The move to digital banking holds huge potential rewards for banks able to innovate quickly and effectively. To succeed, they will need to overcome their own legacy infrastructures, their traditional competitors, and a phalanx of disruptive, digital-only startups.
Those digital-only challengers are growing fast on the back of a transparent, trustworthy, digital-centric vision of banking. Turning established banks into organizations that can deliver multi-channel banking will require serious investment and new strategies for entrenched systems and cultures. Banks need an innovation strategy to cope with three existential phenomena:
- A transformation of the way banking is delivered.
- Competition from digital-only, direct banks.
- Mounting technical debt in legacy systems.
A digital opportunity
Digital banking channels offer completely new ways to interact with customers and promise huge reductions in the cost of servicing them. Branch transactions are orders of magnitude more expensive than those carried out online. According to the Tower Group, writing in 2012, the average branch transaction cost is US $4, compared with just US $0.09 online.
According to analysts McKinsey, European retail banks are currently losing money on about half of their customer accounts, and have only digitized 20-40% of the customer experience.
A digital challenge
Established banks face competition from traditional banks and digital-only ‘challengers’: banks whose principle front-end is an app or website on a customer’s smartphone. Some, such as Simple, are radical new ways of presenting existing banking systems, while others such as Atom and Fidor are aiming to be independent, fully licensed banks in their own right.
The challengers are unencumbered by legacy systems and branch networks, and strongly focused on profitable customer niches. Anthony Thomson, co-founder of Metro, says his latest venture, Atom, will deliver a cost-to-income ratio that’s 30% lower than traditional retail banks.
The challengers are growing fast, are agile, and embrace Brett King’s idea that banking is no longer somewhere you go, but something you do. Superficially, they have more in common with technology companies such as Amazon than they have with banks, and it’s a strategy that’s winning new admirers.
A digital debt
Chris Skinner, chairman at the Financial Services Club, told Computer Weekly that legacy systems are “creaking at the seams” and “will look Victorian by comparison to new competition”.
For years, banking systems have expanded by layering new technologies over old ones, leading to an ossification of core systems, and creating a drain on IT budgets and innovation. As Bernard Golden notes in CIO magazine: “Most IT budget is already committed to keeping the lights on … so too is most of the time and attention.”
Unpaid technical debt is increasing maintenance costs and decreasing agility, and the consequences of it are already a reality. RBS has had significant problems with its legacy IT, leading to a number of high-profile outages, most notably an incident in summer 2012 that resulted in the launch of an investigation by the Financial Conduct Authority (FCA).
The failure to deal with legacy IT may be helping to level the playing field for startups by nullifying the established banks’ advantage of scale. According to KPMG, challengers reported only slightly higher costs than established banks in 2014, with an average cost to income (CTI) ratio of 64%, compared to 63% for the ‘Big Five’.
How banks need to innovate
Although the digital-only challenger banks are innovative, their business models and innovations are concentrated around a few shared principles. It’s these areas that should be a priority for established organizations looking to nullify the challengers’ advantages:
- money management
- niche markets
The current crop of challengers are the third-generation inheritors of the ‘direct banking’ mantle, following on from the phone and internet banks of the last two decades. The message is similar to their predecessors’, but the medium is mobile. Like other direct banks, they don’t have to maintain an expensive branch network, but they have other advantages their predecessors didn’t have. User experience (UX) design is far better understood now than it was when the internet banks first arrived, and as a result their products and services are slimmed down, simplified and finely tuned for their market and delivery platform.
Establishing a trusted brand is one of the biggest challenges facing the digital-only banks, and the marketing costs required to get there are eye-watering. Challenger banks are focusing on social media channels to get their message across because the costs are lower than traditional marketing, and because their profitable customers are there. Some, like Starling Bank, see themselves as inherently social: “We are more like Facebook than a bank.” They have a business model that relies on tapping the “huge, huge rich seam” of customer data available from social platforms.
