Open banking’s promise of a financial revolution

Giorgio Barba Navaretti is Professor of Economics at the University of Milan, Giacomo Calzolari is Professor of Economics at The European University Institute in Florence, Bologna University, and Alberto Pozzolo is Professor of Economics at Roma Tre University

Open banking involves giving third parties access to information that is otherwise captive in a bilateral relationship between a provider of financial services and its client. Yet, there are considerable limits to the diffusion of financial information and to the use of such information to enhance competition.

This column argues that the scope and the aims of open banking, although potentially ground-breaking, may thus be overstated. A new regulatory framework should be devised to deal with the potential shortcomings of open banking along the lines of the EU’s Digital Markets Act and Digital Services Act.

According to Rivero and Vives (2023), open banking (OB) “refers to those actions that allow third-party firms, either regulated banks or non-bank entities, to have access under customer consent to their data through application programming interfaces (API).” In other words, open banking allows customers to easily, swiftly, and freely transfer their own payment information to any authorised third party of their choice, thus increasing the set of financial intermediaries they can use for their transactions and limiting rent extraction by incumbent banks.

Where does open banking come from? The kick start comes from regulation. In the EU, the starting point was the approval in 2015 of Directive (EU) 2015/2366, known as PSD2, which requires that financial institutions open up their data in favour of account information service providers (AISPs), payment initiation service providers (PISPs), and card-based payment instrument issuers (CBPIIs).

In the UK, PSD2 was transposed into legislation with the Payment Services Regulation of 2017, leading to the foundation in the same year of the Open Banking Implementation Entity (OBIE), an independent organisation of the nine largest retail banks in Britain and Northern Ireland.

Similar legislations were introduced for example in South Korea (Beck and Park 2021) and Australia, favouring the diffusion of open banking.

Clearly, the transmission of financial information to other intermediaries was possible also before open banking, and it has become even more relevant with the entry of new fintechs, which may be able to provide to their customers better services than incumbent banks (Boot et al 2020). But regulations like PSD2 make such processes faster and less costly, with potentially disruptive effects.

The reasons stated in PSD2 for giving access to information to third parties are three-fold: enhancing competition, fostering innovation, and favouring inclusion. In this column, we only deal with competition.

Remarkably, PSD2 focuses on data about payments. And in fact, the fastest growing services at the moment are those helping to connect different accounts – for example, bank, credit cards, and investment accounts – to provide a comprehensive view of the financial position of an individual or a firm (Emma, Tink, and TrueLayer already offer these services).

But it is becoming increasingly clear to the industry that granting access to customers’ payment information will also ease a customer-targeted provision of other banking and financial services and the development of a range of innovative products.

On the one hand, liquidity and payments management can be made more efficient thorough a comprehensive view across different banking accounts. On the other hand, payment information generates a great deal of information on the characteristics of a bank customer, which is extremely valuable for the provision of additional products such as loans or investment services.

A realistic outcome of open banking might therefore be an increase of market concentration in the hands of few traditional financial intermediaries that are uniquely placed to offer bundles of services

This evolution towards even broader open banking may have the potential to change financial intermediation radically. But for this to happen, consumers must be willing to share their data and adequate technology must be in place to ensure seamless data access through the use of APIs and cloud computing1. If these conditions are met, open banking is expected to change the way financial intermediation occurs.

Yet, there are considerable limits to the diffusion of financial information and to the use of such information for the purposes of enhancing competition. Open banking is essentially about enabling transfers of data and information to some third parties, but not making it generally available.

Key to the understanding of the potential impact of this innovation, therefore, is an assessment of how information will in fact be spread and used. If we take this perspective, we believe that the scope and the aims of open banking, although potentially ground-breaking, may sometimes be overstated and its desirable implications cannot be taken for granted.

Even assuming that adequate technologies are available, the impact of open banking depends on how the financial information will in fact be spread and used. This is relevant for both the demand and the supply of information.

On the demand side, third parties will enter only if they have some way of leveraging the value of the information that they acquire, most likely keeping it private for themselves.

On the supply side, open banking does not open up information concerning a client to everybody, but only to those that the client explicitly authorises. But to how many potential counterparts are clients willing to disclose their private transactions? It is unlikely that it will be a large number.

An additional issue is how the information can be effectively used. Opening up the information even to a single new provider can be beneficial to the client: compared to the incumbent, the entrant may offer new services or the same services at better conditions.

However, who the provider of these services is matters a lot. Things are very different if the new entrant is a fintech rather than an established bank. If data reach other incumbent operators, like traditional banks, we may not expect a sizeable impact on competition (Barba Navaretti et al 2018).

