Fintech Rising

As the nation, and the world, started to rebound in the wake of the 2008 financial crisis, a new phenomenon arose: the fintech revolution. Seemingly out of nowhere, financial technology startups were transforming the financial services industry in profound ways, from lending, to payments and money transfers, to online and mobile banking, to investments and wealth management, to cutting-edge technologies such as machine learning, artificial intelligence and distributed ledger technology, commonly referred to as blockchain.

Michael B. Imerman doesn’t think the timing of fintech’s rise is a coincidence.

“Fintech rose from the ashes of the financial crisis,” says Imerman, the Theodore A. Lauer Distinguished Professor of Investments and assistant professor of finance. “How did these non-banks, non-insurance companies, non-asset managers, non-registered broker-dealers all of a sudden show up on the radar screen as major players in financial services? The answer that I think most logically explains what happened is that in the wake of the financial crisis, households and businesses and individuals lost faith in the traditional financial system.

“In addition, the traditional financial system locked up in the wake of the financial crisis and wasn’t providing the services that they’re supposed to, in terms of the reallocation of capital resources through the economy and providing credit and facilitating transactions. So these technology firms saw an opportunity to use what they were good at—developing technological solutions—to encroach on what had always been financial institutions’ territory and provide similar services without all of the regulatory burden.”

After all, it’s not as though technological innovation itself is new to the financial services industry. From being able to get cash any time, day or night, from an ATM, to being able to pay bills online, to migrating massive amounts of financial and personal data from server farms to cloud-based services, technological innovations have been a constant over the past four decades—and much longer, going back to the telegraph and telephone.

What is new is the push from non-financial firms to provide technologically driven financial solutions, Imerman says. “That’s really the phenomenon.”

Prior to pursuing his doctorate, Imerman worked on Wall Street as an analyst supporting bond and credit derivative trading desks. His transition to the world of scholarly research and data analytics played out against the backdrop of the worst financial crisis since the Great Depression. Over the past decade, he has continued his research in the areas of risk management and banking and financial institutions.

In Search of Abnormal Returns from the Fintech Industry

According to PwC’s 2017 report, Redrawing the Lines: FinTech’s Growing Influence on Financial Services, 88 percent of executives at traditional financial institutions—commercial and investment banks, insurance companies, brokerages, and investment companies—believe they are already losing money to fintech innovators. The report is based on the responses of more than 1,300 senior financial services and fintech executives from 71 different countries who participated in PwC’s “Global FinTech Survey 2017.”

In the report, 45 percent of traditional financial institutions reported they are already partnering with fintech firms, up from 32 percent in 2016. And a whopping 82 percent report that they expect to increase their fintech partnerships in the next three to five years.

The question of what happens when traditional financial institutions acquire or partner with fintech startups is one that greatly interests Imerman. He is currently working with Ben J. Sopranzetti, professor of finance and assistant chairman of the department of finance and economics at Rutgers Business School, on a research project looking at whether the market differentially rewards financial institutions that acquire fintech companies.

Faced with the growing threat fintech poses to their businesses, traditional financial institutions have three main choices, Imerman says: They can gobble up fintech startups through mergers and acquisitions (known as inorganic innovation). They can invest in developing their own fintech solutions in-house (known as organic innovation). Or they can take the middle road and enter into joint ventures and partnerships with fintech firms.

Imerman’s research has come up with examples of all three options, but his current thrust centers primarily on what happens in inorganic innovation, when a financial institution acquires a fintech or technology company.

Imerman is looking for publicly traded financial institutions based in North America or with stock traded on a U.S. exchange that acquire a fintech company. The goal is to determine whether the acquiring company’s stock got what’s called an “abnormal return” in value above and beyond what would be expected after the deal was made.

With the help of two student research assistants, Yuxin (Cedric) Wu, who is pursuing a master’s degree in analytical finance, and Alison Slivon, an undergraduate finance major, Imerman is collecting data on mergers and acquisitions involving financial institutions and fintech firms, as well as on the number of technology patents held by both companies at the time of the deal.­

“We want to control for that,” Imerman says. “We want to see if more innovative banks are doing the acquiring or less innovative banks are doing the acquiring. And are they acquiring technology firms that already have an established pipeline of technologies or firms that don’t necessarily have an existing patent portfolio, but perhaps have something in the works?”

Imerman’s researchers are using two Thomson-Reuters databases available in Lehigh’s Financial Services Laboratory to collect the mergers and acquisitions data: the Securities Data Company (SDC) Platinum database, which includes all merger and acquisition deals that can be filtered based on specific criteria, supplemented by painstaking, hand-collected data from the Eikon database, which captures some deals that do not show up on the SDC queries.

“We want to hone in on technology-related firms, but that’s a little nebulous because there’s no clearly defined fintech sector yet because it is such a new area,” Imerman says. “So there’s nothing in these databases that are coded for fintech. We need to cast a very wide net and capture as many deals as we can.

