Banks and banking in general are probably, right now one of the most talked about sectors in the disruption discourse. As the story goes, banks are dying; they are dinosaurs with low customer satisfaction and bad customer experiences. To top that off, they (strangely enough) make insane amounts of profit – on our hard earned cash.

But, as entrenched in society and business as they are, can the big banks really be challenged by small start-ups? What will the banks likely response to this challenge be and what will happen in the industry?

Somali shilling notes

Somali shilling notes

 

In this post I will try to create a light backdrop to understand the context of how financial institutions work and provide some thoughts on future scenarios, chalked down as an inexhaustive list of factors and parameters that affecting startups and incumbents in either direction.

The future will probably play out like a big bucket of events and ambitions mixed up anyways so there really is no point in making certain predictions about the future.

What is banking?

The banking and finance sector is huge and contains a myriad of sectors to be broken up and innovated within. A a good place to start is to straighten out the landscape we are talking about. When someone says they are going to disrupt the finance industry, usually they are not. Unless you are some R3-industry coalition or Blockchain type-fundamental-infrastructural idea, in which case you might.

In any type of situation, it really helps to be specific.

Large banks as we know them today are typically huge organisation who is not only vertically integrated, but also within the finance industry, acts horizontally. In banking this is called universal banking. It’s like if Walmart would call its business “universal shopping”. Modest and descriptive.

People in general have three primary needs that the banks are supposed to solve.

We have a daily need of being able pay and transfer money in a myriad of different situations. We need to lend money, for a home, a car or use credit to balance the ups and downs in our personal economy and we need to save money to use later.

Typically we like to borrow money at a low and stable rate, and our savings to grow in a stable and secure manner for a reasonable fee. In the future this fee likely will be $0 – but that’s a different story. The transactions of course should be fast, secure, stable and free.

The basic business model is to make money on the difference between the deposit rate (or any other financing) and the lending rate as well as charging fees around peoples need for cash, credit and payments. (Corporate banking is another space, but we’ll leave that for now)

What are startups and banks doing respectively?

Traditional banks are vertically integrated, meaning that they create, refine and sell the commodity being cash. They own and manage everything from getting funding on the financial markets (i.e. creating the cash commodity) to developing products and building distribution for them by marketing and selling these on different channels and markets. This includes products and services in all three areas for individual banking (above) as well as services for corporates and institutions.

New companies who targets the banks individual customers has to compete with the idea of the universal bank. In order to do that they have to go for the parts that are the most basic and fundamental to banks today, accounts, transactions and payments – i.e. making sure your bills get paid and that you shop with a debit or credit card.

Some of these services, aiming a transaction banking and helping individual customers has not been able, or chosen not to vertically integrate their business. In a number of different ways the have partnered with “a real bank” to supply the backbone and on top of this created an interface.

Another way is to go with a niche segment, like Qapital or Dreams, and attract customers to do something they otherwise might not.

Regardless of what route they take, basically what they are trying to do is to optimise the user experience, which is an area where there is potential upside since banks today lack in this area. In this equation, banks supply the backbone, the infrastructure and the pipes and the startup hopes that the experience they offer can lure the customers to move more and more of their business to them. As they grow they can continually add new services, making an even stronger offer.

The premise is that if you could create a great digital customer experience, one that is far superior to what customer are used to today, the customers will come in masses.

In the tech community, this train of thought is so deeply entrenched that it hard to see that banks create any value what so ever. Obviously that’s not the fact.

There is a tendency to simplify complex events

There is sometimes a tendency to analyse one industry or segment, and believe that you can apply the same logic to any other industry. I believe that all industries have their own challenges and dynamics, making them individually vulnerable to external threats.

You must look at industry individually to understand and be able to analyse its future. The major changes in the food industry, the personal transportation industry and the entertainment industry has all come along in different ways but one thing seems to be universal. It starts close to the consumer and what he or she experiences in the meeting point with the service, and in the distribution of the service. This will then create repercussions further down in the vertically integrated chain – and also the need and possibility that opens to horizontally expand your business.

But in the narrative of the disruptors, when something new comes along, the old immediately dies. As a matter of fact, they tend to live alongside each other for some time, to adapt, or as a phenomenon, evolve or eventually die.

The case for disruption

So in banking and finance, what is the case for disruption? What factors and parameters would force banks to be disrupted and dislocated from its current trajectory?

The universal banks are normally sufficiently good at everything and cater to their customers on the promise of taking care of their entire range of business, weather it is individual or business needs.

That inevitably leads to not being able to the absolute best in each of these segments.

Within large organisations it is a constant struggle for resources and access to platforms to reach customers. Looking at the customer journey, resources and projects end up being focused on the parts where they are possible to implement, rather than where they are necessary or efficient. In practice that means they usually do more customer acquisition activities, rather than optimizing sales and conversion in existing customer journeys.

Slowly but surely this leads to a decrease in the customers experience of each service individually. So the incumbents face the problem of allocating resources wisely, utilising their distribution network and maximising user experience to the large customer base that they have.

On the other hand you have startups, which by design focus on one single service and to provide the absolute best solution to that problem. Their challenge is opposite to what the big banks faces, lack of resources and distribution network and customer base. But with a really good service and patience they can start eating away on the less satisfied customers, piece by piece.

