Why banks probably shouldn't be afraid of fintech firms, but depositors should

Jeremy Kahn and Charlie Devereaux wrote an interesting article in Bloomberg Business last week, on how banks are fighting back against fintech firms:

Scrappy online financial startups have spent the past few years building buzz, backing and the beginnings of a customer base.

For a while, the world’s banking giants largely ignored them. Now they’re starting to feel the heat—and fighting back with the most formidable weapon in their arsenals: cash.

Spain’s Banco Santander SA announced a few weeks ago that it will funnel 20 billion euros ($22 billion) into digital transformation and information technology in the next four years.

On an annual basis, that works out to one-and-half times all of the venture capital Europe’s fintech startups received in 2018—a disparity highlighting that, despite all their rhetoric about burying existing banks, fintech firms and neo-banks are still monetary pipsqueaks facing an uphill battle against entrenched competition.

There's been a lot of rhetoric over the last several years about disruption in the banking sector, and how small fintech firms will eventually crush the banks (for example, see here or here). However, how at risk are the conventional banks really? I'd argue that they're probably not at risk (at least, not yet), and not just because they have financial backing that the fintech firms can only dream about.

This is a story about trust. To see why, let's rewind to a time when banks were still very new. Depositors (or savers) couldn't necessarily be sure that their money was safe in a bank. They might worry that their bank was a crook, and honest bankers had a challenge to convince depositors that they weren't crooks. Essentially, there was a problem of adverse selection in the banking market.

Adverse selection may arise when there is information asymmetry - that is, when there is some private information about characteristics or attributes that are relevant to an agreement, and that information is known to one party (the informed party) to an agreement but not to others (the uninformed parties). The informed party then uses their access to that information to their own advantage (and to the disadvantage of the uninformed party).

In the case of banking, the 'agreement' is between the depositor (who has money) and the bank (who offers to store the money for the depositor). In the early days of banking, the problem was that information about whether the banker was honest, and wouldn't run off with the depositors' money and leaving them broke and angry, was private information. Each banker knew whether they were an honest banker, but the depositors didn't know who was an honest banker. You might think I am joking, but in the early days of banking, crooked bankers were a very real problem.

So, in the early days of banking, the real problem was a lack of trust. Depositors couldn't trust that any old banker would keep their money safe. It wasn't easy to tell the honest bankers and the crooks apart. So, how could an honest banker convince depositors that they were an honest banker?

Honest bankers engaged in signalling. Signalling is when the informed party (in this case, the banker) tries to reveal the private information (that they are honest) to the uninformed party (the depositor). There are two important conditions for a signal to be effective: (1) it needs to be costly; and (2) it needs to be more costly in a way that makes it unattractive for those with the low quality attributes (the crooks) to attempt. One way that signals could meet the second condition is if they are more costly to the crooks. These conditions are important, because if they are not fulfilled, then those with low quality attributes could signal themselves as having high quality attributes - the crooks could easily pretend to be honest bankers.

In the early days of banking, a banker signalled that they were honest by engaging in a costly building exercise. Have you ever wondered why old banks are often huge stone buildings with big classical columns and suchlike? A big stone building is more difficult for bank robbers to break into, sure. But it is also very costly to build. And, if you're intending to build a building for your bank and keep it for a long time (which is what an honest banker would do), it's much less costly than building the bank and leaving it behind when you move onto the next town full of suckers (which is what a crook would do). Depositors could trust the bankers who had big expensive buildings, because having a big expensive building was only something that an honest banker would have.

Anyway, back to fintech firms and modern banks. Fintech firms are new. They haven't had time to develop trust with depositors, or a reputation for being safe, to the extent that conventional banks have. Depositors couldn't know which fintech firms are honest, and which are crooks.

How can fintech firms signal to depositors (or savers) that they are honest? Fintech firms don't have big stone buildings. And basically, anything that an honest fintech firm does to try and differentiate itself from a crook can be easily copied by the crooks. Maybe it's not the banks who should be worried about the fintech firms - it's the depositors who should be worried!

