Palo Alto – January 11, 2024 – New-age fintech challengers are chipping at “traditional banks” from all sides and slowly dismantling the protective walls built up by the incumbents over the past century. The banking and wider finance industry is facing these upstart digital banking innovation challengers across the spectrum of payments, cash, lending, money transfer, investment management, and lending, among other areas.

Some examples of how the incumbents are being usurped include:

1. Credit card/online payments being replaced by solutions from Apple, Amazon, Google, Paytm, Wechat, and Alipay.
2. Digital wallets replacing cash/cards and the need to visit ATMs.
3. Real-time payment platforms and systems removing the need to use cheques or make online payments.
4. Peer-to-peer (P2P) lending platforms (e.g. Lending Club) becoming more attractive than conventional lending.
5. Challenger banks — such as Monzo and N26 — providing attractive mobile-first current account products.

This disruption is predicated on service design that “starts from the end” with a laser focus on customer experience and habits, and then building backwards to meet those requirements. The entire “Design Thinking” focus is to understand the customer, their lifestyle, preferences and then custom build the product to add value and enhance the customer experience. This is in contrast to the traditional banking channels that tend to offer products based on their own strategic interests and existing capabilities, which may at times be suboptimal to end consumers.

Design Thinking Methodology

Emerging digital technologies enable a new degree of freedom to new entrants to the banking ecosystem. This provides a “David vs. Goliath” dynamic that allows them to iterate quickly, compared to incumbent banks. In the past decade, we have seen such scenarios play out in other consumer markets, such as transportation, hotels, media, and photography.

While many industries have been disrupted by emerging technologies, banking is still protected, largely due to it being a critical and a heavily regulated industry that is the safe warehouse for liquidity held by individuals and corporations. Its influence on economic stability means that its regulation and strategic importance to governments can make it a cumbersome industry to transform for new players.

How the Banking Industry Can Transform Itself
This article will address ideas for digital banking innovation and how to decouple the conflicting objectives of “liquidity,” “risk,” and “regulation” from “innovation,” “disruption,” and “transformation.” I will also explore how future M&A could propel the entire banking ecosystem in a new direction that will make the above all possible.

The Banking Industry: A Brief History
Modern banking has its origins in Europe and started in Italy to initially finance farmers, grain merchants, and traders. Over the subsequent centuries, services expanded into a multitude of areas, including merchant banking, deposit-taking, and lending, among others.

The modern banking industry that we now know began to emerge after World War II when it expanded rapidly into many more products and services across verticals. Thus, while the original banking comprised of straightforward loans, deposits, treasury, and insurance products, over the past 75 years, it slowly added more elaborate offerings such as derivatives, asset-backed securities, M&A/ECM, wealth management, and private banking. Banks began to serve two verticals: the corporate/institutional market and retail customers. The strategy had a degree of mutual interest, whereby the liabilities (deposits) from the retail side would fund the assets (lending) within the institutional divisions.

As banks began to grow, the largest began to exert their scale to their advantage and capture more of the market. The banking industry went from being fragmented, to rather concentrated.

US Share of Banking Deposits by Size of Institution 1992–2017

The expansion of services offered and geographies served meant that large banks became “universal banks”, with many merging in order to accelerate the process. Some of these developments were primarily governed by established banks having a captive base of consumers and simply leveraging their scale to increase absolute profitability. Yet, as information technology took hold in the latter half of the 20th century, most implementations of technology by banks were more evolution than revolution. Solutions were premised on legacy approaches and infrastructure and not necessarily innovating the entire process front to back.

The increased integration of the global economy and seamless movement of goods and services around the world has resulted in money flows rapidly expanding over the past 25 years. Such complexity has raised regulatory concerns over aspects such as money laundering, which has raised KYC/AML burdens required by banks to operate. The 2008 financial crisis demonstrated the risks associated with large banks taking on undue credit and liquidity, and since then, a flurry of regulatory interventions has further constrained the global ambitions of large traditional banks. Nowadays, banks have started going back to the basics (i.e. deposits and lending), which can be argued is further slowing down their focus on industry innovation.

Prevalent Global Business Themes
Over the past decade, the emergence of digital technologies has fundamentally influenced the way business is done. Some of the underlying themes that are apparent are as follows:

Emergence of a Global, Borderless Economy
All over the world people are increasingly interacting and transacting seamlessly across national borders much more than any time in the past. They are more frequently traveling, living, and purchasing internationally. The emergence of the gig economy is another example of how people can live in any part of the world and deliver projects without geographical prejudice. Why has this happened?

