The End of the Beginning of Non-bank Finance?

June 8, 2014

Facebook’s plans to offer electronic payments[1] show that there is widespread interest in non-banks challenging the virtual monopoly that banks enjoy over the supply of consumer finance services. But Facebook is relatively late to this particular party; it aims to compete with financial services offered by Google and Amazon, for example, or PayPal, which long ago outgrew its role as eBay’s dedicated payments provider. There are over 200 authorised payment institutions that compete in the EU markets for various types of retail payments. The UK has also recently granted regulatory status to peer-to-peer (P2P) lending platforms that enable individuals to lend and borrow directly, rather than rely on banks’ savings and loan products.

So it’s fair to ask whether these developments really are having any impact on banks’ dominance of the financial sector. In reality, we should be clear that there is no such thing as a ‘bank’. In the UK, for example, we basically have four or five major banking groups that are made up of many subsidiaries and business units that offer different financial services to different types of customers. Each of these areas of focus has different strengths, weaknesses, opportunities and threats. But restrictive and exclusive regulation has allowed the concentration of our banking industry into these few groups, and has protected them from innovation and competition by non-banks.

For instance, only a few smaller banks, building societies and credit unions can accept deposits. And while it’s true that there are thousands of firms in the UK that can offer various types of credit to consumers and small businesses (most of which are sole traders), most of those firms rely on the major banking groups to fund their lending. Banks have also dominated the retail payments market, largely by issuing credit and debit cards through the MasterCard and Visa schemes, but also through their ownership and/or control of interbank payment systems, like BACS.

The first major challenge to bank dominance in the consumer markets arguably came in 2000, when the European Parliament passed the first ‘electronic money’ directive.[2] The intention was partly to enable non-banks (e-money institutions) to process retail payments using the ‘e-wallet’ process, although many e-money issuers operate prepaid card programmes in conjunction with the major card schemes.

To pay using e-money, you first have to purchase some by transferring the equivalent amount of real money to the issuer’s bank account. The issuer opens an account for you in its own IT systems, and records how much e-money you have bought. It keeps the real money you paid in a separate bank account from its own assets, or covers it with an insurance policy. This means that when you ‘spend’ your e-money, the issuer only needs to debit your e-money account and credit the recipient’s e-money account instead of moving real money between bank accounts (for which banks have always charged a lot of money). In fact, in an e-money system no funds need to move in the banking system until someone wants to redeem their e-money, in which case the issuer pays the equivalent amount of real money to the recipient’s bank account.

E-money was slow to catch on. However, the implementation of the Payment Services Directive[3] in 2009 has allowed EU Member States to authorise a new class of ‘payment institution’ to process other types of payments, for which the institution would only have to hold €125,000 of initial capital. These institutions are also free to operate other lawful businesses at the same time. There are over 560 fully authorised payment institutions and over 2,200 small payment institutions, almost half of which are based in the UK.[4] In 2011, the implementation of a second EU e-money directive also reduced the amount of initial capital for e-money institutions to €350,000, and allowed them to operate other lawful businesses. There are over 70 e-money institutions in the EU.[5]

The ability to operate another business at the same time as offering payments should not be overlooked. This ‘horizontal integration’ reflects how the likes of Google grew in popularity, by aligning their systems with our day-to-day activities and adding features that solve our problems in that context, rather than by requiring us to act in a way that is profitable for them regardless of what else we might be doing at the time.

For instance, you don’t really ‘pay’ for anything as a distinct consumer activity, any more than you ‘bank.’ You make payments in the course of wider activities, like shopping. Money transfers are really made in the course of, say, funding your kids’ holiday. Internet technology enables these activities to be supported by combining a number of different services into a seamless process flow, where the financial aspect is just a small, ancillary step. You don’t see ‘banking’ or ‘payments’ products from Google or Amazon, for example. But you do see an offer of credit towards your Google advertising spend, based on the performance of your ad campaigns, while Amazon might also extend credit to selected small businesses against their projected retail sales on its platforms.[6] Independent ‘marketplace finance’ providers have also emerged, such as Kabbage and OnDeck Capital, to enable businesses to leverage their marketplace transaction data.[7] This is something that banks have been slow to grasp, and it helps explain why new financial services are fundamentally different from those offered by banks.

