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New Standard Models for Banking

This article is part of our randomised, post-structural Let’s Build a Bank series of articles.

The disruption to banking arising from changing customer behaviour and use of technology has come later than to most other industries.  Banking is a very conservative industry and we have observed that even challenger banks and Fintechs are largely restrained by conservative approaches, engendered by regulation and the need for security and stability.  We believe this need for security and stability will never go away – after all, customers will always want to know that their money is safe – but we are seeing new ways to protect and guarantee, arising both from new paradigms in financial services and from reduced confidence in sovereign currencies. In parallel, new currencies are emerging, first from non-traditional issuers (bitcoin, ethers), now from consortia of incumbent banks and, we believe fairly soon, from central banks themselves, exploiting blockchain technology and trust-based authentication rather than traditional intermediaries.

In this article we explore why traditional banking operating models are struggling, and describe the emerging models for banks that are being adopted both by incumbents and by challengers, together with some of the opportunities and challenges these new models present.  It’s important to bear in mind that this is still a nascent industry development and, like every other major disruption, early adopters and leading-edge pioneers are more likely to get it wrong than right.  We believe some will succeed, but today there is limited evidence to indicate who that will be.

For the purpose of this article we have segmented the different models as follows, however, in reality there is a spectrum and no clear boundaries between these models:

  • Traditional banking
  • Challenger banking
  • Ecosystem banking

Traditional banking: over-diversification and complexity

When we use “Traditional” to describe a banking model, we’re describing a model that has arisen relatively recently.  Before the emergence of Universal Banks, following changes to regulation which allowed banks to conduct retail, transaction and investment banking, banks were one or the other, but for the sake of simplicity, we’ll use the word “Traditional” to describe the combined, universal bank model.

Traditional banks share the following characteristics:

  • Full service model, including retail, commercial, wholesale, capital markets, wealth management and in most cases insurance services offered through third parties
  • Captive supporting services – banking operations, technology, finance, HR, risk management, etc. managed internally within the bank
  • Captive data centres where core customer and account data resides on bank-owned mainframes
  • Self-developed front-end applications and apps (web front ends, mobile apps etc.)
  • Branches and contact centres
  • ATMs, cards and (increasingly) contactless and mobile payments
  • Organisationally siloed, divided by business line
  • Geographically siloed by country
  • Deep hierarchies with businesses structured according to function (e.g. retail banking operations)
  • Heavily controlled via performance metrics linked to units (products sold, time taken to respond, etc.)
  • Request driven, product centred service models
Full service capability model for traditional banks
Figure EL-BF-NSMB-1: full service capability model for traditional banks

It’s also important to note the drivers that have shaped banks like this – first, deregulation led to the opportunity to merge previously separated banking models, then, following collapses, scandals and backlash post the financial crisis in 2008/9, heavy regulation and the need to demonstrate control became dominant.  The combination of the land grab culture which followed deregulation, and then reputational risk, fines and censure imposed by more rigorous legislation, have led to a culture where decision making is associated with authority and seniority, and where ownership is equated with security. Because senior leaders are held accountable for the outcome of decisions, they feel it is safer to control those decisions personally, rather than delegating them to people who have the opportunity to acquire and use specialised knowledge pertinent to the subject.  Instead, decision making is highly centralised and hierarchical, leading to decision support industries within banks and massive bottlenecks in senior managers’ diaries.

The belief that diversity of products is central to (especially corporate) customers’ experience, based on the desire to be central to customer relationships, and the need to offer every flavour of customer experience, is in many ways a contradictory driver, which together with the need for control, has led to banks becoming both excessively complex and almost entirely self-built and run.  This complexity is further increased as most universal banks today have formed through years of merger and acquisition, often integrating multiple systems and processes rather than replacing the redundant legacy systems on merger.

Universal banks have recognised that this complexity presents a risk in itself. It has become impossible for them to understand their own risk profile and the management of very complex and usually ageing, legacy infrastructure is both costly and risky.  To give an idea of the scale of this problem, a recent programme we worked on to replace core systems identified 992 applications that were integration points for the new core banking and payments systems.  The new payments system was replacing 80 payments capture, 25 payments execution and 40 settlements systems.  These statistics are not unusual.  Large banks have, over the years, invested more in remediation, system replacement and integration programmes than they have invested in developing customer experience or innovation research – not through an assumption that these things aren’t important, but because their business model has led to unsustainable complexity and consequent instability of services.