However, maybe there is one way for a fintech firm to signal they are honest, and it is fairly ironic. Being owned by a bank is costly for a fintech firm, as Kahn and Devereaux note:

And while most fintechs are turning losses, they have one big thing going for them: they don’t have outmoded technology weighing them down. Many major banks would need to spend billions of dollars just to bring their IT systems into the 21st century. Even Santander’s Parthenon back-end software platform is increasingly antiquated even though it is newer than what a lot of the other European banks use.

“While they can copy our features, they cannot copy our cost base,” Starling Bank said in a statement. “They have to contend with legacy technology, not to mention the massive costs of maintaining a branch network and the slowness to action that is inevitable with large bureaucracies.”

Only an honest fintech firm would be willing to face the costs of having a bank on board. And, banks would only want to associate with honest fintech firms (or at least, we can hope that's the case!). A crooked fintech firm isn't going to want to face the costs of associating with a bank. So, maybe being owned by a bank is an effective signal to depositors that they can trust a fintech firm? This key point is missing from the conclusion to Kahn and Devereaux's article:

For now, though, [conventional banks'] giant budgets will loom large over the fintech industry—especially if digital banks fail to win over deposits in the next few years.

Fintechs will need to build “a truly different customer journey” to capture significant market share, said James Lloyd, the Asia Pacific financial technology lead for consulting firm Ernst & Young LLP. “I don’t think it will be sufficient to just have another bank product in a digital format, offering a slightly better customer experience.”

Part of the customer experience is finding some way to signal to customers that they can trust you. In an era where Bernie Madoff and the Global Financial Crisis are still casting a long shadow, trust in finance firms is more important than ever.

[HT: New Zealand Herald]

Jeffrey Clemens on the disemployment effects of the minimum wage

The debate among economists over whether minimum wages reduce employment has been ongoing ever since David Card and the late Alan Krueger published this paper in 1994, if not longer. My reading of the evidence, and especially the recent evidence out of Seattle and Denmark (see my posts here and here and here for more), is that higher minimum wages do reduce employment.

Jeffrey Clemens has a new article on the Cato Institute website that I think does a great job of summarising the literature (including those articles I blogged about), and is well worth reading. Here is part of the introduction:

This policy analysis discusses four ways in which the case for large minimum wage increases is either mistaken or overstated.

First, the new conventional wisdom misreads the totality of recent evidence for the negative effects of minimum wages. Several strands of research arrive regularly at the conclusion that high minimum wages reduce opportunities for disadvantaged individuals.

Second, the theoretical basis for minimum wage advocates’ claims is far more limited than they seem to realize. Advocates offer rationales for why current wage rates might be suppressed relative to their competitive market values. These arguments are reasonable to a point, but they are a weak basis for making claims about the effects of large minimum wage increases.

Third, economists’ empirical methods have blind spots. Notably, firms’ responses to minimum wage changes can occur in nuanced ways. I discuss why economists’ methods will predictably fail to capture firms’ responses in their totality.

Finally, the details of employees’ schedules, perks, fringe benefits, and the organization of the workplace are central to firms’ management of both their costs and productivity. Yet data on many aspects of workers’ relationships with their employers are incomplete, if not entirely lacking. Consequently, empirical evidence will tend to understate the minimum wage’s negative effects and overstate its benefits.

Do read the whole article, if you are interested in what the (especially latest) research on the minimum wage has to say.

[HT: Marginal Revolution]

Handgun purchase delays and suicide

Some statistics really make you sit up and take notice. For instance, in the U.S., there are about 60 firearms-related suicides every day (you can find the data at the CDC website here). That's nearly twice the number of people who die by firearms-related homicide, and more than half of all suicides. Clearly, policy should be trying to address this issue.

Waikato's Economics Discussion Group recently discussed this recent article by Griffin Edwards (University of Alabama at Birmingham), Erik Nesson (Ball State University), Joshua Robinson (University of Alabama at Birmingham) and Fredrick Vars (University of Alabama), published in the Economic Journal (ungated version here). In the paper, Edwards et al. looked at the effect of mandatory handgun purchase delays on firearms-related suicides and homicides in the U.S.

