KATE GOLDFINCH, Science Editor for The Fintech Times.
We live in the world where ten-year-old bank-challengers generate value dozens of times higher than established brands with a 200-years history. Where the central role of banks in the existing ‘financial universe’ is under challenge, and the open-source paradigm is becoming the prominent method for corporates and individuals. The monoliths, or established financial brands, still play the vital role, but their business effectiveness is drastically decreasing under the pressure of growing disruptors.
Time for challengers
Fintech is one of the world’s most dynamically-expanding industries, when ranked according to the capital sums invested. Statistics from KPMG show $100 billion dollars of investment in fintech between 2013 and 2106. This industry is set to change the appearance of traditional finance, using some of the crucial values in today’s modern world – open-source, APIs and transparency. Thanks to these values, fintech can leverage the maximum from integration and interaction with established brands, so that the finance industry could change away from the view that we have of it currently.
The key to these ongoing changes is not protocols or new legislation requirements on the use of client data. Instead, it is in an exit from monopoly rules, in favour of embracing an open, competitive market in which bonuses will go to those able to excel in things that others do worse. This revolution in the paradigms of the financial world won’t come easily. The monopolies (or monoliths) will fight to the last gasp. Yet progress will nevertheless sweep away these dictatorial organisations – which are stuck in the past century, and unable to envisage the new path that leads to an open-source world of apps, APIs, and analytics.
Those with the desire and ability to adopt the new playing-field and its new world will be able to secure new roles and their own place for themselves in the market.
In his book Digital Human, Chris Skinner writes “today’s world is one where PayPal is worth three Deutsche Banks, where Ant Financial is one of the largest financial firms in the world (valuation $60 billion) and where Stripe has risen from nowhere to be a challenger. The only standout bank is the world’s most valuable bank, JPMorgan Chase. Its market capitalisation of $245 billion is pretty impressive. But let’s set that against Stripe, a seven-year-old company at the time of publication (2018 year). Stripe was valued at $5 billion in 2015 but has grown up a lot more since then. It has expanded into Asia and gained investment from Sumitomo Mitsui, the largest Japanese credit card provider. Based on that development, its valuation almost doubled within a year to $9.2 billion. After five years, Stripe’s staff of 400 was generating $22 million of value per employee. JPMorgan’s 219-year history (est. 1799) and 235,000 employees has given it the ability, as the most valuable bank in the world, to generate just over $1 million in value per employee”.
In these terms, today’s established financial brands have no need to waste their efforts on becoming tech companies, developing everything themselves, and doing it all on their own. Instead, they should be finding those who do just one thing, but do it better than anyone else on the market – and collaborate. The era of collaborations has dawned. Interaction between startups and established brands is the name of the game today.
Economics and customer behaviour shifts
When analysing the changes in the financial markets, we could conclude that the role of banks is drastically transforming. That happens under the pressure of economics and customer experience shifts.
Let’s consider how traditional banks – proprietary product providers – make money at the moment. Today, retail banks earn their profits from the margin on savings and loans, from cross-selling to deposit account holders and from fees and charges for overdrafts and borrowings. However, as more specialised digital providers of these products and services appear, the profit margins of the banks stand to suffer as a result and the banks will have to change their role to that of marketplace owners, not monoliths.
Nigel Verdon, CEO and co-founder at RailsBank, predicts in a future shift to so called ‘utility banking’ – a bank offering wholesale access to its core platform, regulatory licenses, on-boarding, payments / cards infrastructure to third parties like fintech companies via API platforms (e.g. Railsbank) or via their own APIs. “Basic retail current accounts do not make money nor do cross border SMEs in banks in G10 countries. Customers do not want to use bank apps because they live their life in social media and don’t care how good that bank app is. Therefore, there is likely to be a structural shift to ‘utility banking. At the same time, the traditional ‘retail and SME’ will remain to target economic customers – those from whom one makes a profit, rather than losing money. Utility banking will be a ‘new P&L’ in the bank where they sell their ‘Payment and Licensing rails’ via distribution platforms like Railsbank”. The fact is that utility banking already exists in China, where banks are a utility to WeChat and other social media platforms. That was caused by the fact that retail banks didn’t really exist in China. “Banks in China were for distribution of central party funds,” Verdon notes.
From ‘geocentric’ to ‘heliocentric’ model
As we can see, the role of banks in the existing financial ecosystem is not a central one anymore. Leading thinking on this is the QED Investors (the fund of Nigel Morris, founder of Capital One), with an interesting theory called the ‘Copernican Revolution’.
According to Wiki, historically, the Copernican Revolution was the paradigm shift from the Ptolemaic model of the heavens, which described the cosmos as having Earth stationary at the centre of the universe, to the heliocentric model with the Sun at the centre of the Solar System. Beginning with the publication of Nicolaus Copernicus’s ‘De revolutionibus orbium coelestium’, contributions to the ‘revolution’ continued, until finally ending with Isaac Newton’s work over a century later.
