Question

What are the challenges or advantages that PayPal potentially creates for financial regulators?

Answer 1

PayPal

1. The challenges for financial regulation

The (global) developments in financial services industries have generally led to improved outcomes in terms of more efficient financial services provision, greater diversity of financial services, and greater access to financial services.

Economies consumers and firms alike have greatly benefited. Yet, these developments are also leading to new challenges facing financial sector regulators and other policy makers. These challenges relate in large part to financial stability as new, possibly systemic risks arise. Stability is, however, not the only concern of policy makers. New issues also have come up in terms of making financial markets function properly, in the sense of delivering the best possible financial services at the lowest cost to an as wide as possible set of consumers.

For both stability and efficiency purposes, there has consequently been a parallel trend to adapt regulations and adopt new regulations in some areas (”re-regulation”) to assure well-functioning financial systems and markets. The design and applicability of these new regulations have been subject to many discussions. Issues arising have been various but include: the overall approach to financial sector regulation and supervision in light of changes in the special nature of banks; competition policy in financial intermediation; consumer protection; the costs of regulation; and further harmonization of rules and practices. I will discuss these issues in turn, focusing in the next section more specifically on the issues facing developing countries.

Overall approach and the (special) role of banks. Liberalization has meant that banks and other financial institutions have moved from being under close control with little competition to having to satisfy minimum prudential standards with more general supervisory oversight and enforcement of good internal risk management practices. In most countries and circumstances, these approaches have led to greater stability; in most developed countries banks and other financial institutions have been able to withstand several large shocks over the last decade (e.g., the late 1990s’ global financial crises, the bursting of the internet bubble) relatively unscathed. Yet, in the first earlier phases of liberalization and in both developed and developing countries, liberalization has contributed to vulnerabilities and even led to financial crises. Some of this was as financial markets’ participants and supervisors only slowly “learned” the new world, but some was also due to ill-designed financial liberalization efforts. More recently, some (near systemic) financial crises have been triggered by failures of non-bank financial institutions, such as hedge funds and large corporations engaged in financial transactions, showing that risks can easily arise from (or migrate to) subsectors falling outside the traditional financial system.

As such, each crisis has taught policy makers new lessons and triggered adaptations to regulations. Thinking ahead of what new risks may arise and how to prevent large impacts remains nevertheless a challenge for financial sector policy makers. The full set of issues of financial stability and related implications for financial regulation and supervision are beyond this paper. But there are clearly some general trends underlying the recent changes that require adaptation of approaches at the level of individual financial institutions, at the level of the overall system and at the international level. Many of these changes relate especially to the role of banks.

The role of banks has expanded in recent decades while at the same time banks have shed some of their more traditional forms of financial intermediation. Banks, especially in developed countries, have become more risk managers rather than straightforward intermediaries. Financial institutions most often organized around “banks” are now engaged in a broad range of complex financial transactions and operate in various markets banking, insurance, and capital markets to take on and lay off risks on behalf of their customers. They underwrite complex financial transactions, provide specialized over the counter hedging and risk management products, and are engaged in highly leveraged financing operations. They help place financial instruments with other, non-bank financial institutions, such as institutional investors, and take on many advisory roles.

As initially argued by Calomiris and Kahn (1991), Diamond and Rajan (2001) and others, it might be that the combination of a fragile financing structure of a bank⎯short-term deposits and high leverage⎯while engaging in risky investments and activities gives a bank (or, currently, a financial conglomerate) the credibility to outsiders that it will manage risks and associated agency problems well. As such, the increased role of banks as risk managers may be a market response and the exploitation of natural comparative advantages. Nevertheless, there are concerns about these trends, concerns, which are mostly, but not only stability related (see further Rajan, 2005). The concerns arise mainly from two, related aspects: financial conglomerates are large and complex to oversee; and financial conglomerates may seek size to maximize potential government support.

The size and complexity of financial conglomerates can make the banking part of the business, the part that is of most concern for systemic reasons, more difficult to monitor for private and official parties. There is empirical evidence for this. Not only has financial institutions’ stock price variability been increasing, uncertainty about financial institutions’ ratings as reflected in splits between Moody’s and S&P about the rating of a bank’s bonds, have increased markedly since 1986 (Morgan 2002). Differences of opinion among analysts are also greater for banks than for corporations. Morgan (2002), for example, finds that uncertainty about banks’ valuation is markedly higher than for other industries. Judging from equity price to book ratios, the market also seems to be discounting banks more than other corporations.

In addition to concerns about market monitoring, specific concerns have been raised for a long time now with regards to large, complex financial institutions⎯LCFIs in short⎯ (e.g., going back to the so-called Ferguson G-10 report of 2001). Besides the difficulty markets and supervisors may have to assess conglomerates, LCFIs may be too big to ignore or too complex to fail by supervisors. As such, they may get preferential treatments during periods of financial stress. And while the safety net is surely not the main reason for the emergence of large conglomerates, financial institutions may have an incentive to grow and become more complex to maximize the benefits from a public financial safety net. While LCFIs have been an issue for regulators globally for the last decade, no easy solutions have been found to limit any benefits from a public safety net. Of course, the reasons to treat banks and financial conglomerates by extension special may itself be subject to debate.

As big technology companies edge their way into financial services, banks still have a few tricks up their sleeve.

Regulated financial institutions benefit from their robust compliance and risk management divisions, specialists say. It’s a point that is underscored by PayPal’s recent decision in Mexico to stop holding deposits, ahead of a regulatory change.

“Banks, unlike most fintech’s, are highly regulated,” says Giorgio Trettenero, secretary general of Fleabane. “They have compliance, anti-money laundering and know-your-customer systems. And additionally, they are very prepared against cyber-attacks and cyber threats.”

The focus on risk and compliance comes as big tech companies move into services that traditionally have been the domain of regulated banks – holding deposits in digital wallets, offering loans, facilitating payments. The shift is changing market dynamics dramatically, increasing competition for banks but also opening opportunities for regulated entities to work with big tech platforms.

For banks, dealing with regulations and compliance processes doesn’t just keep them on the right side of the law. It also drives business. Clients, especially corporate clients, value the confidence gained from dealing with a regulated financial institution.

A recent move by PayPal in Mexico underscores the relevance of regulation and compliance as big tech moves into finance. The global payments company is one of several technology companies that have told their Mexican users they can no longer hold money in their PayPal accounts. Instead, any balances will be transferred directly to users’ bank accounts.

For PayPal, the move is a step back from financial services, and a response to Mexico’s incoming Fintech Law, which introduces new requirements for institutions that hold deposits to register as a financial institution. Effectively, PayPal’s retreat from financial services in Mexico highlights how complicated it can be to become a regulated financial institution.

2. The advantages for financial regulation

§ Improvements in transparency

§ Consolidation of regulatory agencies

§ Higher equity requirements

§ Incentive of risk-taking for banks decreases

§ Lower risk for financial crisis situations

§ Government bailouts will become less likely

§ Financial regulation implies lower costs for taxpayers

§ Contagion effects can be mitigated

§ Accountability of financial institutions

§ Avoidance of monopolies

§ Allows a more controlled recovery or resolution process

§ Questionable financial instruments may be better regulated

§ Banks may concentrate on lending instead of speculation

§ Protection of (private) investors

§ General public may regain trust in financial institutions

What are advantages of using PayPal?

PayPal attempts to make online purchases safer by providing a form of payment that does not require the payor or payee to disclose credit card or bank account numbers. Therefore, money is secure, privacy is protected, and, since the customer base is so large, transactions are faster than traditional methods.