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On Thursday & Friday, March 18 & 19, Amit Seru joined Markus’ Academy and Princeton Lectures in Finance for a lecture on “The Rise of Fintech Intermediaries”. Seru is a Professor of Finance at the Stanford Graduate School of Business, a Senior Fellow at the Hoover Institution and Stanford Institute for Economic Policy Research (SIEPR), and a Research Associate at the National Bureau of Economic Research (NBER).

Watch the full presentations below. You can also watch all Markus’ Academy webinars on the Princeton BCF YouTube channel.

Watch Parts 1 and 2 below. You can also watch all Markus’ Academy webinars on the Princeton BCF YouTube channel.

Part 1

Part 2

Executive Summary

Thursday, March 18, 2021

  • Shadow banks who don’t take deposits and are therefore not regulated like a traditional bank have disrupted every aspect of traditional banking activity from lending to payments to wealth management and investment banking. The disruption is big in most of these segments — for instance in consumer lending, shadow banks have more than 40% share in the new originations occurring in the US right now. Within the consumer market, if one focused on the mortgage market, six of the top 10 largest mortgage lenders in 2018 were shadow banks, many of whom, like Quicken (“fintech”s), rely heavily on technology.
  • One reason for this rise in the lending market — but it could apply to other bank activities as well — is that banks were heavily regulated after the Great Recession, which dampened their activity, a gap that shadow banks filled. Seru’s research has found that there is a strong relationship between regions in the US where regulatory pressure was high on banks and an increase in shadow bank activity. Another reason for the recent rise of shadow banking is technology that some of the fintech shadow banks use relative to banks. The common argument for why such intermediaries are gaining traction is related to lower costs due to technological advantage they possess. Another argument is that technology allows such intermediaries to screen in the “low credit risk” types of borrowers (possibly due to big data/better models).
  • However, Seru argues that many fintech shadow banks that employ new IT technologies are in fact expensive; they gain market share by providing new products to consumers (e.g., offering convenience) who have a high willingness to pay. One way to see whether technology has played a role in how fintech’s operate versus banks is to compare how long it takes to sell a loan after it originated — fintech’s are much faster (15-20 days faster relative to average of 45 days) potentially due to more access to information. Another way to see this is through consumer surveys which consistently place fintech lenders such as Quicken the highest in terms of customer satisfaction based on convenience and speed with which the transaction was done. Unlike the common argument, fintechs are not necessarily cheaper — they cater to consumers whose willingness to pay (measured by interest rates on loans) is higher for fintechs. This may be due to the convenience fintechs provide when helping originate mortgages. Thus, technology in this market leads to higher market share for fintech lenders not because they have lower costs. Nor does it help to screen in “low credit risk” consumers  
  • Another window into what technology is doing to intermediation pertains to iBuyers, intermediaries who have a “balance sheet” and rely on technology to buy and sell homes instantly. They differ from homeowners in that they do not gain any flow benefits from staying in the home. While technology helps them transact in homes quickly (through automatic valuation models for instance), they might suffer adverse selection due to their quickness. iBuyers typically target mid-range, cookie cutter homes and keep them on the balance sheet for around 3 months and earn a high 5% spread (with 3.6% through discount on buying and remaining as premium on sale). Listing is avoided for homeowners who sell through iBuyers, which speeds up the transaction process. For this convenience, such homeowners seem to be willing to pay the “fee” (i.e., sell at discount to iBuyer). With respect to the three key economic forces for intermediaries, iBuyers have fast speed, no occupation during the time they have bought the home but have not sold it yet, and moderate adverse selection due to less evaluation of the house. 
  • Seru’s model found that technology elements of “quickness” (fast speed) and “accurate” (low adverse selection) are essential to iBuyer market share. In short, a balance sheet is not enough — technology has an important role to play in why such intermediaries are able to provide products that have not been provided before. However, this implies that technology has limits on who they can provide the service to. They are able to provide this product in more liquid markets and those where pricing errors from algorithmic pricing is likely to be low. That is, iBuyer technology provides a convenient and quick product for a fee — thus providing liquidity in segments of the market that might need it the least.  
  • In conclusion, fintech intermediaries have facilitated massive expansion of non-bank institutions. Not all of this expansion is due to homogenous products offered at a low cost or due to screening of risk. A lot of fintech innovation is in fact about offering products that provide convenience to consumers who have a high willingness to pay (i.e., for a fee).

  • The talk opened up several open questions from why banks have not adopted such technology on their own, to what the right balance of supervision versus innovation should be for non-bank institutions that are moderating large economic activity, to what the right balance of data and technology used to customize products for consumers should be that maintains appropriate level of privacy.