So traditional banks are developing new models, based around a simpler, more customer centric view of the world, but implementing this is a painful challenge, and we have not yet seen any universal bank address it with complete success.  The change is deep rooted, because it starts with a change to culture and assumptions about customers which are still based in the “old” world and, in many cases, this has been impossible to effect.

Challenger Banks: facing problems of maturity and experience

In contrast, Challenger Banks are largely being built ground-up, unhampered by the baggage of the universal banks and their inherited complexities.  However, they face challenges of their own, and while there is no “typical” model for a Challenger Bank, most share the following characteristics:

  • Focused on limited customer segment/offering – nearly all are aimed at Retail customers, offering accounts and cards – although there is an emerging number supporting the SME sector, see below
  • Heavy use of technology as a customer differentiator
  • Small and agile
  • Use of Fintechs and other service providers to support customer offering
  • Third party payments infrastructure
  • Self-developed Core Banking system (the “full stack” model) or traditional Core Banking managed by a third party
  • No physical branches
  • Untested business model/high risk for investors
  • Low maturity in regulatory and compliance management

Although challengers make good use of technology, we have observed that most are effectively following a reasonably traditional model, i.e. offering traditional products to traditional customers, albeit with appealing interfaces and clever apps.  The challenger model we see most commonly is built by an organisation buying in expertise from traditional banks, or being founded by individuals emerging from traditional banks to inject banking expertise, together with technical specialists who build the “innovative” software on which the new bank is founded.  If we look at the full-stackers – Starling, Mondo, etc. there is a strong rationale for building their own core systems, but at the risk of creating the same challenge of in-house legacy currently being remediated (very expensively) by the incumbents.  While in-house solutions can be attractive as differentiators, their uniqueness becomes a problem when systems age and need upgrading; knowledge is held in a small number of individuals and this creates a risk, while documentation may not be as rigorous as that provided for standard systems from large vendors.  On the other hand, buying in a third party core system (as Atom has done) can create challenges to agility and real-time service provisioning.  OakNorth may be the first of many to go for cloud-based third party core banking, which may address this challenge.

Ecosystem Banks: collaborative, customer-centric services

A third generation of banks are now offering what we call the Ecosystem model, where the service layer is the USP and the bank is effectively a marketplace for services offered by third party providers, together with core banking services offered by the bank or via its partners.  While the examples of this model are limited, the approach is gathering some momentum and we expect to see more emerging.

Ecosystem banks are characterised by:

  • SME/Entrepreneur target market
  • Low number of “captive” technology based services
  • Offering a variety of loosely interconnected service providers
  • Heavy reliance on partnership with fintechs
  • Distributed business model
  • A “full service” approach – some services offered fall outside traditional financial services
  • Small, agile core team
  • Business/customer service focused rather than tech focused

These banks superficially look very much like the other challenger banks, but their focus is different; their customers are entrepreneurs and SMEs with complex financial management needs, and the extension beyond traditional banking services into financial management of services within the customer’s “business as usual” (BAU) operations represents a significant shift of focus from traditional banking.  These banks regard their USP as offering service management at the core, rather than financial services, acknowledging that the financial needs of customers extend beyond traditional product-based banking.  We anticipate that this model will become one of the new standards.

The evolution of banking infrastructure

One of the key challenges facing new banks and incumbents alike, is the significant cost associated with maintenance of infrastructure supporting core banking and transaction processing, which is still largely held on mainframe systems.  Mainframes have the advantage of security, high availability and stability, which makes them the default for critical banking applications. Mainframes are very expensive for banks to maintain. Specialist (and increasingly rare) legacy skills need to be procured and retained; complex organisations have developed over years to manage and remediate them; and the cost of changing these systems to accommodate the consumer expectations of customer-centricity and instant gratification is prohibitive. Also, unless very well managed, mainframes usually carry more redundancy than required.  Maintaining failover is part of this, and managing potential peaks in usage is a significant driver, but the long lifecycle of mainframes also means that planning has to be done with uncertain forecast usage information, which leads to greater redundancy.  Mainframes are now increasingly being used for virtualisation, which can reduce this redundancy, but the cost of physical hardware maintenance remains.

