This article is part of our randomised, post-structural Let’s Build a Bank series of articles. If you’re familiar with our series, you’ll know our articles are long. This one’s longer. We don’t apologise for this, we hope that you will find the additional content more interesting.
In parallel, we examine various models for banking in the related New Standard Models for Banks, and applications of fintech which can remove the need for banks as intermediaries in a wide range of applications. In this article we review the alternative financial solutions emerging to challenge the services offered by traditional banks, and question whether the utility of banks is waning, or whether banking as a concept needs to change.
Elsewhere, we’ve also considered the changing nature of customer loyalty, and we hope to release this article shortly.
What are banks* for?
“A bank is a place that will lend you money if you can prove that you don’t need it.”
The answer you get to this question will depend on who you’re asking, but fundamentally a bank is somewhere safe to keep your money, and an institution that will lend you money when you need it, so it’s about pots of money (positive or negative). Further, it provides the ability to transfer value from one pot of money to another (payments). Obviously it’s a lot more complicated than that, but to the majority of customers that is the utility of a bank. To some, it’s an advisor, a portfolio manager, a market maker, trader or broker and we’ll briefly cover these disciplines and the major disruption below.
Of course, you’re not just giving the bank wads of cash to sit in a vault with a big round iron door; the bank has the ability to use your money in the shape of loans, and take a profit from lending it to other people, whether as a mortgage, or trade finance, or other types of credit. It may also use it to buy bonds and equities, either on behalf of customers or on their own behalf (proprietary trading). Lending and trading activities both carry risks and these are mitigated both by a bank’s strategy (hedging), internal risk controls (customer due diligence, credit and market risk) and by regulatory limits to what banks and in particular, trading divisions, are allowed to do.
Nowadays, in addition to fulfilling these compliance obligations, banks are required to keep a balance of cash in reserve, which varies from country to country and bank to bank, depending on their risk profile and the regulator’s risk appetite, to hedge against potential market collapses, so there’s an inbuilt inefficiency in the way that money is used – this figure is 10% or more in most jurisdictions. Banks also build credit risk into their profit model, so that all borrowers are paying extra for the borrowers who won’t be able to, or choose not to, pay back their loan as well as for the complex risk management systems and liquidity balances.
So far, so inefficient. Then we have to consider that managing that credit risk also requires banks to do very thorough customer due diligence (we’ll get onto regulators in a moment) to ensure they’re not lending to people who are unlikely to pay lent money back, as that would push the risk profile, and the cost of lending, up. That means there’s a high bar to entry for customers, who have to prove lots of things about their history and who they are before they can be given a loan. They also usually need to provide some additional security in the form of guarantees or collateral, of which the most obvious example is a mortgage. This high bar to entry means that many people can’t get a bank account at all, even if they don’t want to borrow any money, so we’re also excluding a significant chunk of the world’s population. This is important because those people are not able to access credit, which in the case of small producers and merchants, is the most important thing they need to climb out of poverty. But we’ll return to that.
Then there are the regulations. Because banks are so big and so important to how the system works, in order to guarantee our safety, governments have mandated stringent regulations via Financial Services Authorities, Central Banks and other legislation. These regulations control restrictions such as the capital ratio mentioned above, who banks are allowed to lend to (more customer due diligence) and on top of that, how well they’re managing their businesses and their risk profiles. All of this is critical while banks are the custodians of our cash and especially in the light of 2008 and more recent high-profile failures, but again it means that running a bank is both costly and extremely complicated. Guess who pays for it?
Alongside money markets and capital markets trading, many also offer corporate finance, or the issuance of equities and bonds, which are then traded on the secondary markets, either for clients or on the bank’s own behalf, and as we saw vividly in the financial crisis, these secondary markets including derivative products such as mortgage-backed securities can be a source of significant losses, as well as significant profits. In order to support these complex markets, banks have specialist divisions of advisors, analysts, product and market specialists, all of whom are paid well to use their significant expertise in advising companies and governments on issuance, or predicting market movements and creating products attractive to investors. Basically it’s very sophisticated betting.
What keeps this system going is a number of important factors:
Size = Security. I’m sure everyone knows the phrase “too big to fail” by now, but even at the smaller end of banking, regulations require institutions to have significant, diversified backing, to guarantee security. Maintenance of balances is further guaranteed by capital ratios, as described above. Higher barriers to entry apply to banks issuing or trading on capital markets so the number of banks able to support an issuance is fairly low.
