Banking’s ‘Amazon Moment’

By Rob Morgan

Fintech is the intersection of banks and technology. Global venture capital investment in fintech has increased nearly fourfold in the last two years, reaching $19.1 billion in 2015, according to KPMG. This figure excludes bank investment in the area, which is also tremendous. For example, J.P. Morgan Chase recently announced that 40 percent of its $9 billion annual IT budget would be spent on innovation.

Simply put, fintech is the process of leveraging technology to deliver traditional financial services. Technology has changed the way consumers interact with all products and services, and banking is no different. Banks have pioneered important innovations in banking, such as the ATM, credit cards and online banking. More recently, a new crop of innovators, enabled by mobile technology and data availability, have begun offering innovative banking services directly to customers. Most of these competitors are customer-facing, origination-based and monoline—which has significant implications for how they will shape the bank-led financial services market.

To learn more about the latest in fintech and download ABA’s members-only Fintech Playbook, visit aba.com/fintech.
Consumer technology has empowered a new generation of startups to connect directly to customers, without the need for a costly physical network. Sixty percent of Americans own smartphones that allow them to engage with products and services from the palm of their hand. What sets technology startups apart from traditional players is their superior user experience.

Most (if not all) fintech startups have focused their efforts on building a seamless digital customer experience that is not offered by all banks today. This focus on user experience, however, means that few startups have developed the back-end systems to handle financial transactions. As such, they rely heavily on bank partners to perform these functions.

Just as they have relied on banks’ technology infrastructure to operate, fintech startups also typically rely on third parties to hold the assets that they originate. Rather than hold onto the loans or relationships they originate, most fintech firms choose to offload the risk and make their profits from originations.

McKinsey estimates that while 54 percent of global banking revenues are driven by balance sheeting assets, this accounts for just 41 percent of after-tax profits. Moreover, when the cost of capital is considered, the ROE for balance sheeting assets is just 6 percent compared to 22 percent for originations.

Finally, the vast majority of startups focus on a narrow line of business, cherry picking the most profitable businesses for banks. A prime example of this is Promise, a company offering only wedding loans—taking the old “something borrowed” maxim perhaps too seriously. Funding for startups confirms this focus, with 46 percent of fintech investment going to lending and 23% to payments. A bank would be hard pressed to find a line of business that is not challenged by one startup or another, but few, if any, startups today compete with banks across multiple lines of business.

Collaboration, not competition

“Silicon Valley is coming,” J.P. Morgan Chase chairman and CEO Jamie Dimon direly warned his shareholders in 2014. Fortunately, this narrative has changed dramatically in the past two years. Today’s fintech startups have pivoted to a collaborative model in which they actively seek partnerships with banks.

Banks and startups both have a unique set of strengths. When the two collaborate, they are able to deliver their customers innovative products that are safe and secure.

Fintech startups bring a culture of innovation that is difficult to replicate at financial institutions that specialize in managing risk. Their technology expertise and lack of legacy systems have allowed them to build a digital customer experience that does not exist at most banks today.

Banks provide tremendous value that is not replicable by startups, the most important being their role as trusted custodians of their customers’ money and information. Banks have established a strong level of trust with customers that is necessary when handling someone’s money. Establishing and growing customer relationships is the largest challenge for startups. Additionally, startups cannot replicate banks’ payments system access and low cost of funds due to FDIC insurance.

Only by collaboration will banks and startups realize the full potential of fintech.

‘Uber for banking’? Think again

Is the banking industry at an inflection point where traditional players are in danger of being “disrupted” by new tech-focused challengers? We have seen this happen as traditional cabs are challenged by transportation network companies like Uber and Lyft.

There is much that we can learn from the example of Uber. Uber took an analog industry and provided mobile access that was seamless and addressed key pain points such as payment and hailing. Uber also provides a full replacement for the service it is disrupting. If you have Uber, you never need a cab. As noted above, none of today’s fintech firms come close to replicating the breadth and depth of banking services. Simply put, you are not going to disrupt the entire banking industry by making wedding loans.

Banking may not have an Uber; instead, it will more likely face an Amazon. We can take a lesson from the early days of e-commerce, when shoe retailers were worried that powerhouse e-tailer Zappos would put them out of business. Many of those shoe retailers were disrupted by digital channels, but not by Zappos. Today, Amazon sells far more shoes than Zappos did before Amazon bought it. A platform that is able to bundle all of these new technologies into a one-stop shop will be best positioned to win digital-first customers.

There are two possible outcomes to this evolution. First, if banks ignore fintech or take too defensive of a posture, someone else will come along and begin packaging all of these narrow fintech offerings into a marketplace, like Amazon did with e-commerce. In fact, the companies that are most likely to do this are the tech platforms that dominate today—Amazon, Google or Apple.

Banks are unlikely to be completely disrupted in this model. There are services that banks provide that are difficult, expensive, and in many cases impossible to replicate. Today’s fintech firms rely on banks for core banking services and this is unlikely to change. Moreover, customers will still demand deposit insurance, something no fintech can replicate. The banks will still be part of this system, but they would lose their customer relationship, becoming back-end facilitators that compete on price alone. A market where banks compete solely on price would mean the end of community banking.

In the alternative outcome, if banks proactively partner with fintech companies and integrate their technologies, they can become the platforms of the future. Banks already own the customer relationships and serve as a one-stop shop today. There is no reason that they should not play this role in a digital future.

In reality, we will end up somewhere in between these two outcomes. The good news is that we are still in early innings, and banks are well positioned to become the platforms. Today, less than one percent of banking industry profits have been claimed by fintech. Few customers, apart from early adopters, have developed financial relationships outside of their banks.

There are a number of banks that have led the way to establish such platforms. Notably, all of these participate and support the fintech ecosystem in three key ways: labs, incubators and venture investments. Each of these banks has an innovation lab to build innovative products inside the bank. They have programs to help the earliest-stage ideas become companies, and they invest in startups directly through venture capital.

Participating in each part of the ecosystem has its own benefits, but participating in all three creates a network effect in which knowledge, talent and connections can be shared. It gives new companies and the brightest innovators insight into the problems that banks face allowing them to create the tools to solve them. It also gives banks a window into the leading edge of how technology is changing their industry.

Fintech startups are looking to change banking, often with little insight into what a bank actually does. Today’s crop of startups has slowly shifted from looking to disrupt the banks to a partnership model. The earlier we get tomorrow’s startups engaged with banks, and expose them to the problems that need solving at community banks, the better they will be able to partner and help solve those problems.

If banks are proactive in engaging fintech startups, they will be best positioned to deliver fintech solutions to their customers in a secure environment—and become the Amazon-style universal platforms of the future.

About Rob Morgan

Rob Morgan
Rob Morgan is vice president for emerging technologies at the American Bankers Association.
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