The introduction of new technologies has facilitated new consumer and customer behaviors. These new behaviors have facilitated the adoption of new technologies. The resulting virtuous circle has ushered a period of rapid change which has profoundly change one industry after another. Industry incumbents have had to face a new reality where vertical integration, a fancy word for “owning the entire value chain” has turned into a liability. Indeed, the virtuous circle I mention has allowed new competitors to deliver value at one point of the value chain, without owning the entire value chain. Take the media and entertainment industries as an example. It used to be that “content was king” and “pipes were dumb”. Based on these heuristics Hollywood studios ruled over an entire value chain and were comfortable living in a world where the only thing they needed to do was to deliver their content to movie theaters. This is no longer true. Even though original content still rules, pipes are not dumb anymore. Pipes are actually smart, and that are built on top of platform strategies. Content is important, but so is how you create content, how you deliver it, with what and to whom, how you measure how it is delivered, plus the balkanization of communities of users make it eminently more difficult for a vertically integrated entertainment business to remain at the top of the food chain without profound changes. Witness the rise of Netflix, Amazon with their different value propositions around entertainment content and compare to how the main Hollywood studios are armed for the future.
The financial services industry in general, and the banking industry in particular are now faced with the same tectonic changes other industries have faced. For banks, this is an even more perilous exercise as most of them have never faced a breakdown of their value chain in the past and have enjoyed “near” monopoly in their geographies thanks to accommodating regulatory frameworks.
For simplicity’s sake, I break down a bank’s business into four layers (borrowing from a Boston Consulting Group framework):
- Infrastructure: comprised of IT hardware (mainframes, cloud, hosted) and software (core banking system, CRM, client reporting, transaction/payment processing, analytics)
- Products: comprised of three parts which are accounts, lending and the rest (payments, savings, investments, brokerage, advisory)
- Interface: comprised of branches, web apps, mobile apps, customer service centers
- Clients ecosystems: comprised of retail, SME and enterprise.
Yesterday’s bank owned each layer. Clients dutifully visited their branches or relationship managers to consume products created by their bank which were delivered by the infrastructure owned by the same bank.
To the extent that banks faced competition it was from another bank which also owned its entire vertical stack end to end, which was operating in the same geography. Oligarch banks ruled.
Today’s bank is under threat at each layer of its stack instead which makes for a much more complex competitive landscape.
First, clients spend more time somewhere else than with a bank. We all know the relative decline of branches. Not only are retail consumers not visiting their branches as much as they used to, but they are also increasingly spending time in completely different ecosystems than in the past; communities where a local bank relationship manager has little leverage if any. These ecosystems are called Facebook, Google, Amazon, WhatsApp, Snapchat, Instagram, Pinterest. (Even though such change is not as pronounced with SME and enterprise clients, there is also change with these segments.) Second clients are used to a different customer experience based on the service they are getting from these digital communities, thereby making bank web apps and mobile apps always play catch up. In other words, clients are moving banks, and bank customer interfaces are under threat. Third, products are under threat although we have to nuance this statement and look at lending separate from the rest. Let’s look at the rest first. Accounts are being loosened from the tight grip of Mr Banker – PSD2 in Europe, the open bank initiative in the UK will take care of that – allowing, under consent, third party access to account data and meta data. Payments is experiencing the highest level of competition given it has the lowest barrier to entry, either from fintech startups endogenous to the industry, new entrants exogenous to the industry (Amazon, Apple, Google, Facebook) or grown up startups (PayPal). Brokerage and Investments are prone to the same opening to multi-competition. This leaves us with lending which I believe should be analyzed completely differently than the rest because no one will ever be able to come up with a “zero marginal cost” lending product. Indeed, the cost of borrowing is comprised of the bank’s cost of borrowing and a margin to compensate for risk and provide adequate profit. That cost will never scale to zero or near zero. This, in my view is the main reason why lending will never experience an “Uber” moment where banks will be completely disintermediated – further, think of the unintended negative consequences of a massively large lender for example – whereas the main cost of the “rest” is that of delivery and marginal cost of delivery can and should be driven down to near zero. Fourth, infrastructure is where there has been to date the least disruption and competition, notably around core banking systems and CRM, even though blockchain technology holds the promise of much change in asset servicing.
To date the overwhelming number of competitors attacking the above layers have not been successful. Fintech startups focused on investments (robo advisory), brokerage, lending have not reached escape velocity and acquired meaningful market share to the detriment of banks. Some pundits believe it is because banks have much more defensible business models (regulation, licenses…). Although I do agree most startups have failed so far, I also know not to discount the entrepreneur/startup threat over the long run on the basis of a failed first wave. I am actually paranoid for banks as the overwhelming types of strategies banks have put in place to deal with change are in my opinion either inadequate or short term focused.
Indeed, banks have focused on revenue optimization strategies (pricing, cross selling, upselling, margins) or cost reduction strategies (layoffs, better hardware, better software) by applying concepts (digital banking, API banking, mobile banking, cognitive banking) on existing business models. To the exception of a few banks who recently started working on a platform strategy – which forces them to address the competition they are will face at each of the four layers – all other banks are still in a “vertical integration” paradigm. This will change – the market will force that change, some banks will adapt, other competitors will rise to the challenge.
I view all these bank moves as incremental evolutionary steps, good enough to compete another day, not good enough to reinvent banking drastically. A digital bank – and there are many startup digital banks in the UK for example – is still vertically integrated, even though it holds the promise of being a “better” bank.
