The opportunity for efficient fintech is huge

Whether it’s a bubble or not, the investment binge into financial services start-ups and financial technology companies (fintech) has long looked unsustainable. There are too many opportunities swimming in an evaporating pool of investment capital.

" Efficiency in financial services boils down to fees and charges and margins on operations, whether that be borrowing, lending or payments."
Andrew Cornell, BlueNotes managing editor

Peer-to-peer lending for example, for which the poster child was long the US-based Lending Club, is starting to look shaky, after Lending Club’s chief executive resigned in fraught circumstances and the shares plunged a third in a day.

But, as always, there is more than meets the eye here. No one would seriously bet all the new fintechs and start-ups would succeed.  The question is will some fail because of idiosyncratic reasons or business model failure or market place shifts? And which will become the next Apple or Google?

There is clearly a place for digital disruption and new business models in financial services. That is clear because a fascinating body of work shows the unit price of financial services – how much it costs to transact or borrow or lend – has moved little in over a century.

The key work has been done by New York University economist Thomas Philippon. Astonishingly, Philippon’s work finds that despite the industrial revolution, the technology revolution and over a century of competition, the “efficiency” of the financial system in the US (and presumably elsewhere in the world) hasn’t improved since the 1880s.

Forget former US Federal Reserve boss Paul Volcker’s observation that the only financial innovation of benefit to humanity in recent decades has been the automatic teller machine (ATM), according to Philippon, even that hasn’t shifted the dial on efficiency.


Donald MacKenzie in the London Review of Books notes Philippon’s estimate of the unit cost of financial intermediation fluctuates through time.

“It rises to a first main peak during the financial excesses of the 1920s, falls during the middle decades of the 20th century, then rapidly increases again,” he writes. “The unit cost has come down a little in recent years, but only to roughly its level in the late 1880s.”

Efficiency in financial services boils down to fees and charges and margins on operations, whether that be borrowing, lending or payments.

Other research shows as economies evolve, financial services – along with services in general – form a greater proportion of gross domestic product. This is not unreasonable: as people become wealthier they can afford to buy and sell more, invest more and wish to protect themselves more with insurance.

Nevertheless, Philippon’s research is compelling. What it seems to be telling us is there is an opportunity for more efficient services in the financial world, whether provided by incumbents, non-traditional players or start-ups.

So there is an opportunity for disruption. Take the rise of mortgage originators in Australia in the 1990s. They didn’t have branch networks and funded their lending off securitisation rather than deposits. In the period when they were most active, more than 2 percentage points was sliced off the price of a mortgage.

For society as a whole, obtaining a mortgage became more efficient. But what happened next? Incumbent players like banks responded by using securitisation themselves, lowering their costs and even buying some of the new players.

Then when the financial crisis hit, the markets which were used to fund lending froze or became prohibitively expensive. Mortgage originators (and indeed some banks, particularly in the UK) failed not because they were insolvent due to bad loans but because they were illiquid – they couldn’t raise money.

Indeed that is what is happening in non-traditional markets today. While Lending Club and others are called “peer-ty-peer” lenders, much of the funding had been coming not from peers but major market investors such as investment banks and hedge funds.


In his review of Philippon’s work, MacKenzie agrees modern financial services are vastly more complex and pervasive. However, he argues that shouldn’t kill off the opportunity for greater efficiency.

He makes two points. One is the complexity has translated into a greater share of the costs of intermediation going to financial services wages. The other is the market actually drives complexity, not – cheaper – simplicity.

“You don’t have to spend long with today’s financial intermediaries to realise that they’re usually clever, hard-working people,” he says.

“Unfortunately, far too much of that intelligence and energy seems devoted to activities that amount to efforts to influence, outwit or outrun their fellow intermediaries. These add to the cost of intermediation without necessarily improving the effectiveness with which the financial system channels savers’ money to productive uses in the non-financial economy.”

The economist John Kay has made this argument strongly in his recent book, Other People’s Money: The Real Business of Finance. When there are no rewards for doing nothing, the market is unlikely to do nothing. And so it also rewards complexity.

So what does that mean for fintech and disruption? Philippon’s research interrogates the aggregagte cost of intermediation.But that aggregate can mask the disparity between high cost and efficient components of the value chain.

The way the latest phase of disruption is evolving, it would seem the opportunity is in the components, not replacing the system as a whole (which would have prohibitive costs) or supplanting major players (who have a degree of protection courtesy of economies of scale, barriers to entry and existing customer bases).

As Erkki Liikanen, Governor of the Bank of Finland, told a recent payments forum, “long-term economic growth and the rise in the standard of living are based on improvements in labour productivity. Digitalisation can be an important factor in this equation.

“Productivity growth means that we achieve more with the same resources. Digitalisation may also help create entirely new products and services in which productivity is higher than before. At the same time, new players will challenge traditional ones. That is precisely why digitalisation and related innovations have great potential.”

Philippon’s work has indeed shown an improvement in efficiency since the mid-90s, when the internet and digital opportunities gathered momentum. The improvement has been unsteady and it remains to be seen if it perseveres.

Liikanen observes “among economists, there are two prevailing views on the opportunities and significance of digitalisation. The pessimists consider that digitalisation's accelerating effect on economic growth is already fading. The best is already behind us.

“The optimists, in turn, predict that new technologies will trigger a sharp increase in productivity in the near future,” he writes. “They point out that development often pleasantly surprises us in the long term.”

Well, over the very long term it hasn’t pleasantly surprised us. However, that doesn’t mean it can’t. It means start-ups and potential disrupters have something to aim at. It also should mean incumbents recognise at least some parts of the value chain they currently make money from are more likely to attract attack.

For example, Bitcoin arose because someone (who knows whom?) realised there was a completely different way of thinking about a cross-border payment which had involved multiple steps and multiple costs.

So it’s not the market opportunity disappearing that’s behind the latest conniption in the fintech space. It’s more likely to be ordinary market forces and the credit cycle.

Andrew Cornell is managing editor at BlueNotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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