Regulation = Security. Customers have guarantees that regulated institutions will be meeting the standards expected of them, or face censure if they don’t. While there continue to be scandals of various sorts which receive wide exposure, in reality the reliability and security of banks is extremely good.
Monopoly on guarantees of identity – banks historically have been the primary means to guaranteeing many critical aspects of our identity, such as our credit-worthiness, and in many cases guarantees of who we are. Being unbanked restricts access not just to banking accounts, but a whole range of financial services, accommodation and even jobs, because these checks cannot be performed.
Financial Products: the most familiar of these are the current (or checking to the US customer) account, the loan including the mortgage and payments. Key to this is maintenance of guarantees against what you put in and what you get out, whether that’s instant access to your cash via an ATM, electronic transfers, etc associated with current accounts, fixed rates associated with mortgages or loans, or fixed interest associated with deposits; all of these products come with inbuilt guarantees so you know what you will be getting. This is further underwritten by central banks and regulation so you can have trust that you’ll get what you’ve been promised. We go into more detail on financial products and their alternatives in the service analysis below.
Monopoly on Access to certain facilities, such as central bank reserves, payments transfers, etc. While alternatives (discussed below) are emerging, the vast majority of transactions are constrained to run over central infrastructure between banks because they a) require the funds to originate from and end up in recognised, secure, validated accounts, b) use recognised currencies, which are backed by central banks, to which the banks have access but ordinary companies and customers don’t, c) have authorisation and the infrastructure to pass payments over centrally managed payments transmission systems.
Familiarity: what’s known as the “power of inertia” describes a negative type of customer loyalty, which is based on two psychological phenomena – one, familiarity bias, or the underlying assumption that the thing you know is automatically better than unknown things, which is one of the things that helps build society, but is really unhelpful when you’re trying to make a reasoned judgement between competing products; the second is the disproportionate perceived effort vs actual effort of actually changing. When IAS (industry account switching) came into the regulations in 2012, governments and banks assumed mass exodus would follow, but in fact not that many people did switch at the time. This is, however, changing.
We’ll discuss these factors as we consider the alternatives, and for simplicity we’ll take it on a service type basis
Banking services and emerging alternatives
NB there are a number of services offered by banks today that we’re not addressing below; Credit Cards and Insurance are not included as these are not generally services operated by banks, but by third parties on behalf of organisations, including banks.
Storing your money and letting you spend it when you want to
The obvious place to start is with the current account (or checking account in the US). A current account has the following features:
- Retains balance including current actual balance, future or virtual balances based on forward payments and remittances, payments in clearing etc
- Linked to bank maintained customer ID via bank’s systems
- Linked to transactions, processed by bank
- May be linked to cards (e.g. debit card) or e-wallet
- May be linked to parallel accounts, usually held by same bank
- May attract interest payments or remittances depending on balance
- Can have positive or negative balance
- Protected by government guarantees, which vary from country to country
Some important considerations are that the bank account is not just a pile of notes in a vault, but a “bucket of money” that can be in several states at the same time (very quantum): the state of actual money that is in the account, has been cleared and paid; the state of balances in clearing (in and out) and various balances based on payments that have been agreed but not yet reached clearing, such as direct debits and standing orders. Interest on the account will also be a factor, and all of these in/out payments contribute to a variety of balances on any one account at any one time.
There are a few alternative ways of storing your money for instant access in the old system; manufacturers and shops have taken advance deposits, and it has been possible to buy prepaid cards or tokens for use as future payment, but these have mostly been issued by individual stores. In some cases multiple stores and manufacturers have signed up to schemes; virtual currencies such as air miles or store points have been around for a long time, used as a loyalty incentive and in some cases allowing customers to spend the virtual currency with other stores (such as the Green Shield Stamp scheme for those old enough to remember it, or the Nectar loyalty card) but these had limited reach and therefore it’s questionable whether they could be described as truly liquid.