In addition to the mainframe cost, all banks have to manage the question of how much physical hardware to maintain in the shape of midrange and micros.  While not as significant as the cost of maintaining mainframe, these still represent a significant investment.  One bank we worked at boasted that they had more developers than Microsoft and more storage than Google (this was some time ago!) – neither is a claim that any bank should be proud to make, given that they are neither development houses, search engines nor cloud service providers.  The shift now is towards alternative infrastructure provisioning in a bid to reduce costs.  Of course, with Google now moving into the Financial Services sector, the quote may come full circle.

As we mentioned above, some pioneers are now exploring banking as a cloud-based service (BaaS), rather than the traditional mainframe-based approach.  AliBaba has recently launched its own BaaS platform, claiming to provide full service core banking, KYC and a number of other services, supporting a number of Chinese banks and now reaching out to global markets.  ThoughtMachine, a startup with a number of Google brains behind it is also entering this space, claiming to revolutionise banking by doing all core services seamlessly.  While these platforms may not yet be fully mature, this trend is accelerating and we can expect more players to enter it.

Traditional banks have needed to own and maintain data on their own infrastructure, mostly because of regulatory requirements and public perception of security, not to mention their own desire to “own” and control critical data.  Many regulators still require banks to hold key data, such as customer data and account data, on their own internal systems, which limits the ability of banks to evolve into using these more flexible services.  This is changing as regulations evolve, and we are seeing a move towards growing acceptance of cloud-based services as regulators acknowledge that resilience and security can be managed effectively in this paradigm and the benefits of cloud in terms of availability and reliability are equivalent to owned systems.  It is our view the cloud-based services can be more secure than traditional mainframe/data centre services depending on the level of security and the cloud model employed, of course – the shredding of encrypted data to multiple data centres and strong authentication being a key element.

However, in the interim and while both cloud security and regulations evolve, alternatives to public cloud are available in the shape of third party providers providing their own captive data centre setups (hybrid cloud), and a number of these are already supporting many challenger banks and other financial institutions with software and platforms as a service (SaaS and PaaS).  BaaS providers can offer tiers of service, from client site support and configuration for installations to fully managed and hosted services.  A number of specialist banks support other banks with payments or core banking systems, again to varying degrees.  So while regulatory drivers are an important factor in shaping how banks choose to design their operating models, the opportunities and options available are significant, and this is why we have seen the evolution of a wide variety of models; the main limitation is how the bank chooses to position itself.

Key to which model any bank – challenger or incumbent – selects for itself, is where it wants to play and what differentiates it.  As discussed elsewhere, banking products per se are not differentiators, but banks have the choice of how to position themselves.  For example, ING has stated very clearly that it is a technology house – it prides itself on its IT, develops in-house, and makes all its senior managers learn coding.  Consequently, it has been able to support adoption of continuous delivery, giving it a competitive advantage over rivals who are slower to market with new technology and products.  Conversely, a bank that regards itself as a service house would focus on customer journeys, customer experience led service design, and support full lifecycle customer management, and is unlikely to have an equivalent level of maturity in technical services management.

Where does this leave the universal bank?  Our view is that traditional banks are currently over-diversified, and that they need to choose what sort of bank they want to become.  As Jim Collins famously described in Good to Great, they need to identify the thing they do best and become the best at doing it – the “Hedgehog concept”.  We believe that no bank is able to be great in the whole portfolio of activities it tries to manage, from IT to customer service and from Retail to Capital Markets.  The evidence supports it – we have tried and failed to identify one bank that does it “all” well, despite significant research.  And the reason becomes obvious when you ask your organisation a simple question, “Where do you put your smartest people?”

Understanding your focus also helps you to understand which services and elements of services you want to own and manage closely, versus which ones you feel comfortable outsourcing or buying in via partner arrangements.  This is covered in more detail in Case Managed and Core Standardised Capabilities.

