Give Fintech Good Incentives, And Its Growth Will Benefit Society
The legacy of the financial crisis is a tendency to place much of the blame for widening inequality on the financial sector. From this origin, there has been an enormous growth in the application of technology to financial services, in what has become fintech. Fintech emerged based on the idea that technology could upend the unhealthy relationship between the financial sector and its customers, but in some cases, it has just migrated the worst of the financial sector “into the cloud.”
To see where the problems emerge and where they could end up if the current trajectory persists, look at the taxi industry. Companies like Uber thrived at the expense of the taxi industry because of its inefficiencies. But these inefficiencies often represented the effect of regulations that were designed to benefit society, even while they had the effect of shielding taxi operators from competition.
Upending this dynamic had consequences both good and bad. Technology, by lowering the cost of delivery, created a product that consumers preferred and they flocked to it in huge numbers. It also introduced a natural competitive edge which, when combined with copious amounts of venture capital funding, allows for massive growth to achieve scale. This cost comes from sidestepping labor rules by making each employee independent of the others and pushing insurance costs off of the company and onto the workers or society at large.
It also comes from cherry-picking the highest margin business away from the taxi companies, while leaving the costlier fares (such as disabled people) to the taxi drivers, who often are required by law to accommodate, while ride sharing companies free-ride. Some of the problems at companies like Uber are driven by growth accelerating faster than company capacity, but others are more systematic.
What does this have to do with fintech, you might ask? More than you might think. The underlying issue that all technology companies are susceptible to is that they often suffer from awe at their own technology, while wearing blinders about its effects on other people. The biggest channel through which this tends to occur is where technology is developed in a way that sidesteps existing regulations, such as those relating to lending standards, capital requirements and conflicts of interest which were at the heart of the financial crisis.
With a whole new generation of financial services institutions walking down a bad road, it is time to ask big questions. Can technology on its own make things better as a disruptive force if it is deployed in a way that primarily focuses on profit-seeking regulatory arbitrage– doing the same thing but in a way to make it subject to fewer regulations?
I think it is unlikely that this will be as socially beneficial as it is pitched, and the late economist William Baumol explains why: “Entrepreneurs are always with us, and always play some substantial role [for good or bad]. At times, the entrepreneur may even lead a parasitical existence that is actually damaging to the economy. How the entrepreneur acts at a given time and place depends heavily on the rules of the game -the reward structure in the economy- that happen to prevail.”
The incentive structures in most of the technology sector is one based on a grow fast or die slow mindset. This is fine for video services serving up cat videos, but it is far riskier when people’s finances are put at risk. There is a fine line, of course, between stifling innovation and protecting consumers, but an incentive structure that doles out money based on valuations that are tied to growth is asking for trouble.
Regulators are put in a bind here because there is a burgeoning demand for fintech from consumers who often view regulators as being held under sway too much by the financial sector already (another legacy of the financial crisis). But regulators are concerned about consumer needs and have imposed some limits by requiring live testing of fintech products within a “sandbox” that lets companies grow their business and their compliance capabilities.
However, again we return to the problem of conflicted incentives mentioned by Baumol. Fintech companies want to graduate from regulatory sandboxes (and often have a limited time of one or two years to do so before being shut down by the regulators). This pressure returns their daily activities to grow fast or else. The conflict between rapid growth or market exit doesn’t just affect the companies– it affects their customers too. In the end, if we want to change incentives, fintech companies themselves have to be offered incentives that orients their business to a positive social objective, so that the time spent in the sandbox growing will more organically create a positive social impact.
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