Before you know it, it might have grown into a Klarna, expanding, growing and transforming the segment of payment services, overlooked by most banks until now.

The case for disruption is that this chain of events will unfold in segment after segment and eventually creating an ecosystem of services competing with the idea of universal banking.

EU-regulations and lawmakers drive the most potent case for banks being disrupted. XS2A and PSD-2 will force banks to open up and grant access to third party entities to view customer’s data and also perform transactions in other financial institutions. This completely changes the landscape of banking for the upcoming decades. Nobody can really be sure how this dynamic will play out, but banks dominance due to the lock-in effect of customers will vanish, as well as the obstacles and mental thresholds that arise on the journey from comparing prices to actually changing supplier.

Another dominant factor that is unfavourable for the incumbents is it’s cost structure. Old IT and legacy systems have a tendency to increase in cost, whereas newer systems increasingly gets cheaper as you scale and grow. That means that incumbents have increasing costs for legacy systems as well as additional cost for building new systems to successfully compete with new entrants.

Banking as we know it will change

Maybe the most interesting aspect of this topic is the fact that when an industry is being transformed, it’s usually not a digital version of what used to be, rather it’s a new industry, with partially or completely changed rules and models. And this is where it’s really difficult for incumbents to adapt, because they are no longer in the same line of business.

Even if you understand what changes are taking place outside your business, making the necessary changes is difficult and risky. To be successful you have to manage the past, your present business model and the future. You have to continuously enhance and perfect the revenues that you have today while planning for a future where you risk cannibalising on that very business.

In finance and in banking you have infrastructural changes, like the blockchain that can rearrange the entire structure of the industry. At the same time, new currencies, AI and machine learning, new types of devices and platforms and access to huge amounts of data will be the foundation for creating financial services and banking solutions that hasn’t even been thought of today. Who has the capacity and courage to expand on this today?

The case for banks thriving

In a way you could argue that startups already are making a great impact on the incumbent banks. The level of activity and urgency in the digital area of any bank has now reached levels that have not been seen before. This pressure, from new entrants as well as the possibility of substantially lower costs, are forcing banks to act. Given their resources, and ability to adapt to changing circumstances most, if not all of them will find a way to compete in this new landscape.

Regulations in the financial sector are a two-sided sword. One the one hand, it forces banks to hold more capital and add even more resources to compliance and steering systems. On the other hand, it is equal on all banks. Startups moving from obscurity to a more established position will quite soon have to adhere to the regulators. Under these circumstances, the incumbents will have an advantage, as they are more experienced in handling this.

In banking, size matters

In banking, being vertically integrated is a huge advantage compared to startups. Depending a little bit on what segment you are in, typically in order to make money you need money. Cash is the commodity in banking and if have none, there’s none to be made. Having a solid and stable track record is also crucial to be able to finance yourself cheaply on the credit market. How well you do there can make a real difference in your profitability.

The matter of size also comes into play in when larger player decide to opportunistically buy some of the angel dust hidden within the startups. This strategy is not new. First out was probably BBVA when they bought Bank Simple in 2014, and then later Holvi in 2016.

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In Sweden, just this year SEB has bought stakes in Tink and in blockchain startup Coinify. We will continue to see shopping spree’s and acquisitions being made, to the point that the startup scene within fin-tech might dry up and new companies starting with the sole purpose of being bought. This will probably have a slowing effect on disruption, since the smartest people and the best ideas will be a part of the big bank offering. How well they execute and deliver these ideas are yet to be seen.

Loyalty and full-service offerings

The universal bank as a concept is something that most banking customers appreciate. Preferably you’d have all of you banking service, and pension, your insurances in one cohesive and easily managed place. The universal bank can for the most part offer this. Banking customers who has this profile tend to be more satisfied customers than the ones just picking the cherries. Attempting to move customers to a full service offering is therefore not only doable for the incumbent, but also strategically wise, since it makes the threshold higher and deters new entrants looking at this possibility.

The EU-regulations might change this dynamic drastically, making it easier for others to create seamless and cohesive services, but it won’t come without challenges and the same type of super universal, all-inclusive banking can also be done by established banks, not just startups.

What is the most probable future scenario?

Banks are probably painfully aware that the playing field, compared to the good old days is changing.

Regulations are driving openness and transparency, and cooperative measures. It will force banks to share their competitive advantage, e.g. – their size, with new entrants. At the same time, new technology combined with regulations such as MIFID II will force prices on investments and savings further down making it much harder to defend revenue and margins in the long term.

Digitalisation will drive cost even lower, especially for the players who are able to not only digitize the front end, but also (optimise) the back end for increasing efficiency.

The most likely outcome is that the shopping spree will continue, where big players buy smaller startups. Digitalisation and the cost pressure will increase the automatisation of customers. Products will become more standardized and run by robots and AI.

On the other hand you will have large groups of customers appreciating a more traditional way of banking, being able to have a personal banking relationship, getting individual advice and so on.

And further down the line, a new type of financial services that is not based on the blueprint of todays banking will emerge. The companies who can make the banking equivalent leap from Kodak to Instagram, whatever that is, will probably be on to something big.

What are your thoughts?