Bank 4.0 Page 19

  Research by PwC last year showed that 95 percent of banks believe that part of their business is at risk of being lost to stand-alone FinTech companies. This is no longer just academic.

  Now I know the first defence that many incumbents will offer—market share. The argument will be that until FinTechs take real market share off incumbents, this is largely a moot point. But is it? Is the aim immediate dominance in a sector? Was Amazon dominant in retail sales in 1995 when their internet service launched? What about in 2005, 10 years later? Was Apple dominant in music sales when the iPod launched in 2001? Were those initiatives a failure in the early years because they didn’t dominate their industry within just a few short years? The data clearly doesn’t support that argument.

  In the US market, regulators have chosen to drag their feet on FinTech licensing for banks12, but there is already a well-established credit market that has been largely based on non face-to-face distribution. Direct mail, outbound call centre sales, brokered lending—all have all been common models over the last 20 years or so. Thus, pure play FinTechs in the lending space don’t have the regulatory hurdles that FDIC licensed checking account operators have, and thus the market share changes have been more pronounced.

  This shift is likely to get even more acute for incumbents as the likes of SoFi, CommonBond, Prosper, Lending Club and others venture out into more complex distribution partnerships to enable greater reach. Check out the data from TransUnion showing the shifts in unsecured, personal loan portfolios in the US market over the last few years. From just 2012 to 2015, FinTechs went from just three percent of market share to over 30 percent.

  Figure 6: FinTech’s impact on the US lending space (Source: TransUnion).

  I don’t know how you’d argue that this is just a coincidence or a non-issue for incumbents. But if you need further proof of why this represents a structural change, just look at the side-by-side operational cost structures of a FinTech lender like Lending Club compared with a traditional lender in the space:

  Figure 7: Lending Club based on data from Federal Reserve Bank of St. Louis and Foundation Capital (Source: Let’s Talk Payments).

  The data shows Lending Club’s business has a 400-basis point cost advantage over a typical bank competitor. When it comes to origination there’s an 80 percent reduction in average cost, and close to 80 percent advantage when it comes to collections and fraud. In fact, the only costs where Lending Club exceeded the average incumbent was in marketing. You might think Lending Club’s IT costs would be more than a traditional bank, given that is their core platform, but no—there, too, they have a 20 percent cost advantage over incumbents. That’s hardly insignificant. This is one of the reasons banks are increasingly working with FinTechs. The fact is that maintaining legacy architecture is super expensive compared with working with a new technology stack.

  These changes are not limited to the lending segment and challenger banks. For example, a recent report by EY showed that use of FinTech players for money transfer and payment services rose from 18 percent in 2015 to 50 percent in 2017, with 65 percent of consumers anticipating they would use such services at some point in future13. McKinsey reported in 2017 that one UK-based international money transfer service provides P2P international transactions at just 10 percent of the cost of the average bank in the UK14. PwC and Accenture research show that between 28–30 percent of existing banking and payments businesses are at risk from FinTech disruption by 2020 alone. That’s two years away, folks.

  Accenture went even further in their research15 of the impact of FinTech on the industry. According to Accenture, there are only one of two possible outcomes for incumbents based on the macro changes we are seeing as a result of investment and traction around FinTech companies:

  Scenario 1: Digitally disrupted—as banks lose their profitability to the more effective FinTech companies in the digital age, they will continue to offer a product-based sales approach rather than to improve the customer experience.

  Scenario 2: Digitally reimagined—banks will increasingly integrate innovations at the business model level. Their focus will shift from asset monopolies to improving a customer’s life by embedding financial services experiences.

  FinTechs are lean, agile and innovative

  Startups rely on leading-edge technology, don’t have to worry about any legacy architecture, and are only partially subject to the regulatory constraints that apply to conventional banks. They require fewer but highly specialised staff, and hardly any physical infrastructure. Their dynamism attracts digital talent. FinTechs disrupt the sales of banking products by fulfilling customer expectations using agile processes and greater customer orientation and accelerating their speed of innovation. They establish a “new normal” for mobile and online user journeys using unique, intuitive features, with regular new releases. They disintermediate client relationships from banks by providing aggregator services, putting banks in the position of pure providers of infrastructure and commodity products in extreme cases. As well as offering old products in a new guise, FinTechs develop completely new services, such as cross-border, peer-to-peer (P2P) payments, micro-lending or robo-investment platforms where almost all processes are based on algorithms and barely any human intervention is required. This makes some established offerings obsolete and diminishes the profit pools of banks.

  FinTech—Challenges and Opportunities

  McKinsey Report, May 2016

  Partner, acquire or mimic?

  Innovation is simply not in the DNA of most bankers. They’ve been trained throughout their whole career to identify and avoid risks, and innovation is about taking small risks and failing fast and cheaply and learning from those mistakes to get to the right answer quickly.

  —J.P. Nicols, FinTech Forge

  Since 2012, the top 10 US banks by assets have participated in 72 rounds totaling $3.6 billion of investment in 56 different FinTech startups alone. All 10 of those banks have blockchain and AI investments.