There is no clear distinction between the new standard models; rather, there is a sliding scale in two dimensions – operating model being one and scale/complexity being the other.  We have, for the sake of argument, assumed that the standard “Traditional” model is no longer sustainable and have here presented alternative evolutionary directions for banks – both incumbent and challenger:

  1. The infrastructure provider
  2. The Supermarket Bank
  3. The service bank with encapsulated IT
  4. The Second Bank

1.    The infrastructure provider – Technology is our strength

A model that we see many traditional banks moving towards, is the bank leveraging its scale, infrastructure and technology operating strength to evolve as a centre of banking processing not just for its own customers, but for other, incumbent or emerging, financial services providers.  Some of these are pure technology support organisations – for example, FiServ offers hosted BaaS to banks; some have evolved from being technology providers to obtaining banking licences enabling them to hold accounts and manage payments scheme relationships on behalf of their customers, while others are evolving from traditional universal banks into this space, such as ING, which has publicly positioned itself as a technology company that offers banking services.  The USP for these organisations is their technology, their robustness and their agility in providing services to third party financial services customers.

There are also a significant number of incumbent universal banks currently serving this market, offering banking technology services to other smaller financial organisations as an extension of the agency banking model.  Our observation is that universal banks offering these core infrastructure and banking services to other institutions are, effectively, multiple organisations running with different heartbeats, values and cultures.  On the one hand, their IT service organisations run efficient sales, implementation and distribution networks akin to technology service providers, while their banking services supporting their own customers may run on more relationship based, “traditional” banking values.  The IT organisations supporting these traditional bank divisions are segmented from the IT service organisations at the expense of the native organisations’ businesses.

A good example of how this can impact ability to run “normal” banking services comes from when one of us was implementing a new core banking system into one of these banks; finding it impossible to get on the workstack to integrate with the in-house payments systems, in order to meet deadlines we had to “buy” payments services from the much more efficient, 12 week contract-to-live agency banking payments service offered by the same bank to external customers, to meet our own deadlines!  Obviously this wasn’t a sustainable solution for that core system, so effectively we were forced to integrate twice, with our own payments systems, by the relative inefficiency of the in-house IT machine.  This anecdote illustrates how native IT services can suffer if banks try to provide both IT services and internal IT – again, how do you answer the question “where do we put our smartest people?” – in this case, the answer was firmly “in the revenue generating IT division”, at the expense of the IT underpinning the bank’s own customers’ services.

This is why we believe, while there is definitely a niche for payments and accounting services offered by banks to other institutions, especially as the Challenger market grows, the suppliers that will be successful in this sector will be those that firmly place themselves in the “we’re an IT company” corner, rather than trying to do it all.  We will be watching ING with interest.

This is also an opportunity niche for fintechs evolving towards a more full-service banking technology model, and a variety of these have started to emerge, particularly from the old core banking technology sector. These organisations may lack much of the banking knowhow embedded in the incumbents, and may focus less on important considerations such as risk and regulation when integrating their services, which could present a risk for customers from less mature sectors, who themselves may lack this knowledge.  The flipside of this is that there is an evolving trend for providers offering BaaS (usually without a banking licence) to be cloud-based, offering security guarantees but in ways not fully anticipated by most regulations.

However, it will also be very interesting to observe how these organisations progress as the maturity of the sector evolves.  While BaaS and agency banking are pretty well established in the industry, the emergence of fintechs into this space and the evolution of traditional banks towards this model are both shaping the future of this area of banking in unpredictable ways.  In particular, we’re interested to understand how this will affect the traditional banks who have offered a full service model, in competition with the technology specific offerings emerging today.

2.    The Supermarket Bank – we’ve got customers, why not?

As we’ve seen, a number of organisations (not just supermarkets) are capitalising on their customer base to increase their offering by including banking or financial services, using their scale, their established reputation and their customer numbers to develop a business case.  Mostly, the offerings of these banks are limited to retail and small business banking with cards and insurance bolt-ons, although we have also seen growing diversification of services.

What we find interesting about these banks is that they’re not trying to offer a significantly different service model to traditional banks; rather, they are trying to capture existing market from traditional customers by giving them a similar, or sometimes, cut-down, model to the traditional banks, but using the power of their brand or, simply, not being an incumbent, to attract customers.  The driver is clear; traditional banks are getting a hammering from governments, regulators, the press and pressure groups, so setting up an alternative is attractive at the moment, and customers are moving despite the relative lack of difference.