The currently available alternative, the Digital Wallet or e-wallet, operates on similar lines, but with significantly more reach, offering the following features:
- Payments, C2B, C2C or B2B, usually via mobile or internet
- Retains balances including current actual balance, future or virtual balance based on payments
- One-time customer authentication linked to trusted source (usually a bank but increasingly other sources)
- Linked to transactions, processed by e-wallet infrastructure
- May be linked to cards, bank account, mobile app and cash top-up
- Usually doesn’t incur interest charges for consumer; merchants pay
- Balances cannot go below zero (unless in special circumstances, e.g. managed e-wallets)
- Usually not protected from hosting company failure
The e-wallet is a massively popular alternative to current accounts today, with three distinct markets: merchants, who benefit from a reduction in margin over card transactions; (largely) banked customers, who are able to seamlessly pay for internet purchases, and both unbanked and banked customers who want to make peer to peer transfers with their mobile phones. The obvious disadvantage is the lack of access to automatic credit, but the advantages are significant, particularly for merchants and unbanked customers. The most common vehicles for e-wallets are mobile phones and online; for the unbanked, this is a very significant development because while about 50% of the world’s population are unbanked, 80% of the population in developing countries owns a mobile phone (women are 14% less likely to own one). For mobile wallets, many are linked to a bank account, but it is also possible to hold them via the mobile provider, removing the need for a bank altogether.
A further development is, of course, the evolution of cryptocurrencies, which are necessarily held in an e-wallet and independent of sovereign currencies (so far). While cryptocurrencies are relatively low in actual value compared to traditional currencies in circulation, there is no theoretical limit to how much value could be transferred to cryptocurrencies, which has led to many central banks seriously contemplating the issuance of their own CBDC (Central Bank Digital Currencies). If this were to happen, the implications for bank accounting as we know it would be huge, as the e-wallet could be held independently of a traditional bank, with customers able to make direct Peer-to-Peer payments in a secure digital currency, backed directly by central banks, without the need for a banking intermediary. This would significantly reshape the way that banks are supported by deposits today and leave a hole in their balance sheet what would have to be filled in other ways, as explored by the BoE’s BankUnderground.
The other challenge which particularly impacts the unbanked, is that these types of account have not been historically accepted as guarantees of credit history, however this is now changing, thanks to alternative approaches to evaluating creditworthiness which are now emerging, as described below.
Storing your money for longer with restricted access
Savings deposits of various sorts are the second type of deposit account held with banks; these can be fixed term – maturing on a certain date – or with restrictions to access, so that the bank can forecast more effectively how much of your money it will have at a given time, and use it more efficiently (or get a fee if you choose to invoke a break clause), or instant access, which is a sort of hybrid between a current account and a deposit account. The main difference with these accounts is that you can’t go below a zero balance, and they will all give some sort of interest, either applied based on balances at agreed intervals, or at the end of a maturation period. In many cases you are able to make and receive payments directly into these accounts, but it varies depending on the terms of the agreement.
Partially equivalent to savings accounts are bonds, which are government or company issued instruments with agreed, fixed rates of return. Unlike savings accounts, they don’t have the flexibility of changes to agreed terms, but they can be traded on secondary markets, so capital can be realised in this way if the bondholder chooses to do so. Equities are more flexible investment instruments; however unlike bonds, the value of these changes with fluctuations in the issuing organisation’s perceived value, so lack the security of either a deposit account with a bank or a bond. And both equities and bonds as financial instruments are moving away from the “saving money” service towards “buying stuff”; if you want a really illiquid asset example, most of us have one in the shape of a bricks and mortar property.
Giving you money for general purposes, that you promise to pay back
As described above, there’s no point in a bank just hanging onto your cash, especially since they’re (usually) either not charging you for the service, or indeed paying you for the privilege of holding onto it. Exceptions such as premium accounts and corporate accounts do attract fees, but at a net loss to the bank. So to make money out of your money, they also lend it out, and charge borrowers for the privilege. And the money they lend isn’t just the money on deposit – banks can lend more than they have on deposit, as long as they hold the prescribed currency reserve to meet their regulatory obligations. This means that they effectively control how much money is in the system.
One form of credit is the overdraft, as mentioned above, but banks will also give you personal unsecured loans on the basis of a guarantee of repayment, usually based on your creditworthiness (secured loans are discussed below). While banks will usually want to know what you’re going to do with the money, the key restriction is whether they think you’re able and willing to pay it back, as Bob Hope memorably said in the quote at the top. Loans, as with deposits, can be and more often are fixed term, but they can also be open-ended, with interest paid on a regular basis for both types. Open-ended credit, the unplanned overdraft being the most common example, typically attracts much higher interest rates than fixed term, because there is a much higher statistical risk of default.