Friday, March 19, 2021

  • The traditional view of banking where deposit taking institutions originate most loans in the economy and keep these loans on their balance sheets is obsolete. The modern view of the intermediation is different and needs to incorporate two major aspects: activity that has migrated to shadow banks and changes to business model of traditional banks. 
  • The first aspect is important because non-deposit taking shadow banks now moderate a large part of lending and other activities. Importantly, shadow banks have not penetrated all sectors of the economy in the same way. Thus it is important to understand which  segments shadow banks are able to compete well with banks and which ones they cannot. For instance, in the mortgage market, shadow banks haven’t gained market share uniformly — they have mainly increased their share in the government mandated “conforming market” rather than in the private “jumbo market”. 
  • The second aspect is important because banks are increasingly originating loans to distribute (OTD) them (i.e.,securitizing them). This is a phenomenon across various loan activities. For instance, banks sell a vast majority of conforming mortgage loans they originate (to Government Sponsored Entities, GSEs). Interestingly the extent of retention versus selling by banks depends on their balance sheet capacity. Those with substantial balance sheet capacity tend to retain more than other banks. 
  • Shadow banks have a different business model from banks, where they retain very little and mainly sell to GSEs. Thus one can imagine the intermediation sector doing lending having a spectrum of lenders with different business models — shadow banks with OTD model on one end and banks with strong balance sheets doing significant retention and some OTD on the other end. Weakly capitalized banks doing more of OTD and less of retention would be somewhere in the middle.

  • Another aspect that is important is how banks and shadow banks fund their activities. Shadow banks finance their activity with much more equity compared to banks.

  • Seru proposes that the modern view of intermediation — and regulatory framework around it — needs to consider all these aspects. This implies appreciating industrial organization (i.e., competition between banks and shadow banks), business models of intermediaries and the equilibrium interactions between them. The model has a rich demand side that captures consumer heterogeneity driven by demographics as well as a supply side that takes into account different kinds of lenders (i.e.., traditional banks, non-fintech shadow banks and fintech shadow banks) as well as regulations they face (in particular for banks, capital requirements and regulatory burden).
  • The estimated model allows Seru to conduct counterfactuals related to different regulations and policies.  The model illustrates the importance of the two aspects — the shadow bank migration channel and the bank balance sheet retention channel and how these interact with different policies in non-obvious ways when thinking about different dimensions such as aggregate lending, bank stability (based on risk on bank balance sheet) and redistribution. For instance, research found that increasing capital requirements from 6 to 7.5% doesn’t greatly change aggregate lending. Activity migrates to shadow banks and banks move from retention to OTD and together these counteract most of the contraction of lending that occurs on bank’s balance sheet due to raised capital requirement. On the other hand Secondary market interventions such as QE dramatically impacted aggregate lending because both aspects — migration to shadow banks and banks selling rather than retaining — are amplified by such policies. These policies have very different redistributional effects. For example, increasing capital requirements in the mortgage market will most impact wealthy borrowers in high house price areas. This is not the case for policies such as QE. The exact nature of redistribution depends on the market structure and industrial organization of banks and shadow banks

  • Modern intermediation viewed this way also allows us to look at shadow bank choices and ask how much lending is possible with much higher capitalization. Shadow banks are able to do as much lending as banks (if not more) with substantially higher equity, no deposits (and no branches). This suggests that concerns that higher equity capitalization of banks — implying fewer deposits — might adversely impact lending might be unfounded.

  • Regulatory burden/pressure is not just about capital requirements. Regulatory pressure on banks explains where banks retreated and shadow banks entered in significant ways.

  • Modern intermediation also implies a different outlook on the nature of debt relief transmission during periods of distress. The changed nature of intermediation does not only impact how we think about aggregate lending and other outcomes in response to regulations and other policies. Because a large amount of activity is moderated by shadow banks — who have different balance sheet and liquidity management than banks — the debt relief passed by these entities to the real economy is quite different. For instance, forbearance to households was passed at a much lower rate by shadow banks relative to traditional banks under the CARES act passed during the current pandemic. Such ex post effects are to be expected given the changed nature of intermediation.

  • Several open questions remain, starting from what activities (such as lending, payments etc) can banks do without deposits (like shadow banks); this has implications on what activities might be bundled or unbundled as banks face competition from fintechs and other shadow banks. It also remains unclear what type of loans banks decide to sell versus retain on their balance sheet. Another aspect that deserves attention is the intriguing pattern that uninsured leverage for both banks and shadow banks increase with size. Finally, given the complexity in the system, should we focus on fine tuning regulation by moving many complicated pieces together or might requiring banks to hold higher equity be a simpler solution.
  • In conclusion, views and regulations focused only on bank balance sheets are very incomplete. Assessing financial stability in this modern era involves understanding the business model of shadow banks and traditional banks, the industrial organization of the market and the equilibrium interaction of intermediaries.