Challenger banks are putting money management front and center, offering features such as:
- automated deposits to help users reach savings goals
- short-term cash flow forecasts to show people an estimate of their available funds
- card restrictions that help customers protect themselves from impulsive behavior.
Money management is an area where customers are giving banks permission to intervene in their lives, something that’s important to companies trying to establish social relationships with customers, and a notable exception to the ‘rule’ noted by Mark Mullen, CEO of Atom, that “the irony of it is that the less you see and speak to your customers, the more satisfied they are with you”.
The digital challengers are almost all pursuing a strategy of “dancing in the gaps” left by the major banks. For example, Lintel Bank is emulating Bank of America’s early years by targeting migrant workers and students who need UK accounts quickly (its founder, Nazzim Ishaque, claims any British citizen will be able open a bank account in just two minutes).
In part, this concentration on niches is the luxury that all small players in large markets enjoy, yet it also reflects the reality that getting people to change their bank is actually quite hard. First Direct enjoys consistently high customer service ratings, but wins far fewer ‘switchers’ than Santander, which gained 69,935 new customers in Q3 2014, suggesting that the appetite for direct banking may be limited.
More than anything else, challenger banks are pursuing a different culture. They’re not just trying to present themselves as something different with names such as ‘Civilised Bank’ – they’re trying to be something different. As KPMG noted in its most recent report on the matter:
“… for all challengers, the main point of difference is their culture. Being largely free of the legacy problems of the past contributes to a sense of social purpose that puts fire in the bellies of their executives and frontline staff”.
Although digital-only banks are a serious proposition, it’s important to understand the limitations and obstacles they face in order to formulate an appropriate response. Disruptive technology often takes a while to gain traction (Uber’s “overnight success” has been six years in the making), so it’s likely that banks acting promptly now have time to develop a considered, strategic response.
The financial barrier to entry for new banks is very high indeed; Atom and Starling are both targeting £100m in funding to establish themselves. Starting a new bank isn’t just costly, it’s difficult too, particularly if you’re trying to break new ground. Atom’s CEO Mark Mullen:
“The process of designing a new bank and obtaining a banking licence is complex and justifiably so … It’s a technical challenge to choose the right tools, partner with the right people, choose the right infrastructure, test it, develop it etc. The whole process is time-consuming, expensive and fraught with stress.”
The history of direct banking suggests that once a new bank makes it to market, lasting success is hard to achieve. So far only a handful of organizations such as Marbles Credit Card, Egg and Smile have succeeded, yet none of them has managed to displace the established banks or the established banks’ business model.
In order to succeed, small, digital-only banks need to scale up, but customers are cautious and finding enough who are willing to switch can be difficult. It has taken Metro Bank more than four years to reach 400,000 customer accounts.
There may even be a natural limit (at least until attitudes change) imposed on the size of the market by the number of customers who are prepared to use a bank with no physical presence. Research suggests that, for the time being at least, most customers want the comfort of knowing they can visit a branch even if they don’t use them.
Large, established financial services organizations generally have a culture dedicated to maintaining and consolidating their position in the market. These cultures are successful in their own right, but they don’t foster the tools needed to take on disruptive startups on startup territory. For that, they will need to do something different.
“To be radical, you need to have a blank sheet of paper and build something from scratch. Then, every decision you make can be aligned to your vision, and can be aligned to the competitive advantages you’re trying to create.” — Mark Mullen, CEO Atom
Grow your own
The all-or-nothing approach to competing with innovative, agile banks is to try to create one from scratch by transforming an entire bank, creating a subsidiary digital-bank or fostering startups.
Transforming the entire organization and its culture is the high-stakes gambit chosen by Spanish Bank BBVA, whose chairman Francisco González has declared: “BBVA will be a software company in the future.”
The scale of the proposed transformation is staggering, with the number of employees working on digital banking solutions projected to increase from under 3% to more than 50% over the next five years. Others are focusing their efforts on a subsidiary that can market itself as a fresh face while leveraging parent company assets such as branch networks. Alior Sync, Hello Bank, Jibun Bank, Soon, UBank, and Zuno Bank are all the fruits of existing banks or insurance companies.