In deciding whether to issue a loan, a bank is usually in a strong position to evaluate your creditworthiness, and they already know who you are, so they are able to perform extremely robust checks when deciding whether to give you the money, which means they’re able to offer relatively low rates of interest.
However, Banks have never had a monopoly on extending credit. Credit cards are a familiar form of lending with huge saturation. Merchants were extending credit long before banking had been invented. People have also always lent each other money, either person to person through trust relationships or, as we know, the seedier side where loan sharks exploit unbanked or vulnerable people by personal loans and extortionate interest rates through to more respectable organisations on a sliding scale from more to less seedy, and there’s some regulation imposed on these organisations.
Banks also are big lenders to businesses, with business or corporate banking core to many large banks. This ranges from small scale loans to small businesses, usually at relatively high interest rates, to tailored loans for larger customers; what is risky at the SME end (with 8 out of 10 SMEs failing in the first 18 months) becomes a way of making your money work at the more robust, global corporation end.
For business customers, again, banks have never been the only source of capital; venture capitalists, angel investors and government-backed funding schemes are all well-established sources of funding for businesses. As for retail customers, microfinance lending has also been available to microbusinesses, but traditionally at disproportionate or extortionate rates, to cover risks and administration costs. As with lending to individuals, the most vulnerable and poorest typically have the fewest options, leaving a huge number of unbanked microbusinesses, especially in the developing world, without access to growth capital.
But emerging lending paradigms are also opening out opportunities for credit both for businesses and for individuals. Peer to Peer (P2P) lending is now flourishing both for business and, to a lesser extent, private individuals. The growth in web platforms offering individuals and larger investors the opportunity to invest in business ventures has dramatically reshaped startup investment. P2P lending, and particularly Crowdlending, is also causing disruption to the traditional VC/angel/bank investment of more conventional ventures. Entrepreneurs present their ideas, usually via a competitive voting system on the host’s platform, to attract small investment from individuals. This is presenting several interesting trends:
- The lower cost of evaluation of ideas and lower stakes mean that more risky or smaller ventures are likely to attract some interest, so the barriers to attracting investment are lower than in the traditional model and more small businesses are able to attract investment
- Fashion and peer reviews may have an even stronger influence than before – and this may be a good thing! Traditionally, investors have assessed the market worthiness of a business venture, which despite significant research and ample data, is often still invalidated by market forces. Going direct to the market and cutting out the middle man has its risks, as investors are relatively uneducated, but are as likely, if not more likely to be in touch with market trends, because they identifywith the idea.
- Clearly, this means that investors are exposing themselves to potentially greater risks, but given the relatively small amounts invested in this model by individuals, it’s mainly important to ensure investors understand the risks, rather than worrying about systemic collapse, as when a larger investor makes an unwise decision.
Unsecured personal loans are also facilitated in this way, again over websites. Because of the low expense of maintaining the websites, in general the cost of borrowing is lower than via a traditional bank; in most cases investment is at the risk of the investor, mitigated by hedging across multiple investments, although some platforms now ringfence funding to recompense victims of bad debt. However, where platforms fail, as TrustBuddy did in 2015, investors’ money is at risk and not protected in the way that a savings account with a bank is, by government or other guarantees.
And as with current accounts, the issuance of central bank cryptocurrencies could significantly disrupt the traditional bank lending model, cutting out the intermediary between the central bank and the borrower and therefore removing the banks’ ability to control the level of money in the system; effectively all loans would have to be backed by deposits, instead of just a portion, as in today’s models.
Giving you money for specific purposes, that you promise to pay back
In addition to unsecured loans, which are guaranteed against your creditworthiness, some specific loans are guaranteed against collateral, usually the thing that you are using the capital to buy, both for individuals and companies. For individuals, it’s the mortgage or the car loan, where the guarantee of payment is linked to the property being financed. These types of loans have varying levels of risk, and there’s a risk that the value of the collateral will fall below the value of the loan, but generally they are lower risk than other types of loan and so can attract lower interest rates; they often have a longer payback period too, which means that the bank creates a long-term income stream, and this is usually reflected in the rates. In contrast to the unsecured loans described above, these are “secured” by documentation promising that you will give the collateral to the bank if something goes wrong and you fail to pay them back.
Even more than unsecured loans, merchants have long been providing secured loans, in the shape of HP, buy-now-pay-in-12-months, and various other models. Manufacturers have introduced creative ways to build the price of an item into reusables, meaning that you’re effectively getting the original item at a discount that will be recouped via usage costs (think Nespresso).
