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The Era of Digital Financial Innovation: Lessons from Economic History on Regulation

David Longworth
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David Longworth: C.D. Howe Institute

C.D. Howe Institute Commentary, 2020, issue 568

Abstract: While digital finance innovation has the potential to provide businesses and consumers with lower costs and a greater range of financial services, it has raised questions regarding the risks it poses to consumers, individual financial institutions, the financial system and the economy at large – and how Canadian financial regulators should respond to those risks. This Commentary focuses on the major macro-level risks that might arise, and sets out to answer three questions. What do we know from economic history about financial innovation in general and banking crises? What are some key areas arising from current and future digital financial innovation that regulators need to examine? And what are the implications for actions by Canadian regulators? Economic history gives us many examples of instances when financial innovations, rapid growth in credit supply and increased reliance on short-term financing have led to financial instability and crises. Therefore, at a time of rapid changes in the financial sector, it is important that regulators pay close attention to what is happening and take appropriate action. After discussing key areas of concern for Canadian regulators, I recommend that they should: (i) Require the explainability of machine-learning models used for lending decisions. As it is, artificial intelligence (AI) is being used in lending decisions at both regulated and largely unregulated institutions. If not properly examined by internal risk managers, it can lead to unsafe lending decisions. (ii) Take care not to rush into open banking regulations, for example regarding money-moving apps, that could increase the likelihood of bank runs. (iii) Collect better and more timely data by type of financial institution on types of credit and short-term financing. (iv) Extend the coverage of stress tests to examine stresses related to rapid new borrowing from non-bank financial institutions, or shadow banks, that are not prudentially regulated. At the micro level, regulators will have to weigh closely the costs of new regulations against the benefits of financial innovations. At the macro level, however, the steps suggested in this Commentary should have little or no effect on the vast majority of digital financial innovations that are underway or contemplated in the near future. Therefore, there would be no real trade-off between the increased stability coming from these actions and the increased competition, efficiency and range of financial services that should come from digital financial innovation.

Keywords: Financial Services and Regulation; Banking, Credit and Payments; Capital Markets; Consumers' Interests and Protection; Financial Innovation and Technology; Financial Stability; Prudential Regulation; Securities Regulation (search for similar items in EconPapers)
JEL-codes: G18 G28 N22 (search for similar items in EconPapers)
Date: 2020
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