The idea is taken a step further by Santander and Barclays, who are fostering numerous startups by operating as fintech VCs through their Innoventures and Accelerator programs. Becoming a VC allows an organization to compartmentalize disruption and experiment with different cultures without betting the farm. Yet, as Philippe Gelis (CEO of Kantox) cautions, it can create a conflict of interest: “It’s a first step for banks to open incubators or to create VC funds … but it’s definitely not enough … They almost never invest in products that directly compete with them.”
Many of the best-known challengers, such as Instabank, Moven and Simple, don’t have their own banking license, but operate as a branded service layer on top of another bank that does. This allows them to focus on marketing and customer service, the areas where the digital-only battle is fought. Other banks have sought to collaborate with technology companies; Jibun Bank is a result of a partnership between Bank of Tokyo-Mitsubishi and mobile operator KDDI, for example.
Collaboration enables banks to add new capabilities quickly without having to develop experience and expertize in-house. Although it doesn’t demand wholesale transformation, it requires that banks work in a different way. A dominant partner that isn’t comfortable ceding some control and doesn’t change its decision-making process risks slowing down a smaller, more agile partner to its own pace.
Collaboration can also raise a lot of questions, and progress and success naturally changes the relationship between the collaborating partners. The price for collaboration for the larger partner can be limited intellectual property rights and a loss of vertical integration.
Banks that want to avoid betting the farm on their own startup can try to acquire one. It’s not certain that digital-only banks will prosper, and if any do grow beyond their market niche, they may need access to a partner with the legacy systems and branch networks they initially avoided. Acquisition may also provide the only realistic way for some banks to deal with the thorniest problem of all, their legacy systems:
“The cost and risk associated with migrating a core banking system to a digital banking platform is too difficult for most existing banks to contemplate … The future will involve the mainstream banks acquiring the digital banks and slowly migrating their customers across to the new platform … [They] could end up being a lifeboat for the mainstream.” — The Nostrum Group
An acquisition strategy will allow banks to avoid potentially expensive mistakes in an uncertain market, but runs the risk of missing the boat. A wait-and-see policy might also forestall the development of an innovation culture, and leave the bank vulnerable to challenges from left field.
Across the world, in every conceivable niche, the internet has given rise to new and often highly disruptive ‘brokerage’ businesses. Brokers such as Amazon Marketplace connect supply and demand in a direct way, establishing their brand as the natural way to access the market, and turning suppliers into service providers. So far, banking has been spared this disruption, but change may be coming by way of the ‘marketplace bank’ based on five simple elements:
- a banking license
- compliance and KYC management
- a core banking platform, built from scratch
- an API layer to connect to third party systems
- a customer relationship management (CRM) system.
The bank will provide its own basic services, but products such as loans and mortgages will come via third parties plugged in to the bank’s API. Customers will be able to mix-and-match the range of products that suit them best from across the market, putting everything from peer-to-peer lending and cryptocurrencies on a level with existing high street retail products.
Digital banking is here to stay, and the banking habits of consumers are changing. The digital-only proposition is compelling and cost effective, but the latest generation of direct banks face the same challenge as the internet and phone banks that preceded them: reaching scale.
A new, simplified, branchless model will suit some consumers, but questions remain about the potential size of the market. Established banks cannot afford to sit and wait. They must act.
At ieDigital, we think that the majority of customers will continue to want the comfort of multi-channel banking that they can reach via mobile, internet, ATM, phone or branch, but all of those things will be changed profoundly by digitization. Banking executives need to move beyond apps and websites, and think about the opportunities for technology throughout the value chain.
By thinking less narrowly about digital, they could realize improvements in Ebitda of more than 40% over five years. For those that don’t, BBVA CEO and chairman, Francisco Gonzalez, has a stark warning:.
“Up to half the world’s banks may lose out and disappear due to failure to keep pace with digital disruption.”
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