Mortgages in particular can be complex, because rates may be fixed for a while, followed by a flexible, index-linked period; there are arrangement fees and buy-out clauses, and the customer can renegotiate the term within certain parameters. There is also usually some linkage to insurance, and in Denmark this is also built into the structure of the mortgage, making these even more complicated. Mortgages are typically accompanied by a long list of clauses, which can be confusing for the customer.
For businesses, trade finance is an extremely important form of lending, as well as being one of the oldest and one that has changed the least over the years. Similar to a retail secured loan, the bank lends the company money based on certain guarantees, but these will be guarantees that goods have been shipped, such as an invoice or a bill of lading for example, rather than deeds to a house. Trade finance is key to businesses managing cash flow, because there is a mismatch between the date when materials are shipped and when the value of those goods can be realised by the seller, and again between the receipt of goods and when the manufacturer can sell them. Conversely, for exporters of manufactured goods, there is a time lag between shipping the goods and receiving payment. Banks have historically been critical in helping companies manage this hole in their expenses, giving them the capital they need to keep producing while their own capital is tied up in supply chains. Currently, ⅓ of world trade runs thanks to trade finance and demand is growing due to uncertainty in international trade markets.
To date, growth of businesses would not have been possible without banks providing commercial lending, and in particular trade finance; as mentioned above, unbanked microproducers are stuck under the barrier to entry to this system, which leaves them unable to grow. Trade finance is also subject to rising fraud, for example with fraudulent individuals raising multiple finances based on a single set of paperwork, pushing the cost for businesses up as risks increase.
But this is changing with the introduction of smart contracts over blockchain. Smart contracts themselves aren’t particularly new; the concept is that you set up a chain of contracts that are pre-agreed between parties, programmatically, so the terms are bound with the execution of the contract. However, as described in our forthcoming article on Smart Contracts and Supply Chain, through the application of smart contracts to blockchain platforms, these agreements can now be made and validated without the need for banks or financial institutions to become involved; the security is in the validation over the blockchain, and transfer of value is also managed in the same way. Once agreed, smart contracts are irreversible, and so form an upfront guarantee that transactions will be executed on certain dates, so rather than waiting for a bill of lading to be produced post-shipment, liquidity can be released on the basis of the contract being agreed upfront by all parties.
The same technology can be applied to mortgages and other types of secured loan; instead of paper documents being validated by banks as escrow agents, transfer of funds can be guaranteed and executed almost instantly via smart contract over blockchain platforms. Cash flow becomes less of a problem and alternative funding sources become available, secured by the guarantees of the contract but not relying on banking intermediaries. Smart contracts also reduce the risk of multiple invoices fraud, where a supplier issues the same invoice as proof to multiple trades; where banks maintain their own ledgers, there’s no opportunity to spot this in reconciliation, but with the full ledger visible at every node, over the blockchain, this type of fraud is not possible.
This is probably the biggest potential disruption to the traditional role of bank lending by new technology; however it’s not there yet, although many institutions and governments are trialling the concept, with Sweden the first country to trial putting its land registry on blockchain smart contracts. Scale is still a challenge, as we discuss elsewhere. And while smart contracts can speed up and validate the value chain, there is still a need to involve a source of funding, which is still today, in the majority of cases, a bank. We anticipate that this will change further, with the introduction of central bank issued cryptocurrencies and with the application of crowdfunding principles to smart contract based trade finance; in a peer to peer system, small and medium size enterprises, or individuals, could lend to support each others’ trade finance, without the need for a bank to intermediate at all.
Then there is the concept of prepaid goods as fractional ownership: thanks to the ability of the internet to broadcast unrealised products through plans, visuals and mockups, to a global audience, the opportunity to pre-sell before manufacturing, which had previously been restricted to a few sectors such as construction and specialist small manufacturers, has exploded. Customers worldwide can sign up in advance to buy bamboo bicycles or cool new gadgets before the manufacturers have invested in raw materials, completely reversing the cashflow challenge faced by traditional manufacturers and importers, so removing the need for trade finance and, in extreme cases, for VC, bank or Angel investment. Another example of this is the common design your own t-shirt model, where the customer pays upfront before goods are created, and another truly disruptive business model in our opinion, is threadless.com, who invite customers to submit t-shirt designs which are then voted on, with winning designs being printed, thus not only creating a strong sales pull, but removing the need for design, distribution channels and much of the marketing challenge, while integrating up to the minute market research into the value chain.