We think this trend is a very important stepping stone on the journey to the ecosystem bank; while the supermarket bank is basic with no desire to enter capital markets, they are a perfect example of how extending service offerings to customers who previously associated the organisation with a different, but related, core service, and want an alternative to the big banks, can work seamlessly.

However, like full-stack service banks, the Supermarket Bank model is usually relatively traditional in approach and limited in market potential.  These new banks are hiring old bankers, assuming that the guys from Lloyds or RBS will have the expertise they need.  While this is definitely true as far as existing industry, core service, risk and compliance knowledge is concerned, this also brings in inherited assumptions about bank organisational and service structures, which has the potential to paralyse fledgling banks or at least to significantly clip their wings.  The challenge of balancing traditional bank knowledge with new-bank innovative thinking is a difficult one; regulations are restrictive, and deliberately ambiguously phrased so that interpreting them is a skilled and complex business, so it’s natural for new players to be cautious, but this can also impede their ability to create a truly differentiated offering.

Key questions remain to be answered before this sector can mature completely; one is, are the businesses entering this market diversifying too much and can they cope?  As with banks over-diversifying by embracing insurance as well as banking, high street banking as well as capital markets, the culture and heartbeat of goods retail and other business sectors is very different from banking culture and heartbeat; these new banks require a different organisation with different values, and managing operations across such diverse businesses is likely to prove challenging.  A very small number of organisations, with global reach and the financial base to create completely distinct businesses, may be successful, although even the Googles of this world may struggle in creating global business models for a new sector, where so many incumbent have failed.

Another question, which also applies to the full-stackers, is how sustainable is the business model, especially now in our low, zero or negative-interest world?  Retail banking and cards have always been low-margin businesses, and while economies of efficient operation can be built into these new banks more easily than into the incumbents, they lack the scale to support a large, operations-hungry and low-margin business, while going through the expensive process of acquiring new customers.  While the supermarket banks are typically investing in vendor supplied core systems, they’re still building their total operation, usually including integration of core banking systems, in-house, at massive expense both from an initial investment perspective and in maintenance.

For global businesses such as Google and Amazon, the landscape is challenging. Current regulations require such organisations to hold licences for each territory and to comply with local regulations there, which is complex.  There is currently no such thing as a global, or internet, banking licence; regulators and central banks are siloed by location in a manner incompatible with the world we actually live in today and much of this is tied into the currency question. As regulations evolve, they may or may not provision for these mega-monopolies, but given trends in regulation, where the priority in most cases is to protect the consumer by encouraging smaller entrants, it may be a long time before global consensus is reached.

3.    The Service Bank with encapsulated IT – build your own bank

As discussed above, there is a growing number of “full-stack” challenger banks offering core services to a clearly defined customer base, usually with attractive and differentiating front-end apps and offering a variety of instant or near-instant, omnichannel services.  These banks are often put together by ex-bankers, frustrated with their original organisations, who still carry preconceived ideas about how banks should operate which influence their operating model design and their choice of technology strategies.  Starling’s Anne Boden clearly articulates the rationale for building core banking from scratch – you can alter it more easily, encounter fewer barriers to providing more real-time services, and a smooth customer experience, which are strong rationales, however the challenge is that you are building legacy – introducing your in-house developed technology at any level means that you are, in perpetuity, responsible for every aspect of maintaining, redesigning and upgrading it; effectively you’re forcing yourself into the Bank as Infrastructure bracket, without the scale, history or solid capital base of the incumbents.

Clearly, maintaining evolving solutions using modern technology is definitely not as challenging as maintaining systems written in Cobol or Assembler, and banks such as Starling can benefit from learnings from other banks, which is where an experienced CEO like Anne is critical to success, but we anticipate the same problems are likely to arise over time; as banks scale, investment in growth overshadows investment in maintenance, and your once-state-of-the-art systems eventually become buried in a soup of patched-on workarounds and integrations with acquisition organisation systems.

