‘Fast-Moving’ Fintech, Defi Need Tougher Regulations, Says New IMF Report

April 21, 2022
A new report from the International Monetary Fund (IMF) has called for greater regulation of “fast-moving” fintech firms, including neobanks and decentralised finance (defi) whose rapid growth could pose “systemic” risks to financial stability.

A new report from the International Monetary Fund (IMF) has called for greater regulation of “fast-moving” fintech firms, including neobanks and decentralised finance (defi) whose rapid growth could pose “systemic” risks to financial stability.

While admitting that both digital banks and defi are “still small”, the IMF has warned in its latest Global Financial Stability Report that the ability of these first to scale up quickly and expand into riskier business segments and clients requires tougher regulation.

The IMF believes greater regulatory scrutiny will ensure fair competition with incumbent rivals and protect consumers.

A high-growth, high-risk headache for regulators

The report begins by stating that digital banks (also known as neobanks) are growing in systemic importance, particularly in emerging markets, but such banks have three main vulnerabilities:

  1. Higher risk-taking in retail loan originations without appropriate provisioning and underpricing of credit risk
  2. Higher risk-taking in the securities portfolio
  3. An inadequate liquidity management framework.

In its main case study described in the report, the IMF looked at competition between 37 neobanks (defined as “direct, branchless banks that acquire and serve customers primarily through digital touchpoints, such as mobile apps”) and 640 traditional lenders across 18 economies.

This allowed the IMF to compare the scale, growth and regulatory framework of both banking models across a range of advanced and emerging economies.

With the exception of one neobank regulated as a payments company, the IMF notes that all other neobanks in the sample group have banking licences.

Using in-house and external data, the IMF found that in markets such as Brazil, UK, South Korea and Germany, leading neobanks now have market caps almost as large as that of some of the largest traditional banks.

Moreover, in markets such as Russia and Kazakhstan, the market caps of leading neobanks have already surpassed that of the largest traditional banks.

Looking at the factors driving neobank growth, the IMF notes that, despite their “relatively modest” balance sheet size, the high valuations of some neobanks are driven by expectations of strong future growth, primarily in their lending businesses.

This is particularly true in the unsecured retail segment, which the IMF sees as one of the riskiest areas that neobanks operate in.

“Neobanks target borrowers with a riskier credit profile,” the report notes. “Neobanks tend to explicitly address financially underserved clients across the consumer/credit card and SME segments in the context of heavily skewed/concentrated — less diversified — loan portfolios."

This in practice "means serving younger individuals with lower incomes and lower credit scores by granting them loans that are mostly unsecured or concentrated around risky sectors, such as commercial real estate (for example, SME loans by UK neobanks).”

Is Basel III a good fit for fast-moving fintech?

Although praising neobanks for their focus on financial inclusion, the IMF warns that a riskier client base comes with heightened credit and liquidity risks.

And if neobanks continue their rapid growth, the IMF’s fear is that the wider financial system will become more exposed to these higher-risk lending operations.

For example, two UK neobanks that took part in the study revealed that 100 percent of their loan book is in unsecured exposures.

In contrast, for the vast majority of traditional banks in the UK, their unsecured exposures are no more than 40 percent of their total loans.

Compounding the high risk of default on these unsecured loans is the lower liquidity coverage required of neobanks.

“On the one hand, neobanks’ client base is younger and likely to be less loyal, implying that their deposits could be less sticky,” the report notes.

“Therefore, caution would call for neobanks to operate with higher liquidity coverage ratios, in line with Basel III requirements.

“Instead, their ratio of liquid assets to total deposits — a measure of liquidity risk — is lower than that of banks.”

A high-tech, low-margin business

Despite the higher risks inherent to the neobank business model, the IMF found little evidence that such banks are outpacing traditional banks in terms of earnings.

Instead, the IMF observed that neobanks typically display higher operating expenses and lower potential for fee income generation.

“Somewhat counterintuitively, neobanks appear to be less cost-efficient than traditional banks,” the report notes.

“This is driven by persistently higher non-staff expenses on the back of either higher customer acquisition costs (such as marketing) and/or higher compliance-related costs.

“If securities income is excluded, neobanks’ margin advantage fades. Overall, neobank returns appear weak, with only a few neobanks generating profits.”

On the plus side, the IMF did note that emerging market neobanks tend to fare better than advanced economy neobanks, since they display relatively lower liquidity risk, a stronger revenue profile, and wider loan and fee margins.

Defi lending - a safer bet?

Switching its lens to defi, the IMF offered similar praise for its goal of financial inclusion, but warned that this emerging ecosystem is home to a wide range of both consumer and regulatory risks.

The IMF defines defi as “financial applications — called ‘smart contracts' — processed by computer code on blockchains, with limited or no involvement of centralised intermediaries”.

Defi has grown significantly in recent years from around $10bn worth of in January 2020 to a peak of $110bn in November 2021, although asset size has since fallen to around $77bn as of today.

As a lending and borrowing model, the IMF’s report is much more sanguine about the promise of defi than it is about neobanks.

Importantly, the report notes that most defi lending is overcollateralised, meaning that the value of a borrower’s collateral must be higher than the amount they wish to borrow.

In effect, this insures the lender against the risk of default, because if the borrower is unable to pay back the loan, or if their collateral drops below a predetermined loan-to-value threshold, their collateral is automatically transferred to the lender.

Although risks to lenders in defi are relatively minimal, the report notes that there are plenty of ways that borrowers could lose significant amounts of money due to price volatility and platform vulnerabilities.

For defi borrowers, the most obvious way to lose money is by leveraging their already volatile crypto-assets in order to borrow even more volatile crypto-assets.

This kind of high-risk borrowing tends to exacerbate liquidation cascades during price downturns, as collateral is forcibly liquidated and returned to lenders, who then immediately sell that same collateral for stablecoins to guard against further price drops.

In January 2022, for example, liquidations across all defi platforms surged to their highest level since May 2021, erasing $50bn in borrowed asset value during heavy selling.

But by far the biggest risk, which is inherent to the defi ecosystem, is that of cyberattacks.

In 2021, hacks of defi platforms eclipsed that of any other year, with more than $900bn in value stolen in Q3 alone.

To protect against these risks, the IMF proposes that future regulation should focus on elements of the centralised crypto ecosystem that facilitate access to defi.

For example, stablecoin issuers, cryptocurrency exchanges and hosted wallet service providers all have touchpoints with the traditional banking and financial service infrastructure, and they each provide the typical on-ramps and off-ramps for those who wish to use defi.

According to the IMF, these centralised entities would benefit from robust and comprehensive national defi regulatory frameworks, delivered through common global standards.

Secondly, the IMF proposes that authorities regulate the “key functions” of defi platforms using a range of code auditing measures.

For example, defi protocol developers could work with regulators to audit their code for bugs or suitable risk parameters. This could be done either before or after the code goes live.

As the IMF admits, however, this would be an immensely complex task for regulators, who would likely need to rely on public-private collaborations to deliver high-quality audits.

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