in modelling non-linear behavior of financial instabilities?
Financial crises are rare events. Hence, it is a statistical challenge to test theoretical models that
can generate financial crises.
Likewise, it is difficult to know whether we really capture true invariant relationships when we use
data-driven empirical models to trace the likelihood of financial instabilities.
You are the experts in these matters, but it seems to me that the big challenge in this research
area would be to find a way to combine the power of data-intensive nonlinear analytics to uncover
hidden relationships in the data with a proper understanding of the underlying economic
mechanisms at work.
In any case, given the limited number of crisis observations, it might be advisable to also use
clever theoretical models to gauge future risks. The models could be used to produce scenarios
of adverse developments, even such that may not have yet happened in the past.
To adapt the idea of a famous physicist in the opera Dr. Atomic, written by Peter Sellars, perhaps
experts in financial stability analysis should regularly "indulg(e) in controlled fantasies, trying to
dream up new ... phenomen(a) that (are) not contrary to our knowledge, but perhaps beyond our
experience".
5. Conclusions
To conclude, let us not forget that trust remains the necessary precondition for well-functioning
financial markets. Building and maintaining trust will ultimately determine the success of the
developers of financial services based on new technologies.
Regulation and supervision are necessary backstops to the new developments, and they must
evolve with the times.
Thank you for your attention!