1. Seamless Integration — Internet-facilitated technologies allow for better oversight and efficiency of demand, supply, and supply chain fulfillment operations.
2. Mobile Connectivity — Mobile networks are more cost-efficient than their fixed-line equivalents and have allowed rapid infrastructure build-up, bringing large parts of a hereto unreachable audience in the “consumption” economy.
3. Increase in Data Availability — Shifts to digital methods have brought large increases in data availability; both from conventional data (e.g., financial) to non-financial (social media, geotagging, AI-based models, etc.)
4. Reduced Cost of Acquiring and Servicing Clients — In general, digital technologies are allowing banks to reduce their costs to acquire/service customers, by automating tasks that would have otherwise been performed by human labor.
5. Trust-based Transactions — Digital social identities are allowing completely new ways to identify, monitor, assess, score, engage, and track customers. The objective nature of a digital footprint offers large incentives to play it fair and straight, and align transactional parties.
6. Cloud > Physical Infrastructure — Physical location of most businesses, especially in services, has ceased to be a bottleneck for geographical growth. Companies in one corner of the world can now onboard and service customers on the other.
7. Scaling-up Businesses — is becoming easier with cloud-based distributed and “pay-as-you-go” scalable infrastructure allows the rapid building of businesses at low fixed CAPEX costs.

The Issues Faced by Traditional Banks
Some of the issues faced by traditional banks today face due to evolutionary reasons are as follows.

Branch-presence Led
Historically, banks were built around their physical branch and with customer relationships primarily being driven by the factor of access. Hence, these models required high investment in physical branch infrastructure, with a certain minimum business volume necessary to support the costs of a branch. This made banks focus more on urban agglomerations and thus, left many rural and interiors of countries unbanked, creating issues of financial inclusion. Upfront investment became an entry barrier for new players, as branch networks built at historical costs provided a disadvantage for any new entrants to scale their business.

Yet, nowadays, complex branch networks can be an issue for traditional banks. Consumers are increasingly self-servicing themselves through mobile banking channels, leaving branches with diminishing customer numbers. Managing this issue is tricky and slow due to the financial and strategic ramifications of handling the decline in branch-based banking.

Complex Legacy IT Infrastructure
Over the years, traditional banks developed their IT systems in patchwork and using legacy old technologies which required a lot of hardware and patched together software. Over time, this has become a complex cocktail of myriad solutions that have been pieced together and do not have the advantages that new age scalable, plug and play technologies bring. It is not easy to fix these and that is why we see new-age banks building more optimal IT infrastructure from scratch using state of the art technologies.

Silo-ized Existence
Most global banks operate as multiple business silos, with awkward coordination and communication between different parts. Each silo largely exists as a separate organization with its own metrics. This severely affects the customer experience and banks’ ability to provide a seamless experience, through reduced ability to track and manage customer life cycles across product verticals.

Silo Approach Toward Organizational Management in Banking

Complex Culture and Power Structures
Big banks have a very unique culture and power structure, which exemplify typical hierarchical organizations with little incentive to promote innovation, risk taking, and experimentation. They work more like command structures from top to bottom. The typical bank is a “fixed mindset” organization with a focus on “individual” performance over holistic company gains. Innovation and collaboration become difficult to foster on a macro scale in such environments.

Cost of Servicing
According to a study by KPMG New age digital banks/fintechs are actually much more efficient, agile, and flexible. They have lower technology costs, which beat the traditional banks’ cost structures. These lower costs are in part born from fintech being able to exclusively rely on newer, efficient technology stacks and staff compensation having a higher blend of equity incentives.

Monopolistic Charges
Due to competitive familiarity and incumbent numbers downsizing through M&A, bank pricing is very uniform and similar across markets. Consumer surplus has been lowered through the necessity of banking services in everyday lives, and the activities and mentalities of banks normalizing as they become more similar over time.

Cross-Subsidization
Cross-subsidization is a historic element of traditional banking (remember the dynamic of consumer depositors funding corporate borrowers). This has made it difficult to gauge true efficiency of business units and untangle webs of dependence which restrict innovative thinking.

Predictions for the Future
I believe that over the next ten (if not five) years, the number of traditional banks surviving across the world will reduce by at least 50%, through a mix of closures, mergers, acquisitions, and spinoffs. As explained in this article, traditional banks have evolved under the old paradigm where physical infrastructure mattered when servicing customers, which provided an economy of scale moat. Hence, as the banking industry grew, new services continued to be added–for lack of better options–to service the customer better, in a disjointed, piecemeal basis, which eventually leads to a complex, unwieldy paradigm of “universal banking”. This aggregated financial services across the full spectrum. The previous half-century saw the growth and consolidation of banking business, with large universal global banks that provided one-stop-shop access for all services.

