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The Future of Banking

Traditional banks are under serious threat from the branchless digital banks and FinTech companies that offer niche products to select customer segments. Also, technology companies like Amazon and Google, with formidable brands and large customer bases are bundling financial services with their core products. And with the rise of cryptocurrencies, a new set of DeFi protocols with innovative financial offerings are joining the fray. For now, technology majors look like winning!

The banking industry is facing the toughest challenges in its history. Spiraling costs, falling profits and growing non-performing assets are major negatives for incumbent banks. And there are huge technology-related challenges as well. For example, technology infrastructure that is falling apart, an aging workforce resistant to learning new digital skills and tech-challenged top managements are major issues. And post the financial crisis of 2008, regulatory compliance has grown expensive. But the biggest challenge is the growing number of dissatisfied customers, particularly millennials used to cutting-edge customer service experiences from top tech majors such as Amazon, Uber and Netflix. Collectively, the industry has a poor record of financial inclusion. It doesn’t even offer basic financial services to a whopping 1.8 billion who need these services.

A slew of well-funded competitors in the form of neobanks and FinTech companies are challenging the industry with their completely digital offerings. In addition, established tech majors with formidable brands are experimenting with financial services offerings. With the rise of cryptocurrencies, a new class of competitors appropriately called DeFi (decentralized finance), is threatening to change the industry landscape with a revolutionary new technology.

But all is not bleak for the incumbents. Many have a hoary past and have built trustworthy brands over a long time. They also have a wide and deep product expertise as well as regulatory experience. Plus, they have a large base of wealthy, older customers and a big business clientele.

Challengers that incumbent banks need to fight against

  • The first category of competitors is the neobanks or challenger banks that offer digital-only services.
  • The second category is the FinTech companies that target niche customer segments with specific products.
  • The third category is the technology companies like Amazon, Apple and Google, that offer payment, credit and other services along with their core offerings.
  • And the fourth is the game-changing, blockchain-based, decentralized finance (DeFi) protocols that offer innovative financial products.

Let’s look at each of these categories.

  • Digital-only challenger banks

    Challenger banks or neobanks are digital, branchless alternatives to conventional banks. And they offer banking services on the web and on a mobile app. Like traditional banks, digital banks offer a wide range of banking products. And like conventional banks, they have regular banking licenses.

    Broadly, there are three different types of digital banking licenses offered in different parts of the world. In countries such as Brazil, South Africa and Germany, digital banks receive the same treatment as regular banks. In other countries like Taiwan, Korea and Hong Kong, neobanks get bespoke licenses. In the United Kingdom, Australia and Singapore, there is a system of phased licensing. In these countries, digital banks can start with a limited set of services. And then graduate to full-fledged banks over a period.

    Digital banks have the advantage of lower capital costs and operational costs because they do not need physical branches. Also, unlike traditional banks, they are not saddled with legacy technology. But building trustworthy brands that can compete with the brands of traditional banks built over a long period of time, is a formidable challenge.

    But digital banks can effectively compete against FinTech companies because they have the regulatory approval that increases the trust factor that customers value. The other competitive advantages are their wider product range and a diversified customer base.

  • The rise and rise of FinTech companies

    FinTech companies seem to use the equivalent of the ancient Chinese torture tactic known as lingchi — which translates loosely to ‘death by a thousand cuts’. Unlike traditional banks that offer a whole range of products and services to many market segments, FinTech companies offer one or a few products to select customer segments, say, retail customers or small businesses. For example, payments and money transfer, peer-to-peer lending and SME lending are popular categories.

    In many countries, there is no or little regulatory oversight resulting in low compliance costs for FinTech companies. In addition to possessing cutting-edge technology, they also attract a young and tech-savvy workforce. Growing millennial population, huge venture capital financing coupled with the luxury of not needing to achieve profitability any time soon, are fueling the growth of this set of competitors.

    While FinTech companies together have definite competitive advantages over traditional banks, they are going to find competing against licensed digital banks a lot more challenging.

  • TechFin competitors

    TechFin is the new emerging phenomenon of tech companies entering financial services. Google, Apple, Amazon and Uber have already started offering financial products and services. These companies may turn out to be very powerful competitors to incumbent banks. They have a lot of things going for them. Well-known brands, large customer bases, technology expertise and highly trained workforce as well as top quality management teams, are hard to beat. Plus, they have a huge pile of cash! But the factor that is going to tilt the scales in their favor is the synergy between their core offerings and financial services.

    For example, Amazon has millions of suppliers who need working capital financing. Amazon is already funding its suppliers in many markets. Amazon has significant advantages over incumbent banks. Amazon need not worry about repayments. It can simply deduct the payment dues and transfer net earnings to sellers. Also, Amazon, unlike the sellers’ banks, has complete visibility over the finances of the sellers.

    Similarly, Uber can offer car financing to the participating drivers more easily than the banks that serve these drivers. And Apple can bundle payments and other services with the phone that customers buy.

    Interestingly, regulators in several countries also seem to be in favor of granting digital banking licenses to tech majors. The Hong Kong and Singapore markets are good examples of this.

  • DeFi: Decentralized alternative to traditional banking

    Decentralized finance refers to the offering of financial services products using blockchains. Popular DeFi protocols such as Compound Finance, MakerDAO and Dharma offer blockchain-based lending and borrowing products. There are several other protocols that offer innovative savings and payment solutions as well.

    But these are very early days for DeFi. Blockchain-based technologies are continuing to evolve. Also, DeFi protocols are likely to take off once there is some regulatory clarity on cryptocurrencies. Blockchain technology is new and complex. So, early adopters seem to be the tech-savvy developer community. But in time, DeFi has the potential to dramatically transform the banking and financial services landscape.

How are incumbent banks responding to these challenges?

Banks are figuring out a number of ways to handle the threats from their digital competitors. The most common strategy is to drastically increase investments in new technologies. But this strategy does not seem to be working very well. Banks are bogged down by legacy technology infrastructure, not quite amenable for modernization.

Some banks are taking the route of setting up completely new digital subsidiaries. Examples of this are the digital bank with a brand name, Marcus by Goldman Sachs and the impending launch of a digital bank by JP Morgan Chase. And a few others are setting up fintech accelerators and incubators. The idea is to take over the successful startups.

Another common strategy is to partner with fintechs, but this idea doesn’t seem to be very successful. So, at this point, the incumbents are still figuring out the right next-moves.

Conclusion

As you might have guessed, physical banking will be a thing of the past. And to survive, traditional banks will have to morph into digital entities while retaining their brand values built over a long time. What about the neobanks? They have the arduous task of building trustworthy brands, creating a broader product range and also diversifying their customer bases. And the fintechs may have to merge to offer a wide range of services to several customer segments and achieve scale.

But the most formidable competitors of the lot are the large tech firms. To become clear winners, they have to learn to navigate the regulatory maze. And in the long run, when crypto becomes mainstream, DeFi protocols may emerge as significant players.

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