This then makes any change expensive and complex, which means more patches, workarounds and partial integrations, until you reach the point we have seen in every single incumbent bank we’ve worked in; the legacy system is out of date, the documentation hasn’t kept up, the infrastructure is a spaghetti of magnificent complexity and your core systems are on their last legs.  The support team is a shrinking and ageing set of key SMEs who become a critical point of failure as their numbers diminish, and eventually nobody in the bank really understands how the systems work.  Replacing them is expensive, complex and only solves part of the problem, because you’ve still got the spaghetti to sort out.  Every bank that we’ve seen replace its legacy systems has opted to buy in vendor-supplied software, rather than trying to build its own again, based on their experience with legacy. We also think that there are alternative approaches to providing integrated customer experience, flexibility and real-time services, as we discuss below.

If that sounds dystopian and over-dramatic, you haven’t been close enough to the heart of the core systems and surrounding applications in a typical incumbent!  While the legacy problem is addressed by the full-stack visibility Anne describes in her blog, this model isn’t easy to sustain once an organisation scales.

So, while we understand the philosophy, it has surprised us that so many of the new banks are based on operating models which involve building in-house core systems.  We believe these banks, Challenger or no, are effectively replicating the old model; after all, every one of today’s universal banks started out as a more specialised, customer sector focused bank, that built its own core systems.

However, these banks do offer some interesting differentiators – in how they support customers and the nature of their offering; they are more likely to include “life management” apps, which extend beyond the traditional transaction account, payments, cards and mortgages offering of the traditional retail bank.  This is, in turn, changing customers’ expectations of what a bank can offer, which in turn is putting pressure on other challengers and incumbents alike.  As with the Supermarket Banks, we see a lot of challengers entering this space who don’t clearly articulate how their business model will generate a profit.  However, if they are successful in changing customer expectations and behaviour, even those that fail will have made their mark.

4.    The Second Bank – Our focus is customer service

Other emerging challengers are positioning themselves deliberately as “second banks”, explicitly offering a partial banking service either in the retail or (more rarely) the business support space, with differentiating products which are their primary focus, on top of some banking services.

Not mutually exclusive to our definition of full-stack Challengers, this model is emerging alongside the full-stackers, with critical operating model differences but little fundamental difference of philosophy.  Banks building in this fourth model are focused on the differentiator they can offer to the market through their customer journeys and the services that underpin them, often linked to clever fintech apps and appealing interfaces.  These banks rely on both incumbent and, increasingly, emerging fintech and infrastructure BaaS providers to underpin their service model with both core financial services and, to a lesser extent, the niche apps which can support their chosen offering.  They share the targeted market philosophy of the full-stackers but with less of the baggage of trying to build full traditional banking models.  In common with both supermarket and full-stackers, there are also significant concerns about the viability of their business models, however operating costs are generally lower due to the more distributed risk of their operating model and the reduced need to invest in infrastructure.

As with the full-stackers, the provision of life management apps has the potential to significantly change customer behaviour and expectations, regardless of the success or failure of individual organisations in this sector.  For example, Swedish bank Resurs provides a wallet app for organising loyalty cards and vouchers for Swedish retailers.  While this is still relatively niche, it’s an example of a growing number of organisations explicitly aimed at the second bank market, never intending to capture the full portfolio of a customer’s financial needs.  As the service portfolios offered by these “second banks” grow, they will encroach on the portfolio of traditional bank offerings, unless those offerings are equally attractive to customers.  Traditional banks, being slower to market than these more agile startups, face the choice of speeding up their product development cycles, reducing their market share, or partnering with these new competitors.

These four models are different from each other, but they have one common feature: they are all based on the traditional bank model – either as a subset of the service, or as a smaller, leaner, more agile version of the full service; using new technology and delivery channels but with mostly traditional operating models.

The fifth, emerging model of banking partially breaks this paradigm, and we believe is a key component to the future of financial services.  The model is evolving and, like all new paradigms, will probably pivot significantly before it’s proved in any direction, but we believe it will both support sustainable customer outcomes by leveraging traditional and emerging banking paradigms, and provide a platform that is sufficiently agile to adapt to new customer and market directions as they evolve.

The Ecosystem Bank – we’re part of how your business runs

Everybody is talking about Ecosystems.  What does it mean?  Probably a lot of things to a lot of people.  To us, the term means the breaking down of barriers between banks and their suppliers, banks and customers, and between customers and suppliers; it is about the distinction between organisations becoming less relevant and the diminishing need for full ownership of services.  It is about the growth of trust- and consensus-based transfer of value, removing intermediaries to allow value chains to operate independently of central institutions like banks and governments.