Illustration of face looking at phone

“Once we get this big collection of deals, we have to go through manually, line-by-line, to validate and verify whether or not the deal that resulted from this database query was, in fact, a financial institution acquiring a true tech firm. We had a lot of false positives, as we called it.”

Because of the parameters placed on the queries, Imerman says, a deal that looks on the surface like it might involve, say, an algorithmic-based asset manager sometimes turns out to be just an asset management company.

Imerman and Sopranzetti started out looking solely at banks that acquired fintech companies, and found only 25 examples—too small a sample to draw any conclusions. But the results were promising enough to justify expanding their search to a broader group of financial institutions that currently includes almost 200 deals.

The researchers also are coding the fintech firms that were acquired by financial institutions in five categories:

  • Lending (online lenders or peer-to-peer lending firms)
  • Payments and Money Transfers
  • Online and Mobile Banking
  • Investment Management (roboadvisers, replacing human financial advisers with a proprietary algorithm that takes personal and financial information and creates an optimal portfolio allocation; also includes high-frequency and algorithmic trading firms)
  • Cutting Edge (a category that covers what Imerman calls “the next wave,” including predictive analytics with artificial intelligence and machine learning; distributive ledger technology [blockchain]; cloud computing; and cybersecurity)

The final steps are to collect financial information about the acquiring financial institutions and then examine how the stock market reacted to each deal.

“All investors expect to earn a certain amount over a given time period, so we use a model to predict what that expected return should be,” Imerman says. “The amount that’s earned above and beyond that expected return is what we call the abnormal return. That’s why we’re collecting the financial information about the acquiring institutions, because we want to see if a big bank is more likely to generate abnormal returns for investors by acquiring a peer-to-peer lender or if an inefficient bank is more likely to generate abnormal returns by acquiring a cutting-edge technology firm.”

It will take a while to sort through all the data from their expanded queries, and the researchers are fine-tuning their experiment design to, in Imerman’s words, “reduce the amount of noise we have in it and get more statistical significance to pinpoint where value is being added.”

Fintech Trends and the Next Financial Crisis

Meanwhile, Imerman is embarking on another research project that asks a question that would have been unthinkable 12 years ago when he began researching financial institutions and risk management after leaving Wall Street for academia: Does fintech pose a systemic risk to the financial services industry?

Imerman says he is in discussions with a potential collaborator at another university regarding a research project that will aim to answer that question. It is now in the “model development and hypothesis construction stage,” he says.

“Systemic risk is one of those things that, 10 years ago, people knew about, but weren’t that concerned with,” Imerman says. “After the financial crisis, we were able to see how a relatively localized problem—specifically, sub-prime mortgage defaults in the southwestern United States—could blow up and become a full-fledged credit crisis, financial crisis, and ultimately, the Great Recession. It really drew our attention as researchers and scholars, as well as regulators and industry participants, to what the risks are of having an interconnected and highly complex financial system.”

However, the question that interests Imerman today is not about the interconnected financial system, but the linkages between financial institutions and non-financial firms through technology.

“What hasn’t been taken into consideration is, what role are technology firms going to play in the next financial crisis?” Imerman says.

According to the latest EY Fintech Adoption Index, which surveyed consumers in 20 global markets who are active online, fintech use doubled between 2015 and 2017, to 33 percent. The report found “that fintech firms have reached a tipping point, and are poised for mainstream adoption.”

Illustration of bank and cell phone smiling at eachother

Yet, many of those firms remain outside regulatory bounds. What would be the impact if, for instance, PayPal, which also owns Venmo, were to fail?

“One factor in systemic risk is the substitutability of the service,” Imerman says. “To the extent that a service cannot be easily substituted, the service provider represents a risk to the financial system as a whole because if they fail, there’s no substitute service to step in and fill that void.”

Imerman is planning to collect supply chain data to look at the “nexus of transactions” between tech firms and financial institutions. Ten years ago, systemic risk was found in a far different “nexus of transactions”—capital market transactions, unsecured lending transactions, and over-the-counter derivative transactions, he says.

Exploring “technology-based transactions,” Imerman believes, will provide “a lot of insight into where the next financial crisis potentially could be brewing.

“What technologies are traditional financial institutions relying on? And if those firms were to go under, how big of a loss could it potentially cause? That’s another of the questions we ask with systemic risk. What’s the potential loss if a firm were to fail?”

For example, most people wouldn’t think of Amazon as a potential source of risk to the financial services industry. But the online retail behemoth is now the largest provider of cloud computing services, including to major financial institutions as they have migrated their data from mainframe computers and server farms to the cloud.

“That’s something a lot of people haven’t thought of and that’s what’s scary about this,” Imerman says. “Regulators need to be considering these types of connections and linkages between financial institutions and tech firms. Linkages that were not previously considered have to be considered now if you want to get ahead of the next financial crisis.”


Written by Jack Croft

Illustration by Pawel Jonca

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