Incumbents will have to choose how they want to compete going forward. Below are some of the potential options available:
- The “Better” Vertically Integrated Bank: Essentially more of the same, that is a bank that still owns the entire stack, will compete against a multitude of competitors, but will do so better armed marginally – digitally so, less siloed, better hardware, better software, less employees. Although I believe some will be successful at this strategy, I am afraid it will be a very risky one. No network effects to speak of, no ability to drive to meaningful zero marginal cost of delivery for all products such a bank would offer
- The “Platform” & Vertically Integrated Bank: Same as above but with some type of platform strategy that will allow a bank to partner with third parties and share the value created by delivering better product and service to consumers. Probably less risky than the above and one many banks will want to deliver. Still a difficult proposition in a world where modularity will be more and more important.
- The partially Vertically Integrated Bank: Whether traditional or platform driven, this Bank will drop a few non core activities, not enough to not be vertically integrated but enough to reach another level of rationalization. I expect tier 2 and tier 3 banks with limited resources to be the best candidates to follow this model and some shrewd tier 1 banks to make a hard turn towards this model. Very interesting as a platform.
- The “Interface” Bank: No more vertical integration for this type of bank. To date we have only seen Interface examples (Simple is but one of the examples). The Interface specialists have suffered from a disconnect with the ecosystems where users gravitate and have not been successful to date. They key to success will lie with how an Interface bank partners with these digital ecosystems. My gut tells me AI powered virtual assistants may have a shot at being very successful Interface Banks. Strong potential for network effects and driving to zero marginal cost of delivery
- The “Product” Bank: By far the most intriguing layer strategy. Product banks focused on innovating only on one particular product or a family of products (when was the last time the financial services industry came up with an innovative lending product tailored to someone’s cash flow patterns for example). A Product bank would partner with Interface providers and/or ecosystems of users for example. Not network effect to be expected for lending products – definitely for other products – but the benefits of innovation and differentiation can be powerful. I would even expand the horizon of what a product could be by including “data”. Data being the new hot asset class and data management as well as identity management being crucial in our digital age, why not see the emergence of data banks.
- The ”Infrastructure” Bank: I see three separate models. First, the generalist “Bank as a Service” (BaaS) model that will deliver services to Product Banks, Interface Banks, startups, partially vertically integrated banks, fintech startups, enterprises. BaaS is the most promising bank model of the future as the focus is on the provisioning of products as a service, or of services. We are not dealing with lending here, we are dealing with delivering the building blocks to enable lending – the same applies to all other activities. As such there is a very high probability for this model to drive to near zero marginal cost of delivery. In this context, we can apply the “Uber” label. Second, the differentiated specialist BaaS. This model is particularly relevant for high value add services such as advanced data analytics, underwriting analytics, risk analytics. Remember one of the points I made at the beginning of this post: there are no dumb pipes anymore, only smart pipes. To date banks are arming themselves with the services startups specialized in data analytics can offer (CRM, fraud…) but it is conceivable the specialization will be so important going forward and the pipes so strategic that a “Bank” will provide this as a service going forward instead of a non-licensed startup. Third, the commoditized specialist BaaS. I expect some infrastructure services to become commoditized faster than others. Think hardware fine tuned for banking use cases or core banking systems. Think about an AWS offering but for banking. Much like there are core processors for specific activities (video, gaming, AI tomorrow), there may very well be core infrastructure providers for banks.
I have to make several additional comments to tie loose ends.
If the above vision comes to fruition and we do see a segmentation of banking, I fully expect the regulatory and licensing landscape to change. In other words, we will see a new regulatory approach where different types of banking licenses will be issued based on the business model and its implicit and explicit risks to the market and to clients/consumers. Just to give one example, an Interface Bank as an AI powered Virtual Assistant may have to meet certain licensing requirements around providing financial advice to its clients but may not need to comply with lending requirements. To be clear, some fintech startups competing or providing services at each layer level may not require the same type of banking licensing as the Banks that will operate at each layer level.
Further, competition at each layer level forces one to think platform strategy which results in either developing and implementing one’s own platform strategy or becoming one of the building blocks of someone else’s platform strategy. There is no escaping platform strategies.
Additionally, layer specialization, other than with Lending, and I repeat myself here, can deliver very strong network effects enabled buy near zero marginal cost of delivery. This I believe will be in and of itself a revolutionary paradigm for banking.
Finally, the bank that will successfully partner and integrate with ecosystems of users, regardless of the approach taken, will stand a higher chance of success than trying to create their own new communities or continue with existing ones. Like it or not, social networks are here to stay and will take on a greater importance in our lives going forward.
Trying to craft a roadmap for the above vision is tricky. We are in the early innings of platform strategies or API/marketplace strategies for banks and much remains to be done – no one has declared a BaaS for example. I venture that we shall see increased activity along these vectors in the next 5 years – the actions of Facebook, Google, Amazon, Apple, Alibaba (and Snapchat, Instagram, WhatsApp, WeChat….) will make that absolutely inevitable. Incumbents may also naturally gravitate towards a few of the six options I laid out above – either as a result of further divestitures, acquisitions or mergers – leaving space for new entrants (large tech companies, fintech startups). In other words, the industry is large enough to see various participants succeed and avoid a banks lose, new entrants wine scenario, or vice versa.
Last parting thought. I strongly believe the above also applies to the insurance industry – with the appropriate tweaks.