The following is a summary of an article authored by Sam Ferraro that appears in the April 2020 issue of the Australasian Journal of Applied Finance, entitled The Future of Shadow Banks and Fintech Lending in Australia.
Overview
Australia’s shadow bank sector – which includes most fintech lenders – remains small by global standards. The phased introduction of Open Banking and Comprehensive Credit Reporting is expected to foster innovation and provide growth opportunities for fintech firms. Big technology firms with well established brands and access to granular user data are also likely to contribute to growth in fintech lending. Nonetheless, our key contention is that institutional and policy developments will likely impose a constraint on the size of fintech lending and shadow banking more generally.
Disruption
Fintech lending holds out the promise of disrupting the provision of traditional financial services through intermediated and disintermediated solutions. Digital or neo-banks offer prospective borrowers the ability to fill out a loan application completely online, while online payday lenders provide immediacy in terms of the funds lent, often making the loan amount available on the same day. Online marketplaces such as peer-to-peer and crowd-funding platforms, represent solutions that involve lighter touch intermediation by matching borrowers with investors via a common digital platform (Davis & Murphy 2016). In future, blockchain or distributed ledger technologies might offer a completely disintermediated solution.
The dark side of fintech
Fintech lenders have focussed on small personal loans and mortgage lending. These loans are more homogeneous than business loans and rely heavily on ‘hard’ sources of information around creditworthiness; information which can be easily communicated online and processed quickly. The fast track applications of some short-term lending models are exempt from the responsible lending provisions of the National Credit Act, which imposes caps on costs payable for short-term credit products. This allows the lender to charge borrowers exorbitant financial supply and account fees to obtain ‘credit’. ASIC has proposed using its new product intervention power to remove this exemption (ASIC July 2019).
Some fintech lenders advertise low headline interest rates but with a sting in the tail: high establishment fees, and high default and late payment fees. Having accessed five online short-term credit lenders in mid-2019, we obtained estimates of the weekly repayment and number of repayments based on a loan of $2,000 with the term ranging from 13 weeks to 52 weeks. The implied interest rates ranged from 120% p.a. to 220% p.a., which includes establishment or set up costs but does not incorporate default fees.
The consumer protection provisions of the National Credit Act also do not apply to BNPL activities, which allow a consumer to buy and receive the good or service immediately but pay for the purchase over time (ASIC November 2018). BNPL providers charge a small fee or no fee to consumers – as long as consumers meet their scheduled payments – but charge the retailer around four per cent of the purchase price. ASIC has found that some terms of BNPL contracts are potentially unfair to consumers: the providers have unilateral discretion to vary the terms of the contact and they provide for a wide set of circumstances that trigger consumer ‘default’ (ASIC November 2018). Because of the small fees levied on consumers, BNPL arrangements are not considered to be a provision of credit and are therefore exempt from the responsible lending provisions of the National Credit Act. Consequently, BNPL vendors have little incentive or obligation to assess the creditworthiness of users.
ASIC is considering using its new product intervention power to extend its regulatory authority over BNPL arrangements and the provision of short-term credit, as part of its renewed focus to address and prevent significant consumer detriment. We view this as a welcome development. Firms would no longer be able to exploit loopholes in the National Credit Code to avoid responsible lending provisions, which should assist in reducing the incidence of ‘at risk’ borrowers getting caught in a vortex of debt repayments.
Lessons from the financial crisis
Policy makers’ concerns around systemic risk represent a key constraint on the future growth of shadow banking and the fintech sector. A key lesson that prudential regulators around the world have heeded from the financial crisis is to better manage risks posed by the growth of shadow bank lending. In the United States, shadow banks’ excessive leverage, their securitisation of poor quality assets and limited access to central bank liquidity exposed fault-lines in the financial system. The RBA has stated that growth in shadow bank lending could potentially pose a risk to financial sector resilience (Gishkariany 2017). This view is shared by a former member of the Board of Governors of the Federal Reserve, Mr Daniel Tarullo, who draws attention to the systemic risks posed by shadow banking. “…the current regulatory framework does not deal effectively with threats to financial stability outside the perimeter of regulated banking organizations, notably from forms of shadow banking.” (Tarullo 2019).
Concluding remarks
Fintech firms are at the forefront of the information revolution in finance and related sectors. The revolution is not all just about the technology of big data reducing the costs of efficiently processing large amounts of granular user and customer data. It is as much about the phased introduction of Open Banking, which will reduce the institutional barriers to information sharing between industry players. Fintech firms will continue to innovate and disrupt, some in collaboration, others in competition with conventional banks.
Despite these developments, we believe that a number of regulatory factors are likely to limit competition in financial services and cap the size of the fintech sector and shadow banks in Australia. ASIC is narrowing the scope for fintech lenders and shadow banks to engage in regulatory arbitrage because of heightened concerns around addressing significant consumer detriment in light of the findings of the Hayne Royal Commission. Moreover, authorised deposit taking institutions will continue to enjoy a competitive advantage in relation to access to low cost funding. Finally, our analysis highlights the trade-off that policymakers face between encouraging competition in the provision of financial services and containing systemic risks within the financial system.