With a handgun purchase delay, you can't simply rock up to a gun store and walk away with a pistol - you have a stand-down period, after which you can return to pick up your weapon. The theoretical argument here is that this should reduce firearms-related suicides, because it provides for a cooling-off period, during which the potential victim has an opportunity to change their mind (about inflicting harm on themselves), or others may have an opportunity to intervene. You wouldn't expect such a cooling-off effect in the case of firearms-related homicides.

Using state-level data on whether handgun purchase delay policies are in place, Edwards et al. find that:

...any mandatory purchase delay reduces firearm-related suicides by between 2% and 5%, and we find no statistically significant substitution towards non-firearm suicides. Additionally, mandatory purchase delays are not statistically significantly related to homicides.

More or less, that is what you would expect from theory. Of course, this policy has no effect on people who already own a gun. If you're thinking about this sort of policy to reduce suicide, you would go into it knowing that it would only be effective for preventing suicides where the potential victim has to first purchase a gun. And, it won't stop them from trying some alternative means (although Edwards et al. do show a negative, but not statistically significant, effect on all suicides). The paper made me wonder about whether this sort of policy would be effective in a country like New Zealand. Of interest on that point, Edwards et al. also find that the:

...effect seems to be largest in states with relatively few firearms and that the effect dissipates as firearm prevalence increases.

As I noted in a post in March, gun ownership (of all types, not just handguns) is much lower than in the U.S. So, maybe that gives some cause for optimism for a policy like this in New Zealand? However, I'd argue that we already have a mechanism in place that delays firearms purchases. People wanting to buy a gun for the first time need a firearms licence, and the licence granting process has an in-built delay while reference checks are made, etc. So, there is already a cooling-off period for anyone who might be thinking of self-harm but first needs to buy a gun.

Not all gun restricting policies are necessary.

Read more:

• Registering guns vs. registering gun owners

When you ban plastic bags from supermarkets...

... people will take the supermarket baskets instead. As the New Zealand Herald reported a couple of weeks ago:

Since the move away from having plastic bags in their stores, some Countdown supermarkets have had the odd shopping basket go walkabout.

For the most part, Countdown says Kiwis remember to bring their own shopping bags and use them to carry their groceries.

However, one customer found out the hard way yesterday afternoon that some people clearly haven't got used to bringing their own bags.

When the customer walked into Countdown Lynfield in Auckland he could not find any of their distinctive green shopping baskets.

A staff member told him 175 baskets had been stolen.

Why steal a supermarket basket? Basket thieves could be rational, and weigh up the costs and benefits of their actions. The options for a would-be basket thief are to take the basket, or to buy a reusable bag, or to do neither and find some other way of transporting their groceries home. Assume the benefits of all three methods of transporting groceries are the same (after all, the outcome is that the groceries end up at home, either way). The difference is in the costs, and the rational basket thief will choose whichever option has the lowest cost.

Reusable bags have a monetary cost (at Countdown they start from $1 each). Not using a bag or a basket comes with a cost in the form of the awkwardness of transporting the groceries (balancing multiple items in your arms), or having them rolling around loose in the back of the car, etc. Taking a basket comes with a moral cost (the thief feels bad about taking the basket) and a social cost (other people will think badly of the basket thief if they find out).

How this calculus plays out will be different for different individuals. Those who feel moral and social costs greatly will buy the bags (or do without a bag or basket), while those who care less about moral concerns and how others think about them will take a basket.

How should the supermarkets respond? Increase the costs to would-be basket thieves. Make the security doors beep loudly when a basket is taken out, drawing attention to them. Have penalties for stolen baskets. Shame thieves by posting CCTV photos of them and their ill-gotten baskets. All of these options increase the costs of stealing a basket. They won't deter the most brazen basket thieves, but basket theft will reduce. When the costs of doing something increase, we tend to do less of it (including stealing supermarket baskets).