FinTech growth and digital banks' risk appetite stoking stability concerns, IMF says

Neo banks and financial platforms are rapidly growing into higher-risk business segments, creating regulatory challenges

The IMF says FinTech platforms and neo banks are more exposed to risks from consumer lending their conventional counterparts. Reuters

The combination of rapid growth and increasing importance of digital banks and FinTechs entail system-wide risks for financial stability as new digital platforms grow aggressively into risky business segments, the International Monetary Fund said.

Although FinTechs can broaden consumers' access to financial services, reduce costs and increase efficiency, their rapid growth in “systemic importance” is also creating regulatory challenges, the fund in Washington said in a blog on Wednesday.

“Such changes also raise the stakes for regulators and supervisors — while most individual FinTech firms are still small, they can scale up very rapidly across both riskier clients and business segments than traditional lenders,” Antonio Garcia Pascual, deputy chief at the IMF’s Global Markets Analysis division and Fabio Natalucci, deputy director at the fund’s Monetary and Capital Markets department, said in the blog post.

“The risk management systems and overall resilience of most neo banks remain untested in an economic downturn.”

The pandemic has accelerated existing trends in the payments industry, including shifts toward touchless payments, instant payments and cash displacement. Getty Images

Demand for digital payments and other FinTech services has grown during the pandemic as more people use online banking services to transfer money and pay for e-commerce transactions.

The global FinTech market is expected to reach $334 billion by 2026, growing at a compound annual rate of more than 25 per cent between 2022 and 2027, research consultancy Market Data Forecast said in its FinTech report.

Globally, digital payments are expected to grow to $8.26 trillion by 2024, from $4.4tn in 2020, Statista says.

Banks, which directly compete with FinTechs for business, are also aggressively investing in their smaller rivals or creating their own digital arms to capitalise on growing demand for digital banking services.

In the Middle East, the FinTech sector is growing at a 30 per cent annual compound annual rate. By the end of this year, more than 800 FinTech companies operating in segments including payments, InsureTech and cyber security are expected to raise more than $2bn in venture capital funding, estimates by the Middle East Institute suggest.

Mena start-ups received $2.6bn in venture capital investments last year and FinTech was the only sector to have recorded more than 100 deals, accounting for 17 per cent of total capital raised last year, data platform Magnitt said.

The IMF said despite growing importance of FinTech platforms and neo banks in their local markets, these platforms are more exposed than their traditional counterparts to risks from consumer lending, which usually has fewer buffers against losses as it tends to be more uncollateralised.

Their exposure also extends to higher risk-taking in their securities portfolio, as well as greater liquidity risks, specifically in terms of liquid assets held relative to their deposits as they tend to be lower than what traditional banks hold, IMF said in its Global Financial Stability report.

“FinTech companies not only take on risks themselves but also exert pressure on incumbents,” the IMF said.

“The case study of the US mortgage market presents evidence of a significant negative impact of competitive pressure from FinTechs on the income of traditional banks.”

The extraordinary growth in the past two years of financial intermediation based on crypto assets, known as decentralised finance, or DeFi, can potentially offer higher efficiency and investment opportunities.

However, DeFi is increasingly becoming linked with traditional financial intermediaries and while its market size is still relatively small, “unregulated DeFi poses market, liquidity and cyber risks against a backdrop of legal uncertainties”, the IMF said.

To mitigate risk, policies that target both FinTech companies and incumbent banks proportionately are needed.

“This way, the opportunities that FinTech offers are fostered, while risks are contained,” IMF officials said in the blogpost.

For neo banks, more robust capital, liquidity and operational risk management requirements in proportion to their risk levels should be implemented. Greater focus on the health of less technologically advanced banks is also needed as their existing business models may be “less sustainable over the long term”.

“As more financial-services activity moves from regulated banks to entities and platforms with little or no oversight, so do the associated risks,” IMF officials said.