So, if we are removing the intermediaries, where does that leave banks?  This is the challenge that is worrying the traditional banks the most; PSD2 and applications of blockchain (and other distributed ledger technologies), such as smart contracts and cryptocurrencies, threaten their central cost models, reducing the stickiness of their offering for customers in both retail and corporate offerings.  See also What’s the point of Banks? for more on this.  Banks can choose to continue to play in the old paradigm, but a combination of threat from more agile challengers and fintechs moving into this space and the reduction of margin resulting from this competition means the opportunity to use their scale in a different way may be easier to monetize and sustain.

The ecosystem bank, fundamentally isn’t really what we think of as a bank.  Yes, it offers financial services – accounts, loans, payments, all the usual things – but the key thing it offers beyond traditional banks is its multi-sided platform networking, the ability to connect many to many across the network between customers, service providers and financial services including, importantly, disintermediated services where the bank is not part of the value chain at all.  The bank’s margin comes from customers subscribing to integrated full service applications such as supply chain and accounting, whereas the fintech providers pay a proportion of their transaction fees, in exchange for access to the bank’s wider customer base.  The bank itself only provides very core services (possibly even buying payments and core banking as BaaS), using partners to support the wide variety of services needed by its customers and using its knowledge, customer relationships and reach as key differentiators.

To achieve this, operating models must be completely rewritten.  We believe that all banks will need to change their operating models and pricing models with the emergence of open data and customer ownership of data, so this challenge is not unique to new types of banks, but with a specific focus on disintermediated services, revenue models need to focus on other value adds, and therefore the service model becomes a key differentiator.  This isn’t any more straightforward than building traditional banking services, of course, and risky because of the use of emerging technology and some ambiguity about the bank’s purpose. It’s important for these banks to be focused on market sector because, due to the extensible potential of the operating model, it could quickly become unfocused, so we believe this model is likely to give rise to a number of regionally focused organisations, sharing market sector and partnering with each other via their networks.

Multi-sided platform ecosystem bank operating model
Figure EL-BF-NSMB-2: multi-sided platform ecosystem bank operating model

Blockchain/crypto-technology and digital assets

The fundamental principals of what banks are and what are they for is changing rapidly and these ecosystem banks will, we believe, come into their own as the technology supporting them becomes more accepted by the global financial community and in particular by regulators. Financial institutions and technology organisations along with central banks are exploring the implications of some of the current technology-related megatrends – digital assets and cryptotechnology (e.g. blockchain and smart contracts), in particular – and building a view of how to / how much to control them.  These trends are driven by consumer adoption and the innovative and imaginative startup sector that is flourishing in San Francisco, London, Tel Aviv, Singapore and elsewhere. An ecosystem bank enables these new fintech players to flourish, giving their customers what they want along with unprecedented choice and individualization. If a customer wants to switch between the financial services offered then it should be the easiest thing possible – a truly free market driven by demand and quality of service. For its part, the ecosystem bank, or more accurately the financial services platform, provides the resilience, trust, and scale that is required.

Much has been written over the few years about the promise of blockchain-type technologies and given the amount of focus, investment and seriously intelligent people collaborating globally to develop it beyond its current ‘experimental’ state, we believe that this will underpin the ecosystem banks of the future. It is looking highly unlikely that there will be a single blockchain technology standard but rather a combination of those that are being worked on by the various consortia (R3CEV, Hyperledger, etc.) and leading Blockchain-specific companies (Bloq, Blockstream, Digital Assets, Consensys, etc.). Progress will be therefore be dependent on the establishment of an inter ledger protocol that allows these blockchains to securely and privately inter-communicate and establish exponential growth through network effect rather than the constraints of a one-size fits all standard. Also, the resolution of issues around how one’s digital identity is combined with blockchain technology will, we believe, release a number of the current inhibitors on the evolution of blockchain generally and for financial service applications in particular.

The fundamental disparity between boundary-based jurisdictional currency regulations and the boundary-free nature of cryptocurrencies is a big challenge to address for banks and regulators, but possibly bigger is how to manage security and authentication in disintermediated transactions.  As we’ve seen from recent setbacks to Ethereum and other high-profile challenges such as the recent Bitfinex exchange hack, we’re not there yet, but we believe the opportunity for ecosystem banks is here already, with growing application of these technologies accelerating.