The newest application of the Copernican Revolution to the modern financial world was represented by Frank Rotman, Founding Partner at QED Investors, as “The Copernican Revolution in Banking”. This concept is based on the aftermath of Copernicus’ statement that the Earth moves around the Sun. Nothing in the physical world changed as a result of this statement, and yet everything changed about our understanding of the world. “What Copernicus did was take the existing a priori concept of the world (geocentrism) and pose an alternative a priori concept of the world (heliocentrism). Both fit the facts, but the new world view allowed for innovation (Kepler, Einstein, etc), while the old world view had stagnated after 1,500 years and had hit a dead end,” Frank Rotman argues.
According to Frank Rotman, The ‘Geocentric Model’ of Banking consists of the following principles: banks must manage a complete suite of banking products (core banking, lending, payments, wealth management, etc.); banks must serve all clients (consumer, SME, and corporate) through all channels – branch, online, telephone, mobile, etc.. The ‘Geocentric Model’ of Banking produced solid economic returns for many years, but this is no longer true (see the picture Banking return on average equity in the U.S.).
“It’s easy to blame all of the banking ecosystem’s problems on increased regulatory scrutiny and capital requirements, but there is a profound shift occurring that can’t be ignored. Armed with more information, consumers increasingly shop and banking products are no exception. Full transparency enables rational decision-making by consumers. Thus, the big question every business needs to ask itself: If a rational consumer were armed with perfect information, would they choose my product?” a founding partner at QED Investors asks. It’s impossible to believe that all banks are adequately resourced to deliver a complete suite of best-in-class products. Share will increasingly become concentrated in the hands of best-in-class product providers as channel barriers fall and information becomes more abundant. The time is right for banks to take a ‘Copernican Leap’: be willing to offer your best products and capabilities to other institutions’ customers; be willing to replace non-core products and capabilities with best-in-class offerings from third parties.
Rotman believes in this new world, four types of players will emerge:
Transactional Banks manufacture white-label versions of specific products and services.
Key characteristics: Legal right and skills to manufacture best-in-class products, paired with efficient and scalable operations. Amazon Web Services (AWS) is a good analogy for how Transactional Banks that specialise in specific service layers and core functionality could emerge. AWS also serves as a great proof point that well-managed back-end functionality can generate a giant profit pool. AWS has centralised 1MM+ cost centres into one giant profit centre. Transactional Banks can do the same in the Banking world.
Genpop banks serve the general population with a broad suite of products. There are many full-service banks and credit unions today, most of which are too small to deliver a suite of products profitably. What if the 5,000+ banking institutions substituted their current offerings with third-party bestin-class products and infrastructure?
Key characteristics: Complete suite of products (own and third party) that cater to the general population.
Vertical banks serve specific segments vs the general population. Focus on a single segment (agriculture bank, SME bank etc.) allows for the curation of a best-in-class suite of products and tailored customer experience. Vertical banks will be very disruptive to the banking ecosystem. They will dominate a segment by offering a small number of world-class products that are hyper-focused on the segment’s needs.
Key characteristics: Curated offering of products (own and third party) that are tailored to the segment’s needs.
Non-bank players will be able to distribute banking products manufactured by the transactional banks.
Key characteristics: Massive base of engaged customers.
Diversification and more choice for customers
According to Frank Rotman and other experts, the future of retail banking will definitely see a diversification of business models. “We are seeing the emergence of new business models that use technology to innovate in distribution, user experience, and pricing. However, very few of these business models seek to completely replace traditional retail lenders, instead they’re likely to be complementary. This is good news for customers, with more choice than ever before, and good news for banks, which will have a broader canvas to play on, with more opportunities for differentiation,” Alex Park, Director Digital at Metro Bank comments.
Park believes that a major driver for the above mentioned transformation will be the rise of ‘connected banking’, fuelled by fintech friendly regulation, API proliferation and the abundance of finance-focused venture capital.
Perfecting the existing approaches to analysing big data using AI, and machine learning, there will be a parallel implementation and distribution of what’s being touted as the Semantic Web – or the Conscious Internet – alongside wheeling out such new institution as the Semantic Bank of the Future, Chris Skinner predicts. It might happen in the next 20-30 years.
“By their very nature, banks collect more customer data than almost any other entity, which represents a significant opportunity when it comes to ‘big data’. However, consumer-ready AI remains much more limited and immature than contemporary hype lets-on,” Alex Park argues. At the same time, banks keeping on the strategy of using machine learning and AI to gain a far deeper knowledge of customers’ financial lifestyle and habits, integrating financial data with contextual and social data, have a great opportunity to save their leading market positioning.
In the future, banks will not be limited to merely clinging onto their client-base or producing half-baked solutions for their customers – but will instead curate of a thousand apps and APIs, as well as securing funds reliably, and digital assets. They will also create and own numerous fintech marketplaces.
Those incumbents who do not grow into these new roles will be uncompetitive technologically in an open sourced and fully digitalised ‘financial universe’, and are unlikely to survive the revolution.