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Can E-Money Do to Banks What Amazon Did to Booksellers?

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Will technology transform financial institutions in the same way that Amazon disrupted the bookselling industry, or is talk about the impact of increased digitization of financial services merely hype? The answer depends on what type of financial service we're talking about.

At the basis of a financial system is money as a trusted means to facilitate economic transactions. Without it, we would live in a barter economy, and my life -- for one -- would be pretty rough. Which farmer or landlord, for example, would value reading this blog enough to give me food or shelter in exchange? Money allows me to get paid for my work by one set of people and buy goods and services from another.

Financial services then let me use my money to meet additional needs. Financial institutions intermediate money in terms of space, time and possible risk outcomes. Payments or an overseas transfer intermediate money across space; today's savings for future retirement income is intermediation across time; and buying life insurance to cover your kid's upbringing and education if something happens to you is intermediation across possible risk outcomes. Without such financial intermediation, life would be a roller coaster. On payday, we would be flush with money but on others illiquid. Managing unforeseen events would be difficult. Want to buy a house? Forget it. No one can save up for that kind of expense by stashing cash under a mattress.

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Photo credit: Yavuz Sariyildiz

The impact of digitization is likely to vary significantly across these forms of financial intermediation. Payments will be affected most. Carrying and sending physical wads of cash is not an efficient way to do business. Studies estimate that physical cash as the basis of transactions, whether in a low, mid or high income country easily costs an unnecessary one+ percent of GDP. When people trust digital means of payment, and when regulators let the system flourish, people start going "cash-lite." That's why mobile money is spreading in a number of developing economies, and why, according to a new study, 40 percent of Americans now typically carry less than $20 cash in their wallets. Digital payments have additional benefits as they can contribute towards broader societal objectives such as greater transparency in government payments, reduction in possible corruption and greater efficiencies in taxation.

On the other end of the spectrum, financial services that involve more intermediation over a longer time period and trickier risks are less likely to be affected by digitization. Privately funded pension schemes, for example, are driven by life expectancy and the cumulative effect of decade-long contributions. Digitization in of itself does little to alter the fundamental actuarial economics of financial security in old age.

A lot of action in-between impact extremes

A new crop of innovators are trying their luck somewhere in-between these impact extremes, in the nexus of shorter-term savings, credit and current accounts. Here the digitization of financial services can match borrowers and savers in novel ways and new digital data can improve the underlying business economics.

One of the pioneers is Silicon Valley-based LendingClub. Since 2009, its online platform has channeled $2.6 billion directly from investors to borrowers. Because it cuts out the traditional branch-heavy bank cost structure, it claims it can pay attractive rates to lenders while reducing interest costs to borrowers.Germany's Lendstar and Puddle in the United States are creating web platforms that allow friends and family to borrow from and lend to each other. Emerging market start-up Lenddo is transferring the idea of social collateral that played a role in the microcredit innovation 30 years ago to the Internet age. It uses social standing and peer pressure via social media to assess credit risk and to nudge repayments.

The biggest potential in this arena might be with Internet juggernauts like Google, which have built trusted brands and large user bases. Alibaba out of China has created online platforms with 800 million registered participants, processing one million transactions a day at the end of 2012.

Expanding beyond online payments, it has launched the "Alipay Wallet" that lets subscribers invest in money market mutual funds. Within a week, the new offer had one million subscribers. Similarly, "AliFinance" provides loans to vendors on the marketplace platforms. It has built a proprietary credit scoring model based on online user data to underwrite loans at a far lower cost and with much faster turnaround time than traditional banks could.

Technically, Alibaba at this point is "just" one gigantic frontline agent for the Asset Management Company that takes the mutual fund deposits and the Non-Bank Finance Company that extends the small business loan. But because of its sheer size, Alibaba's contribution in the new, emerging provider eco-system dwarfs the valued add of its partners and thus has the potential to fundamentally change the traditional supply-side economics.

The increasing digitization of financial services should help reach more people with better-suited services at lower costs. How much of this potential can be realized will depend on the way in which consumers trade off benefits of innovation against concerns they might have around issues such as privacy; on what regulators will allow as they try to optimize across the financial policy objectives of inclusion, system stability, financial integrity, and consumer protection; and on the ability of providers to truly create new value for consumers.

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