Blockchain infrastructure developments aside, the adoption of digital currencies has continued to grow but at a slow pace. Bitcoin, is the best known, but there are many other ‘altcoins’. Banks, however, with very few exceptions, have failed to find a way to address this new kind of currency and governments have failed to find a common way to view and treat it. It is often dismissed as niche (“only for geeks”), misunderstood (just “magic internet money”), and risky due to its tarnished history and use for illegal ends. Also, although Bitcoin has a USD 10 billion market capitalization, its price is volatile and has insufficient volume to prevent manipulation by big traders or resilience to good/bad new stories.

That said, Bitcoin and its brethren are being increasingly used for beneficial purposes. The two billion unbanked people in the world who the traditional banking system have turned their backs on are using digital currencies widely via their mobile phones to transact and gain access to financial services that hitherto they could need reach. This means that they can trade, do business, make payments and store value. Digital currencies also circumvent the old, slow, batch-based, banking infrastructures of the past – by design. Payments are almost instantaneous anywhere in the world; Bitcoin has proven to out-strip the riskiest of funds as a long term investment class; derivatives and products based on it are being created; so, in short, it looks and feels like money, so why shouldn’t there be an integrated services system that supports it?

And why stop there? Digital currencies don’t have to look and feel like money. They can represent stocks, securities and other asset classes, even loyalty and reward points are a kind of digital asset. If Bitcoin can be traded between parties in a secure and private way then so can these classes and it is not beyond the imagination that a financial services ecosystem along the lines of that proposed here, would offer services to support innovative businesses operating in this area.

We will explore these ideas in a later article on the conditions required for the emergence of cryptobanks.

Startups, incumbents and the new models

Banking, like many other industries before, is going through a hype curve driven by disruption, new applications of technology, changing attitudes to data, hyper-availability and changing customer expectations.  Like other industries, many of the incumbents will probably not survive, while some will pivot and thrive, possibly even dominate.  Most of today’s startups will not exist in the years to come; like the boom, early entrants don’t necessarily have first mover advantage, and later entrants will have the benefit of opportunities to learn from the mistakes of earlier entrants.  Who will end up dominating is anyone’s guess, but we can forecast with some level of confidence is that the dominant players will not look like banks today, and probably not much like the early Challengers.

As during the boom, there’s a lot of investment capital available for Fintechs and challenger banks today; VCs are falling all over themselves to offer funding, banks are building their own accelerators, and crowdfunding is giving everyone the opportunity to get involved.  Many of these are putting money into business models with four or five-year break-even horizons in an uncertain competitive landscape and, in many cases, that break-even will never be reached.  All startups suffer from scale challenges and typically those that grow too quickly, or without sufficient focus, are the ones that fail the fastest.  Conventional wisdom says that startups should focus on a small market to succeed and avoid being out-competed in their early months and years, but how can a global multi-sided platform or ecosystem bank restrict their markets?  Is BaaS sustainable and how will it impact competition?  And will central banks actually start issuing cryptocurrencies, or will the cryptobanks get there first, undercutting them?

Conclusion: the future looks horizontal

We think the ecosystem banking models are at least evolutions towards what banking will look like in the future, but that all these models will need to mature in parallel  with the evolution of the ecosystem itself as a core customer and partner enabler, before stability is achieved.  Wherever banks move themselves in this landscape, the universal model looks unsustainable, and we believe banks will either initiate their own focus towards one or other of these models, or be forced in that direction as regulations and market forces change – as is happening right now with regulations such as PSD2 and GDPR in Europe.  Whatever happens, the distinction between bank, fintech, service provider and customer is blurring and may eventually disappear from a customer perspective as more services migrate to multi-entity, cloud-based value chains, where the existence of an entity as a bank, a service provider, a source of funds or a fintech, becomes indistinguishable and therefore irrelevant to the customer.

Does this mean the death of banking?  No, but it does mean that banks need to learn to win through others winning, collaboratively, rather than through the old “I win you lose” paradigm.  This will be good for the customer, good for service providers, and eventually good for banks, but will require a significant shift in mindset.

Shifting values in the connected economy develops some of these ideas.