Innovation in Retail Payments and Its Impact on a Country's Economic Growth and Financial Stability Presentation in Bank Indonesia Seminar and Workshop 13 November 2017

1. Unrestricted
Bank of Finland
Innovation in Retail Payments
and Its Impact on a Country's
Economic Growth and
Financial Stability
Presentation in Bank Indonesia Seminar and
Workshop 13 November 2017
113.11.2017
Seppo Honkapohja

2. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Agenda
1. Effects of innovation at the level of whole economy
 The big picture: Digitalisation, technological change, productivity, and well-being in the
long run
 Optimists and pessimists: how will digitalisation impact the economy and society as a
whole
 Widening use of digital technology and new opportunities
2. Effects of innovation in financial markets
 The financial system and economic performance
 Payment systems and economic well-being
 Innovations in financial services and financial stability
3. Evolution of payment systems
 Main drivers and trends: consumer expectations, fragmentation of the markets, real-time
payments, “embedded payments”
 Assessing the change: European situation (PSD2, PAD)
4. Conclusions and policy considerations
 Key areas and challenges for policy makers
13.11.2017 Seppo Honkapohja 2

3. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
1. Effects of innovation at the
level of whole economy
1.1 Long-term trends
13.11.2017 Seppo Honkapohja 3

4. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted13.11.2017 Seppo Honkapohja 4
Why has our standard of living improved
so much over last 150 year?

5. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted13.11.2017 Seppo Honkapohja 5

6. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
The rise in the standard of living 1860−2010
13.11.2017 Seppo Honkapohja 6

7. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Labour productivity growth and improvement
of living standard in Finland in 1860−2015
13.11.2017 Seppo Honkapohja 7

8. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Technological development evident as
waves of productivity growth
13.11.2017 Seppo Honkapohja 8

9. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
1.2 Debate about digitalization
13.11.2017 Seppo Honkapohja 9

10. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
What is digitalization?
 Digitization:
To convert, store, transfer, and
process information in a
format understood by computers
– Binary data
– Digital information can be music, movies,
documents, maps, observational data etc.
 Digitalization:
Widespread economic and social transformation made
possible by the development of information and
communication technology
– A change that is visible in all sectors of the economy
– Automation, robotization, digital platforms, artificial intelligence,
industrial internet, internet of things, digital government etc.
13.11.2017 Seppo Honkapohja
”Suomen Pankki”
=
01010011 01110101 01101111
01101101 01100101 01101110
00100000 01010000 01100001
01101110 01101011 01101011
01101001
10

11. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Will digitalization cause a new wave of
productivity growth which matches the
previous technological revolutions?
Pessimists
 Computers are seen everywhere
except productivity statistics
(Robert Solow)
 Development has been limited to
entertainment and communication
(Robert Gordon)
 The low-hanging fruits have already
been picked (Tyler Cowen)
 We’ve been waiting for accelerated
growth for a long time now
 Economic headwinds will dampen
growth despite technological
progress (Robert Gordon)
Optimists
 We ain’t seen nothin’ yet (Joel Mokyr)
 The second machine age
(Erik Brynjolfsson & Andrew McAfee)
 We tend to overestimate the effect of a
technology in the short run and
underestimate the effect in the long run
(Ray Amara)
 The same pessimist arguments were
made before the previous technological
revolutions
 The statistics do not tell all
 The rate of new innovations has not
slowed down
13.11.2017 Seppo Honkapohja 11

12. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Prices of ICT equipment and services
have fallen exponentially
13.11.2017 Seppo Honkapohja 12

13. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Prevalence of ICT equipment and
connections in households
13.11.2017 Seppo Honkapohja 13

14. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Mobile data transfer volume
in Finland, 2007−2016
13.11.2017 Seppo Honkapohja 14
Currently almost 10 times
more data is transferred
in one day than in the
year 2007 as a whole

15. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Technological development, economic
growth and the road ahead
1. Productivity growth derived from technological
development is the main driver of improving living
standards in the long run.
2. The future impact of digitalization on economic
growth is uncertain, but signs of its potential are
already clearly visible.
3. Digitalisation is bound to transform industries based
information processing and communication −
such as finance and payments.
13.11.2017 Seppo Honkapohja 15

16. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
2. Effects of innovation in
financial markets
2.1 Financial systems and economic
performance
13.11.2017 Seppo Honkapohja 16

17. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Financial systems and economic
performance
Source: Hartmann et al. (2007) “The role of financial markets and innovation in productivity and growth in Europe“
13.11.2017 Seppo Honkapohja

18. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Impact of finance on economic
growth (1)
Question: Can there be too much finance?
Source: Cournède, B. and O. Denk (2015), “Finance and economic growth in OECD and G20
countries”, OECD Economics Department Working Papers, No. 1223, OECD Publishing,
Paris.
13.11.2017 Seppo Honkapohja 18

19. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Impact of finance on economic
growth (2)
Other views also exist:
 For example, Durusu-Ciftci, Ispir & Yetkiner (2017)
find that by fostering the development of a country’s
financial sector, economic growth will be accelerated.
Journal of Policy Modelling, Vol. 39, Issue 2.
(http://www.sciencedirect.com/science/article/pii/S0161893816300631)
For financial innovation both “bright and dark sides”
exist:
 For a recent review on innovation-growth view and
innovation-fragility view, see e.g. Beck, Chen, Lin &
Song (2016) “The bright and the dark sides”
Journal of Banking and Finance, Volume 72, November 2016
(http://www.sciencedirect.com/science/article/pii/S0378426616301133)
13.11.2017 Seppo Honkapohja 19

20. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
2.2 Payment systems and economic
well-being
13.11.2017 Seppo Honkapohja 20

21. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
On the relationship between retail payments
development and economic performance
13.11.2017 Seppo Honkapohja 21
Source: “Efficient retail payments: An untapped source for reviving growth in Europe?”, Iftekhar Hasan & Tuomas Takalo,
VoxEU, 24 January 2014

22. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Some studies on payment systems and
economic growth
 DeRenzis et al (2012 & 2013):
– Electronic payment instruments have overall a positive impact on
economic development
 Tee and Ong (2016):
– The impact of adopting cashless payment on economic growth
can only be significantly observed in the long run
 Zandi et al. (2017):
– Increasing use of electronic payments boosts consumption and
GDP, and the impact increases as penetration rises. Effect on the
global level is 0,1% of GDP.
 Ilyes & Varga (2016):
– Utilise a DSGE model to study impacts on the performance of the
Hungarian economy if retail cash payments were substituted with
card payments. Results show both positive indirect and direct
effects.
13.11.2017 Seppo Honkapohja 22

23. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
References of the studies mentioned
 Hasan, De Renziz and Schmiedel (2012), BOF DP
19 2012 and ECB WP No. 1572, 2013.
 Tee and Ong (2016), Cashless payments and
economic growth, Financial Innovation (2016) 2:4.
 Zandi, Koropeckyj, Singh and Matsiras (2017), The
Impact of electronic payments on economic growth,
Moody’s Analytics (2017).
(https://usa.visa.com/dam/VCOM/download/visa-
everywhere/global-impact/impact-of-electronic-
payments-on-economic-growth.pdf)
 Ilyes & Varga (2016) Macroeconomic effects of the
increase in electronic payments – a general
equilibrium approach using Hungarian data, Financial
and Economic Review, June 2016
13.11.2017 Seppo Honkapohja 23

24. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
2.3 Innovations in financial services
and financial stability
13.11.2017 Seppo Honkapohja 24

25. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Financial services and Fintech
 Use of advanced technologies by financial services
firms is not a new phenomenon:
– Internal technological solutions to service provision and to compliance
with regulatory obligations.
– Also outsourcing with external service providers has existed for long
time.
 But the rise of FinTech is a recent phenomenon.
– Definition of FinTech: Technology-enabled innovation in financial
services that could result in new business models, applications,
processes etc.
 It has led to
– Increased technological, especially IT, investments
– Appearance of a whole array of different firms:
 Incumbents
 specialized start-ups and
 global telecom/technology companies (“GAFAA”: Google, Apple,
Facebook, Amazon and Alibaba”).
13.11.2017 Seppo Honkapohja 25

26. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
FinTech: Opportunities and challenges
for central banks and regulators
Opportunities:
 Financial inclusion; more people gain access to
financial services.
 More competition; leads to lower prices and better
services.
 More efficient processes and financial intermediation.
Challenges:
 Financial stability
 Banking supervision
 Payment systems
 Transmission of monetary policy
13.11.2017 Seppo Honkapohja 26

27. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Overview about regulation of FinTech
activities in Europe
 Public authorities in the EU are investigating the
impact of FinTech.
– Impact of FinTech on the financial system and
– on its the regulation and supervision thereof.
 Recent European Banking Authority (EBA) survey of
financial services, innovations by FinTech firms and
their regulation.
– See next slide
 Significant percentage of services provision is not
regulated.
– Regulation practices are likely to vary from country to country.
 However, stability problems with FinTech have not
risen thus far.
– Rapid growth of FinTech => Important to remain alert
13.11.2017 Seppo Honkapohja 27

28. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
European Fintech activity
13.11.2017 Seppo Honkapohja 28
Source: EBA (https://www.eba.europa.eu/-/eba-publishes-a-discussion-paper-on-its-approach-to-fintech)

29. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
3. Evolution of payment
systems
3.1 General features
13.11.2017 Seppo Honkapohja 29

30. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Payments play an important role in
innovations in financial services
13.11.2017 Seppo Honkapohja 30

31. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Main driver in retail payment
developments: consumer expectations
 In payments, there is a movement towards a 24/7
world.
 Consumers expect instantaneous transactions as
well as easy and handy payment applications.
 These are not isolated trends but a paradigm shift
in consumer behavior.
 Consumers compare financial services to other
services and expect the same usability and customer
experience.
13.11.2017 Seppo Honkapohja 31

32. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
An example of one major driving force:
mobile device penetration
13.11.2017 Seppo Honkapohja 32
Mobile devices play a growing role in the supply of
financial services
Source: World Bank

33. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Three trends in payment markets
1. Payment landscape has become fragmented.
2. Payments are becoming instant / real-time.
3. Payments are becoming embedded into the service.
13.11.2017 Seppo Honkapohja 33

34. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Trend (1): Payment landscape has
become fragmented
 Several new payment applications
 Several new actors in the customer interface
 Open interfaces enable ecosystems to evolve
13.11.2017 Seppo Honkapohja 34
Source: Edgar, Dunn & Company

35. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Trend (2): Payments are becoming
instant / real-time
 The world moving towards 24/7 services
 Also in (retail) payments pressure to move from
traditional t+1 towards “real-time” is growing
 In some countries (e.g. UK, SE, DK, FI, PL, SG,
MEX, etc.) national instant payment systems exist
 In Europe, pan-European instant payment systems
are being built
13.11.2017 Seppo Honkapohja 35

36. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Trend (3): Payments are becoming
embedded into the service
 Payments become integrated into the buying process, game,
social media or other user experience.
 Payment details are submitted only once, but transactions can
happen frequently.
 Consumer is not necessarily aware of making payments.
 Makes individual financial management more demanding – there is
a need for better financial literacy.
13.11.2017 Seppo Honkapohja 36

37. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
A contrasting case: cross-border
payments (1)
 The area of cross-border (c-b) payments is ripe for
major change.
 c-b payments still feature long-chains of operations
and multiple intermediaries. [See Figure in next slide]
– Account-based systems with capturing, messaging, two-legged
settlement, and disbursement.
 These are handled by multiple intermediaries.
 Transfers are costly, cumbersome and opaque.
– Personal example: I had to cash a cheque from US.
 It took at least five days and transaction cost was significant
(about 9%).
– Operations involve substantial fixed and sunk costs as well as
network effects.
 There can be market concentrations.
13.11.2017 Seppo Honkapohja 37

38. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Contrasting case: cross-border
payments (2)
13.11.2017 Seppo Honkapohja 38

39. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
On c-b payment innovations
 Innovations are creating new and more efficient
methods for making intra-country payments.
– DLT can in principle be used in different ways.
– So far, the potential gains are ”can/would be”.
 One area is speed, transparency and end-to-end
tracking of c-b payments.
 Costs of compliance can be reduced through KYC and
digital identity procedures to share customer
information.
– Privacy and security issues can arise.
 New techniques like DLT can lead to new means of
payment.
– E.g. hub-and-spoke payments network with digital wallets of virtual
currencies. [See Figure in next slide]
– Possible concerns: erratic valuation of currencies, lack of trust,
operability issues.
13.11.2017 Seppo Honkapohja 39

40. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
On Payment Innovations: virtual
transactions
13.11.2017 Seppo Honkapohja 40
Fiat
Money
Means of
Exchange
Private
Virtual
Currencies
HUB SPOKESSPOKES
Digital
Wallets
Means of
Exchange
Fiat
Money
VIRTUAL TRANSACTIONS
Hub-and-Spoke Network, Source: IMF (2017)
Digital
Wallets

41. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
The Single Euro Payments Area (SEPA)
as an example facilitating cross-border
payments
13.11.2017 Seppo Honkapohja 41
Source: ECB; http://www.ecb.europa.eu/paym/retpaym/html/index.en.html

42. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
European regulation in the retail payments is
evolving: Payment Services Directive (PSD2)
 EU legislation for regulating payment services and payments
service providers in Europe, has been part of national legislation
since 2009.
 PSD2 is an update to the directive and has to be implemented into
national legislation by 13.1.2018.
 PSD2 will enable bank customers to use third-party providers
to access their payment accounts and to initiate payments on their
behalf.
 Banks are obliged to provide access to accounts to third-party
providers through APIs.
– This allows third parties to develop their own services on top of the infrastructure and data
owned by banks.
 Through this legislation, the EU aims to increase innovation,
improve consumer protection, and improve the security of
payments.
13.11.2017 Seppo Honkapohja 42

43. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
On the potential effects of Payment
Service Directive 2
 Payment Services Directive 2 (PSD2) is not only about
payments.
 PSD2 forces banks to open their payment infrastructure
to all third-party providers.
– Customers are free to choose.
 For banks, payments are the most frequent touchpoint
to their customers.
– losing this interaction would mean that banks risk fading into
background.
 Payments also provide data which can be used to
analyze customer behavior
– Identifying profitable customer segments
– Analyzing credit risk
– Creating cross-selling opportunities
 Also Payment Account Directive (PAD) 2014:
– Basic banking services for everyone.
13.11.2017 Seppo Honkapohja 43

44. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
4. Conclusions and policy
considerations
13.11.2017 Seppo Honkapohja 44

45. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Conclusions and policy considerations (1)
 Fintech has the potential to shape the financial
industry.
– Startups and big IT-firms are entering the financial markets to compete
with incumbents
 Retail payments are an area where the new products
and players have already entered.
– In Europe, the regulatory framework (e.g. PSD2) is also facilitating
change in the playing field.
=> The supply side of financial services is changing
In this changing environment, authorities should focus to
preserve security and reliability of financial services.
=> trust will remain the necessary precondition for
financial services also in the future.
13.11.2017 Seppo Honkapohja 45

46. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Conclusions and policy considerations (2)
Key focus areas for authorities:
 Competition
– Increased competition in services but further consolidation of
financial infrastructures are to be expected.
 Resilience
– Digitalization holds promise of better resilience through
decentralization but can also lead to increased vulnerabilities
 Integrity
– Protection of sensitive customer data and legitimate privacy
 Access and inclusivity
– Certain financial services must be regarded as necessities
13.11.2017 Seppo Honkapohja 46

47. Suomen Pankki – Finlands Bank – Bank of Finland Unrestricted
Thank you!
13.11.2017 Seppo Honkapohja 47