Transferring your money between people or businesses
Payments between individuals, companies and governments are one of the mainstays of banking. Banks are authorised to make payments on your behalf and, conveniently, as they hold your money, are also able to extract the funds from your account. They can accept payments into accounts and set up regular payments on your behalf (direct debit or standing order payments). All payments other than currency payments are electronic transfers, usually between banks, and we cover the mechanics in more detail elsewhere, but essentially there are central bank currency accounts held by each bank (nostros and loros) between which value is exchanged by a series of electronic messages, and the value is transferred by the bank between these central bank accounts and the originator’s or receiver’s accounts. As only certain banks are able hold these central bank currency accounts, larger banks will also maintain loros and nostros on behalf of other, smaller, banks, increasing the number of intermediaries. It’s important to note that the central bank issuing the currency needs to be involved in every single payment – either as issuing that currency in note or coin format, or by holding the currency accounts and validating the payment between the banks. As this is restricted to certain banks, this is the main reason payments have to go through banks today.
Credit card payments are a form of liquid credit issued as payments via a card, and the mechanism is essentially the same, with value being transferred via a receiving bank (the merchant’s) and added to the merchant’s account. The issuing card company, which may be a bank, carries the risk of default and charges fees for late payment accordingly, while settlement of the debt is again paid from the carrier’s bank account, in another normal payment. Cheques, however, are not actually payments; they are a form of contract between the purchaser and the merchant, who can choose to refuse the cheque, which then need to be cleared by the bank (or clearing house on behalf of the bank) before the payment is made. Debit card payments, by contrast, are more directly linked to a bank account, and will usually be settled in a bank’s standard overnight processing. International payments between different currencies are more complicated, because the central banks don’t guarantee each others’ currencies and so additional checks need to be introduced. On top of this, banks also monitor payment activity to detect fraud and misuse of funds (e.g. for terrorism).
All of this costs money, and of course it’s the customer who pays, usually the merchant. That means that selling goods for low amounts of money is not economically viable for merchants, because there’s a lower bound to transaction fees (usually around $1, although it can be lower, depending on the type of transaction). In other cases, the customer is charged directly, for example CHAPS payments and international transfers usually attract fairly high fees. So if, for example, you make a payment in a different currency to the one your bank account is held in because you’re buying off a foreign website, you’ll be paying exchange fees (usually about 3%) and the merchant will be paying a fee for the payment to be processed at their end. That’s before you’ve even paid for shipping!
Mobile payments are the main movement currently disrupting the traditional payments model. The great strength of mobile payments is the ability to unlink the payment from a bank as intermediary; in the model popular in Asia and parts of Africa, the price of the purchase is underwritten by the mobile operator or an e-wallet provider such as mHITS in Australia, rather than by a bank, in a model similar to a credit card purchase. The big difference is that unlike a credit card, you don’t need a bank account to get a mobile phone, and e-wallets can be topped up via cash payments to agents. Of course, many mobile payments are linked to bank accounts, and this model is growing in popularity wherever it’s launched, as even fully banked people are more likely to have their phone than their debit card to hand.
Mobile payments, while growing in maturity and popularity, are still finding their feet in some ways; the e-wallet paradigm is still not completely reliable, while there are challenges in fulfilment, lost or hacked data and a high cost overhead, which is passed on to the customer or merchant, or both. Mobile payments linked to bank accounts need to evolve a strong pricing model, with merchants currently picking up the bill, although as noted above, the cost is generally lower than for traditional payments.
The other big disruptor is, of course, blockchain, although because of the scale challenges discussed in our parallel article, the platforms and technology is likely to undergo some significant changes before it has the potential to become a universal paradigm for payments. While the applications of smart contracts over blockchain are already presenting a major change opportunity in trade finance, blockchain for B2B/P2B/P2P payments is likely to reach saturation more slowly, partly because of the scale issues but also because of trust challenges; the image of the bitcoin blockchain as a subversion of trusted currencies is falling away as its use becomes more mainstream, and financial institutions are investing in more secure uses of the paradigm, but it’s still open to questions about regulation and as with all new developments, has yet to reach commonly agreed standards. Very public failures, such as the recent DAO collapse and its impact on Ethereum, are not preventing institutions from moving forward, but illustrate the risks inherent at this stage in a new paradigm’s development.