In particular, the online P2P or ‘marketplace’ model pioneered by eBay in 1995 is now spreading from e-money to other regulated financial services, such as P2P lending and crowd-investing. The P2P model differs from the traditional retail/banking model by recognising that certain transactions do not need to be heavily intermediated anymore. Payments can be made directly between payer/payee at the same time as a direct sale of goods or services is agreed. Spare cash can be put to work more efficiently through direct contracts between lender/borrower or investor/issuer. In each case, the activity can be facilitated through a common platform that charges a transparent fee to either or both participants.

By contrast, a banking group earns its income by keeping depositors and borrowers apart, and selling each of them products that are profitable for different areas of the bank. As a result, banks have been able to charge unseen ‘interchange’ fees in their card schemes, and to enjoy a significant ‘spread’ between their savings and loan rates, rather than leaving most of the margin with the participants.[8] This also introduces the artificial concept of a ‘depositor’ or ‘saver,’ who is really just a lender to the bank.

I helped launch the first P2P lending platform, Zopa, in 2005 in the UK. By June 2012 nine other P2P finance platforms had launched, some of which enabled loans to people or small businesses or discounting of invoices, while ‘crowd-investment’ platforms had begun offering equity funding for start-ups or longer term debt finance for alternative energy projects. Six months later, 33 platform operators from across the EU signed an open letter to UK and EU policy-makers calling for more proportionate regulation to open up the P2P finance sector.[9] The Financial Conduct Authority has since introduced specific rules for P2P lending[10]  and crowd-investment.

In purely economic terms, the impact of these developments on the business of the major banking groups to date has been marginal. Most retail payments still flow through the card schemes and inter-bank payment networks -and even e-money institutions, payment institutions and P2P finance operators need to keep their customer’s outstanding funds in bank accounts. Nesta estimates that between 2011 and 2013 only about £1bn worth of finance passed over the various types of P2P platforms in the UK, excluding donations, although that figure is estimated to be about 1.6 billion in 2014.[11]

However, it is important to recognise that the major banks have had to substantially reduce their loans to people and businesses as a result of their own problems during the past six years. That process is continuing, so the market share of new entrants is more significant than it would have been if the market conditions of 2007 had continued to prevail.

In addition, the P2P model has only recently received regulatory support in the form of more liberal e-money and payment services regulation, as well as regulatory clarity on the status of P2P lending and crowd-investment. So we are still in the very early stages of industry development.

In these circumstances, Facebook’s application for e-money authorisation perhaps marks the end of the beginning of non-bank finance -and the beginning of the end of bank dominance.

Simon Deane-Johns is a Consultant Solicitor, Keystone Law, London: This article first appeared in E-Finance & Payments Law & Policy:

[1] UBy7XxIc

[2] payments/emoney/index_en.htm

[3] payments/framework/index_en.htm

[4] documents/download/38/attachement/1 30724_study-impact-psd_en.pdf

[5] Ibid.

[6] 2012/10/google-wants-be-bank-now/57691/

[7] 2014/05/05/business-lender-kabbage-closes-50-million-round/

[8] E.g. research in 2009 revealed that bank spreads were 8.6%, rather than 2.2% on Zopa: press/2009/bank%20spreads%20betwe en%20savings%20and%20loan%20rate s%20at%20historic%20levels%20_final_. pdf

[9] Peer-to-Peer_Finance_Summit_Open _Letter.pdf

[10] documents/policy-statements/ps14-03.pdf and news/firms/ps14-04-crowdfunding

[11] publications/rise-future-finance