  Research shows that FinTechs are consistently between 25–70 percent cheaper to market, or operating at a significantly lower cost base than incumbents16. FinTechs are faster and first-to-market at delivering the big innovations, which are the likely foundation of the future of banking from an experience and technologies standpoint.

  If you’re a bank, then, statistics indicate you have two choices. Deliver it internally at a slower and more expensive rate than a technology player, or partner with a FinTech to do the same, but faster and cheaper. And yet, the vast majority of banks today are not yet partnering with FinTechs. Regardless, McKinsey research shows that only eight percent of incumbents believe that they don’t need to respond to these industry wide changes. That means most banks already know they must respond—the question remaining is how?

  Figure 8: There are now very few incumbent banks that don’t see FinTechs as a threat (Source: McKinsey).

  First principles thinking is a key element in this landscape.

  It would be illustrative to revisit the SpaceX example in their quest to deliver cheaper launch costs for rockets and spacecraft. Recall that the recent Falcon Heavy (FH) launch bought the cost of delivering 64 tons into orbit down to just $90 million—a 90 percent cost reduction from the days of the Space Shuttle, and reusability will bring that down further. The nearest government competitor to this is the long-awaited SLS, or Space Launch System, being developed by NASA and its contractors. But the SLS, which will only be able to carry 70 tons into orbit (just 10 percent more payload than the Falcon Heavy) and has an estimated cost of $1 billion per launch, is already three years overdue. The projected costs of the SLS are greater than 10 times the FH launch cost, for just a 10 percent increase in capacity. In other words, for the cost of one launch of the SLS platform that pushes 70 tons into orbit, SpaceX could have delivered more than 700 tons into orbit for the same spend. That’s illustrative of the sort of comparisons we’re seeing in incumbent-based digitisation efforts versus those in FinTech. Sure, you can
build it yourself, but economically it simply makes no sense. If you can get the same result for one-tenth of the price in one-third of the time, why are you screwing around trying to copy what a FinTech has already built?

  Bank Strengths Fintech Strengths Fintech Differentiation

  Broad existing customer base New ideas/thinking Experiences tailored to specific consumer groups

  Broad product set Agile implementation Greater flexibility in service approaches

  Low cost of capital Cutting edge analytics and data management New business models that change economics

  Regulatory protections (deposit guarantee, etc) Online customer acquisition Inclusion and serving underserved customers

  Revenue source (for fintaech) Online/Mobile UX optimized design Shift away from products to differentiated technology experiences

  Table 1: The benefits of collaboration between Banks and FinTechs.

  FinTechs bend space and time for incumbents when it comes to technical capability.

  To be fair, FinTechs need incumbents, too. They need the scale and revenue that partnerships with banks provide. Their growth is dependent on these sorts of partnerships to deploy their technologies. It sounds like a marriage made in heaven, but only if you recognise the key strengths and weaknesses of both parties.

  In the end, banks actually have four choices in how to respond to the structural changes financial services is witnessing as a result of the explosion in FinTech-led innovation:

  1.Do nothing (slow decline into obsolescence, ultimately very expensive)

  2.Partner with a FinTech (cheapest and fastest)

  3.Acquire a FinTech (potentially fast, but still expensive and culturally challenging)

  4.Copy or mimic FinTech innovations (slow and very expensive)

  What are the benefits of copying a FinTech instead of working with one? It’s hard to define specifically beyond retaining budget internally, avoiding culture clash and owning the IP. It’s unlikely those benefits justify the sort of costs and delays that would otherwise come from partnership with a more agile technology partner.

  In almost all cases incumbent banks can only really iterate on what a FinTech has already done. Look at Greenhouse from Wells Fargo, Finn from Chase or Liv from Emirates NBD. What are these if they aren’t clones of Moven, Monzo, Digit and Acorns? Imitation is the sincerest form of flattery, but when it comes to banking, technology development is also the most expensive form of flattery.

  Hackathons, accelerators and incubators—shall we dance?

  It is quite common for larger banks to start their own incubators or accelerators, offering up mentoring, legal, marketing, or technology support to startups to attract them. Such programs can also be accompanied with direct equity investments in participants. For instance, Wells Fargo invests between $50,000 and $500,000 in each participant in its accelerator program, which was launched back in 2014. Wells uses the program as an extended audition to consider purchasing the startups’ products. Barclays runs an accelerator program that it recently expanded to New York, London, Tel Aviv and Cape Town—with investment of up to $120,000.

  JPMorgan Chase partnered with the Centre for Financial Services Innovation17 to create the Financial Solutions Lab, with a $30 million investment over five years. The advisory council for FinLab includes Kosta Peric from the Bill and Melinda Gates Foundation, Arjuna Costa from Omidyar Network, Susan Erlich from Simple, Arjan Schutte from Core Innovation Capital, and others.

  On the down side, these kinds of programs are extremely costly to run. Banks should have extensive experience in dealing with startups through other kinds of collaboration before shelling out for such a program. Additionally, banks need to have very specific objectives when they start an accelerator to ensure they get their money’s worth. Barclays have already invested the resources to develop 43 different financial blockchain applications in its internal labs, so it makes sense to strategically supplement that work through its accelerator program.