On the contrary, data availability may induce a ‘winners takes all’ scenario, where few companies offer multiple products and services. Digital markets are a clear example of the effect of strategies that rely on the reusability of personal data for multiple purposes and services.

A realistic outcome of open banking might therefore be an increase of market concentration in the hands of few traditional financial intermediaries that are uniquely placed to offer bundles of services.

Established banks might even be challenged by platforms offering several products and services (Cornelli et al 2020). Such platforms would broker numbers of potential suppliers of financial services, matching clients with services, acting as the intermediaries in a two-sided market.

Having the technology to guarantee efficient matchings, they would keep the information within the platform and would limit its transfer to other providers of financial services. If the client only transferred their information to a single platform, that platform would enjoy monopoly power and information rents.

Network externalities would be a distinctive element of this scenario. Only platforms with a very large client base and a large number of potential suppliers can effectively use clients’ data to offer efficiently targeted services. The market power built on relationship-based financial intermediation with restricted data access would be replaced by a new, network-based market power with customer-shared data.

Another risk emerges if the provider of financial services and hence the holders of the data on financial transactions is a bigtech firm (eg. the recent opening of Apple Bank). In principle, if these companies entered the market, competition would increase. Yet, these firms leverage detailed users’ information to capture clients in several markets, with reinforcing feedback effects induced by even more data from the many services and products they offer.

Open banking thus has the potential to favour bigtech companies disproportionally, and strengthen their business model with the inclusion and mutual reinforcement of financial services in their ecosystems. Remarkably, the flow of data originated by open banking may be more valuable for bigtechs than for traditional banks.

Currently, the promise of innovative banking platforms remains unfulfilled, as new entrants primarily focus on creating effective application interfaces rather than offering truly ground-breaking financial services. However, once open banking reaches full potential, it may reshape the financial landscape. It will be essential to guide this process to prevent market tipping and concentrations similar to those seen in digital markets.

Historically, policymakers believed that ex-post interventions would suffice to address market power issues in digital markets. However, as we have learned from experience, this is not the case, and regulators have had to catch up with new regulations like the Digital Markets Act (DMA) and the Digital Services Act (DSA).

In the case of financial markets, proactive regulation will be crucial to avoid a similar scenario of late intervention. To achieve this, it will be useful to learn from the lessons of digital markets while creating regulations tailored to the unique characteristics of the financial industry (Caffarra et al 2020).

Endnotes

1. A related issue, that we do not address here, is that such enabling technologies (Garcia and Ehrentraud 2020) themselves pose regulatory problems, as shown in the Wirecard case (Barba Navaretti et al 2020).

References

Barba Navaretti, G, G Calzolari and AF Pozzolo (2018), “FinTech and banks”, VoxEU.org, 1 March.

Barba Navaretti, G, G Calzolari and AF Pozzolo (2020), “Regulating Fintech in Europe: Lessons from the collapse of Wirecard”, VoxEU.org, 22 November.

Beck, T and YC Park (2021), “Fostering FinTech for financial transformation”, VoxEU.org, 16 September.

Boot, A, L Laeven, P Hoffmann and L Ratnovski (2020), “The old and the new of fintech”, VoxEU.org, 21 July.

Caffarra, C, F Scott Morton, F Etro and O Latham (2020), “Designing regulation for digital platforms: Why economists need to work on business models”, VoxEU.org, 4 June.

Calzolari G, A Cheysson and R Rovatti (2023), “Machine Data: Market and Analytics”, SSRN, CEPT and European University Institute working paper.

Cornelli, G, J Frost, L Gambacorta, R Rau, R Wardrop and T Ziegler (2023), “Fintech and big tech credit markets around the world”, VoxEU.org, 20 November.

Garcia, G and J Ehrentraud (2020), “Managing the winds of change: policy responses to fintech”, VoxEU.org, 20 April.

He, Z, J Huang and J Zhou (2023), “Open banking: credit market competition when borrowers own the data”, Journal of Financial Economics 147: 449-474.

Parlour, CA, U Rajan and H Zhu (2022), “When Fintech competes for payment flows”, The Review of Financial Studies 35: 4985-5024.

Rivero, D and X Vives (2023), “Open banking: promise and trade-offs”, European Economy, Banks Regulation and the Real Sector, 18 April.

The latest issue of European Economy: Banks Regulation and the Real Sector discusses the implications of these developments in financial markets. This article was originally published on VoxEU.org.