• W. Scott Frame, Larry Wall and Lawrence J. White

Technological Change and Financial Innovation in Banking

FinTech has captured the popular imagination whether it be the use of artificial intelligence for financial product marketing and advisement, borrowing money from virtual marketplace lenders linked to capital markets, or the curiosity of cryptocurrencies. In a recent working paper, ‘Technological Change and Financial Innovation in Banking: Some Implications for Fintech’, we surveyed the academic research literatures pertaining to several technology-driven financial innovations that appeared in prior decades in an effort to glean some insights into the prospects for certain widely discussed fintech applications.

Finance facilitates virtually all production activity and much consumption activity, and so improvements in the financial sector can have direct positive implications for an economy. Advances in telecommunications and information technology have spurred financial innovations that have altered many financial products, services, production processes, and organizational structures. To the extent that such innovations reduce costs or risks, social welfare may be improved.

A good example of technological change that has been dramatically reshaping the financial services industry is the ongoing shift from relying on human judgment to automated analysis of consumer data. This has taken what had been largely local markets for banking services and opened them up to competition from physically distant banks and nonbank financial institutions. For example, consumer and small business loan applications are now routinely evaluated using credit scoring tools built using comprehensive historical credit registry databases. This automated approach eliminates the need to have a local presence to make a loan and substantially reduces underwriting and compliance costs for lenders. The resulting data can also be leveraged to improve further their risk measurement and management. Such a reliance on hard information also makes underwriting transparent to third parties and hence facilitates secondary markets for retail loans through securitization, which allows nonbank firms that lack deposit funding to compete via capital market financing. The academic literature evaluating these trends indicates that they have resulted in expanded credit availability along both intensive and extensive margins.

Many fintech firms combine automated analysis of retail customers with more user-friendly interfaces to provide services that are more convenient, and sometimes lower cost, to consumers. For example, “marketplace lending” platforms have emerged as a new organizational form that attracts borrowers with a simplified loan application process, leverages credit scoring tools to analyze these applications, and then matches creditworthy borrowers directly to investors. Furthermore, in some jurisdictions, machine learning (artificial intelligence) is now being leveraged to further improve retail loan risk measurement.

Another set of recent technological developments are being touted as potentially affecting the financial system even more fundamentally. Blockchain and distributed ledger technologies are currently being used for the issuance and transfer of cryptocurrencies as well as for early-stage funding of technology companies via initial coin offerings. Looking to the future, some have promoted blockchains as a way of eliminating the need for trusted third parties in multiparty transactions; for example eliminating the need for banks to actively manage a payments system. Whether -- and to what extent -- blockchains and cryptocurrencies will disrupt the existing financial system remains to be seen, as the technology is too new and immature to draw firm conclusions. However, the potential benefits of cryptocurrencies and blockchain technology are sufficient to attract considerable interest from tech-knowledgeable individuals, large financial organizations, and even major governments.

This is a very exciting time to study financial innovation and the continued evolution of banking.

The views expressed do not necessarily reflect those of the Federal Reserve Bank of Atlanta or any other entities within the Federal Reserve System.

W. Scott Frame and Larry Wall (Federal Reserve Bank of Atlanta), Lawrence J. White (NYU)

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