  Some of these partnerships are now mature enough for tactical benefits to be measured. A recent survey from global law firm Mayer Brown18 showed three key areas where incumbents say their partnerships with FinTechs are paying off:

  •Cost savings: 87 percent of respondents said they were able to cut costs to some extent by working with FinTech providers. Most likely, these savings are coming from incumbents spending less on the development of new experiences, as well as the efficiencies FinTechs bring to legacy processes, their agile operating structures and the use of the latest tech.

  •Brand refreshes: 83 percent of respondents said collaborations with FinTechs offered opportunities for incumbents to refresh their branding. Speed to market and cheaper development efforts allow incumbents to reposition themselves as better serving a particular market, or simply as cutting-edge.

  •Increased revenue: 54 percent of respondents said partnerships had resulted in boosted revenue.

  Ultimately, however, if your organisation structure is not geared towards working with startups, these accelerators and hackathons don’t get you big bang for your buck. If you have anyone in the bank telling you that you could run a hackathon and take the best ideas and implement them yourselves in the bank, then give up now. This might work once, but after that your bank would quickly become labelled within the informal network of FinTech professionals globally as an innovation bystander and tire-kicker, and not as a team player. The only way these programs work is if you are really serious about engaging with FinTechs for longer-term partnerships.

  The problem for banks is that even with an incubator or accelerator program, your access to FinTechs is extremely limited compared with stand-alone accelerators. The success of a standalone accelerator like Y Combinator is in part because it has funded more than 500 startups since 2005. By comparison, the innovation labs at some of the biggest banks house no more than a handful of startups at any given time. Some accelerators I’ve seen only accept one or two percent of the applications they receive. This is hardly a guarantee of diverse and comprehensive innovation through FinTech partnerships.

  The other key problem we are seeing develop is that leaders of accelerator and innovation programs are increasingly being aggressively targeted by competitors who want to start their own initiatives. When a leader of an accelerator or innovation team leaves, in many cases the executive team that they hired beneath them dissolves or moves on too. It appears that innovation programs within banks often hinge on a key individual. When that individual moves, it sets back the team’s progress considerably. Innovation needs to be an organization-wide activity. That’s possible when you are running a FinTech; it’s almost impossible at an incumbent bank.

  Killing FinTech partnerships—the barriers to cooperation

  We have a chance to rebuild the system. Financial transactions are just numbers; it’s just information. You shouldn’t need 100,000 people and prime Manhattan real estate and giant data centers full of mainframe computers from the 1970s to give you the ability to do an online payment.

  —Marc Andreessen, Andreessen Horowitz, October 2014

  Looking at all of the above data, there are a ton of compelling reasons for cooperation between FinTechs and incumbents, but partnerships between banks and FinTechs are still in their nascent stage. The good news is, it is changing. In 2012 more than 50 percent of banks surveyed by Statista felt that FinTechs were largely irrelevant, but by 2017 that number had changed, with 93 percent of banks intending to partner with FinTechs. But what are the keys to success and the barriers to collaboration?

  Figure 9: Some of the barriers to successful FinTech-bank partnerships.

  Internal build mindset

  I think we’ve covered this often enough already, but needless to say this will become harder and harder to justify over the coming years. I can tell you personally that at Moven we’ve engaged with a number of banks that spent literally years picking our brains about our tech. In the time these incumbents spent trying to learn as much as they
could about our technology, they could have implemented the technology much faster and cheaper by working with us.

  Licensing technology rather than building technology internally also gives the bank the ability to reject a path in the medium term without committing too many internal resources to it.

  Poor cultural fit

  For the next few years this will remain a potential area of conflict. A startup moves fast, doesn’t worry too much about regulation until there’s an event that threatens the business, and has a culture of risk acceptance that would curl the toes of most chief risk officers. A bank needs to be careful that their compliance, legal and risk teams don’t kill off the advantages, enthusiasm and drive of a FinTech partner in a collaboration effort. While being risk adverse has been at the core of banking, the ability to transform your organisation digitally will increasingly depend on agility. Banks should seek to learn from the culture of FinTechs they work with and get the support of key internal stakeholders to give FinTech partners plenty of latitude when it comes to solutions architecture and delivery. Too often new initiatives coming into a bank are perceived culturally as a threat because of the change it forces, and the bank reacts like an immune system attacking a virus.

  Procurement workload

  It’s likely that when you first meet a FinTech the procurement and legal teams will drive contracting. In that case bank procurement departments will tend to favour contracts that have previously been drawn up internally in the bank, because new contracts will need much longer approval times. The drawback is that in many cases an IT contract with service level agreements for technology partners (like Oracle, IBM or Temenos) will be massive overkill for a small startup working with you on integrating, say, voice AI technology. Internet security compliance and audit requirements, joint IP ownership claw back rights for project failures—or, in the case of termination, 80 pages of legalese—and so forth are all going to be massively problematic for a small VC-backed FinTech who is just out of beta with their technology and has no in-house legal team.