However, over the last few years, with the changes in technology, we are now seeing a completely different paradigm, where physical location has ceased to be essential. Adopting new technologies and using quick, iterative improvements to offer tailored service is the new paradigm for servicing customers. According to Mckinsey & Co., some of the trademarks of new age agile organizations are as follows.

Framework for Agile Organizations

The banking industry is now facing the same challenges and in the process of a transformation. Some of the factors leading to this disruption in the banking industry are as follows:

Physical Branches Are No Longer a Prerequisite
When was the last time you visited a bank branch? Now, ask yourself when you last logged into an online banking app?

Today, it is no longer a requirement for customers to visit the branch and most services are performed online using a self-service or text-assisted model. This enables even a small startup with very few offices to provide services to a large number of customers. In fact, there are a significant number of “digital only” banks present in the world today, that only service customers online. Revolut, for example, has 6 million customers globally and zero branches.

Disintermediation/Unbundling Through Specialized Offerings
Traditional banks have followed a strategy of offering a general service of everything to everyone, which has resulted in some compromises of fitting exact consumer needs. Fintechs, on the other hand, have built up in stages by offering one service and only expanding once they have tweaked it perfectly to fit their customers’ needs. Individual product focus apps/fintechs do a much better job of taking away slices of business from banks, as they are more focused on solving one particular problem as compared to traditional banks who are not able to match the cost/service levels.

Fintechs have also solved problems in a more engaging and useful manner. Gone are the days of bored focus groups, instead they have connected with users in a more sincere manner and employed unconventional (to the industry) practices, such as the aforementioned design thinking process.

Cloud-Based Technology Architecture
Traditional banks had built their systems and processes over decades using legacy technology, which previously was a competitive advantage. However, with the advent of new cloud-based technology, scalable, modular (agile) approaches to developing platforms with plug and play functionalities (APIs) have completely changed the game. New age digital architecture is highly modular and plug-and-play in nature, thereby allowing customers to pick and choose the specific service that they wish to choose and build, in an almost “lego” style that may be incomprehensible to “old school” financial service managers.

Decoupling of Liquidity/Risk/KYC Management from Banking
Today a customer only really only needs a bank to hold its “liquidity” safely and ensure that “credit” is assessed and priced correctly, everything else can be done better by a downstream company. This, in my view, will lead to much-needed decoupling in the industry that will also bring more credibility to banks as they will no longer have to face a conflict of interest between the safety of customer money versus increasing returns for shareholders.

Collaborative Ecosystem
The entire banking ecosystem should be more highly collaborative in nature and players should be incentivized to allow simple API based integrations through marketplaces. This will bring about a more interdependent industry, where customers would be the ultimate arbitrators, in terms of which products they wish to use for their financial services requirements.

Predict, Engage, and Offer Personalized Solutions
Developments in big data can allow banks to provide more customized banking to consumers, based on their lifestyle and transaction history. Big data can give clues on life stages and banks could subsequently offer products around the customer life cycle, (i.e. student and mortgage loans). using the data that they have access to, but previously haven’t mined so extensively.

Financial Inclusion Spurred by Increased Access and Lower Costs
This advance will lead to an increase in the ability to build alternate credit models and further welcome a large portion of the hereto unbanked economy into the bankable population. This will help to finally break down the barriers towards building a true financial inclusion model.

Partner with Challengers
As mentioned, one reason behind the success of fintech upstarts has been their use of more modern and innovative measures to enhance customer experience (CX). In my opinion, banks will increasingly partner (or buy) disruptors to leapfrog and fast track their digital banking innovation journey and adopt similar strategies. They may also shift towards embracing open-source platforms and collaborate with third-party product providers to allow better integrations of their apps with their banking platforms that enhance CX and increase value.

Moving Towards a Layered Industry
In my view, these factors are all good developments for the industry to correct a historical structural imbalance that took place due to the serendipitous, needs-based development of universal banking.

The decoupling of services and ring-fencing of the three core functions of the industry (liquidity, risk management, and KYC) with erstwhile traditional banks will allow the rest of the value chain to innovate, experiment with cutting edge solutions much more freely. This will lead to a much more financially inclusive world, from developed metropoles to the remotest corners of the Earth.

The next stage of this change will be how financial services will be layered in the future. Directionally we will see a new banking ecosystem emerge that will be divided into multiple layers focussing on the separate needs of the financial services ecosystem.

A broad architecture of the same can be visualized along the following lines:

1. Central Banks: Executing fiscal mandates and regulatory oversight
2. Warehouse Banks: Warehousing liquidity and risk
3. Platform Banks: Marketplace aggregators
4. Fintechs: App-based banks
5. Identity/KYC Management