Major threat to South Africa’s biggest banks

The boom of fintech firms in South Africa presents significant risks to the country’s incumbent financial institutions, particularly big banks.

While local fintechs have created new opportunities to make financial systems more efficient, they have also created challenges that could affect the country’s financial stability.

This is because big banks are slow to adapt and, in the wake of serious competition from fintechs, could take more risks to compete with the leaner, more flexible start-ups.

The Reserve Bank’s economics research department recently published a working paper titled ‘Fintech and financial system stability in South Africa’ that examines this relationship.

This study covered the period from 1998 to 2020, which coincides with an era when South Africa experienced significant growth in fintech firms.

South Africa has a fast-growing fintech industry. As of December 2021, over 200 fintech firms were operating in the country, with this number expected to grow year after year.

The working paper explained that the boom in local fintechs is largely thanks to a conducive regulatory environment that has allowed the industry to grow.

The fintech landscape in South Africa is segmented into eight functional areas: payments, lending, savings and deposits, insurtech, investments, financial planning and advisory, capital raising and business-to-business technology providers.

All of these areas overlap with those offered by full-service banks in South Africa, especially the so-called Big Four banks of Absa, Nedbank, Standard Bank, and FirstRand.

However, the research explained that what sets these fintechs apart is that many have identified consumer pain points and developed simple solutions that reduce the friction experienced in traditional financial services processes. 

“Their ability to innovatively use technology to find alternative solutions to banking clients’ needs is putting pressure on incumbent retail banks,” the paper explained. 

“The traditional banks realise that the disruption by these non-traditional competitors is threatening their survival.” 

This is because big institutions, especially traditional banks, are far slower to adapt to new innovations, making it more difficult to compete with start-ups that are modern and flexible.

The paper referred to the results of a PwC survey in South Africa, which showed that the banking and payments industries are feeling the most pressure from fintech companies. 

In South Africa, this can clearly be seen in the rise in popularity for payment solutions for small businesses, offered by fintechs like Yoco and iKhokha.

While this opens up the door for some fintechs to collaborate with traditional banks, it also presents a significant threat to incumbents.

Risky business

The PwC survey found that two-thirds (67%) of financial services firms surveyed ranked pressure on profit margins as the top fintech-related threat, followed by loss of market share (59%).

However, the research paper explained that the threat to incumbents’ operating models and the increased competition not only negatively affects profitability, but also, consequently, results in threats to systemic stability.

As banks lose market share to fintechs, they may be forced to take bigger risks to adapt, and adaptation is far costlier for big institutions than small start-ups.

“Similarly, there is evidence that fintech firms are partnering with banks and other financial institutions, which creates systemic risks because of potential disruptions to these third-party services,” the researchers said.

This is largely due to the vulnerabilities this interconnectedness could create to cyberattacks or operational failures.

The research further found that fintech formation has different effects on large versus small banks.

While small banks tend to see more positive results, the researchers found a negative and significant association between fintech formations and the bankruptcy risk of large banks. 

“This suggests that fintech development makes large banks more unstable,” they explained. 

While fintech formations predict the default risk of large banks in South Africa, they positively predict improvement in the bankruptcy risk of smaller banks. 

“Overall, fintech formations appear to adversely affect large banks’ bankruptcy risk and positively affect small banks,” they said. 

This is largely because large banks are often slow to adopt and use technological innovations due to bureaucratic cultures compared to small banks, which may adopt innovations proactively. 

Large firms respond slowly to technological transformations due to their legacy systems, which may require substantial modifications.

Consequently, these firms must bear substantially higher costs in reorganising their infrastructure than smaller firms, which can adjust more easily.

As fintechs become more popular in South Africa and competition increases, larger banks may find themselves unable to compete or risk high costs in their efforts to keep up.

“The finding that fintech formation is negatively associated with large banks’ risk calls for caution on the part of policymakers, as fintech development can accentuate the ‘too big to fail’ problem,” the researchers said. 

“In addition, collaboration between banks and fintech firms can create stability problems. The risks stemming from the failure of fintech firms or data breaches could affect the whole financial system because of the interconnectedness that results from such partnerships.”