Despite this, we anticipate that the use of Ethereum and other platforms for peer to peer disintermediated payments will rise steadily and soon present a significant challenge to existing payments services; as do the banks, hence their sharp interest in the opportunities presented by the technology.
As with holding accounts and managing payments, historically banks have been key holders of information about who you are, whether you’re an individual or a company. Holding a bank account still gives you an entry to many opportunities, such as many types of employment or housing, that are closed to the unbanked. As with access to credit, this creates a sharp divide between banked and unbanked customers; even if you are able to build your business up, without a bank account you are still a non-person in the eyes of many.
Banks provide validation of your financial history, of course, but they also provide other validation, including being used to authenticate your address. That model worked fine when people generally had a single bank account, held at a local branch, which was responsible for looking after all of your finances, but it breaks down in a world where people are likely to have two or more bank accounts with different institutions, on different ledgers. Your transaction history with one may be very different to another. For example, I currently hold several accounts with two banks in different countries, one of which I just use for payments and the occasional international transfer, whereas the other is used for my salary and personal day to day payments. Reviewing the first might tell you a bit about my taste in culture and charities, but it wouldn’t give you an idea of my spending power or creditworthiness.
Of course, this problem is addressed by data aggregators such as credit ratings agencies like Experian, who take information from a number of different bodies including banks, credit card providers, mortgage providers, etc. With the introduction of PSD2 and open data, it will also be easier for additional authorised entities to access this information, but with the growth of all the other products and financial opportunities we’ve discussed here, it no longer makes sense for a bank to be central to that validation in all cases. We are already seeing pilots of the use of mobile records to validate behavioural patterns, which are a much stronger indicator of creditworthiness than transaction records. Mobile data is much richer than pure transaction history, because it can include physical movements and of course communication history, which in turn leads to the opportunity for network-based validation. This could present PI challenges, as behaviour patterns are likely to be as unique as thumbprints, and with the availability of data today, that means it’s possible to identify individuals from their aggregated data, but that is not the concern of this article. There’s also a growing number of blockchain-enabled authentication protocols that threaten banks’ position in this niche, as well as the traditional providers such as Experian.
Managing your Portfolio and placing your bets
For corporations, wealthy individuals and governments, many banks have long provided additional services including managing investment portfolios, investment advice and a more person to person service than to their general customers. This interaction is usually strongly based on personal relationships either between the wealthy individual and family members, or C level executives for the corporate market, and the bank. Banks with trading divisions can also offer brokerage on behalf of corporate and personal clients, as well as on their own behalf. These disciplines are known as Asset Management, Wealth Management and Brokerage.
Banks also offer different tiers of financial planning advice to their customers, depending on the value of the customer and their needs. The financial advice offered by banks to customers is, however, restricted by anti-trust laws, which means that they are not able to recommend specific products under most circumstances. Financial planning is most used by individuals when planning major investments or lifestyle changes, such as buying a house, marriage or retirement, while businesses and wealthy individuals will have a more regular, personalised service, depending on their value and the size of the challenges they face.
Portfolio management, brokerage services and advice have always been available from other organisations, and many independent wealth management institutions exist. They are now being joined by a growing number of “robo-advisors” which use automatic intelligence, usually combined with human expertise, to create a variety of bundled products for investors and execution, at much lower fees than would typically be charged by an investment advisor. We have seen more and less automated versions arising and to date, customer numbers, while high, are not sufficient to balance the cost of customer acquisition and running these firms. However we anticipate as they mature, they will start to capture a greater share of banks’ traditional investment customers.
Cash management and payroll
In addition to managing accounts and payments on behalf of governments, businesses and individuals, banks typically offer larger corporate customers and some wealthy individuals services such as cash pooling/concentration, where money from various accounts is consolidated for better liquidity, or managing automated clearing on remittances, physical bulk clearing, for example cheque processing, and regular bulk payments such as payroll or pensions payouts.
Pooling and sweeping of corporate accounts helps companies to move money from multiple accounts to central accounts, and to use excess liquidity in other ways, such as investing in mutual funds overnight to earn interest, and then being returned the next day.
So far, we haven’t seen any new entrants in this market, and there’s a good reason for that; the management of companies’ bank accounts is intrinsically linked to cash management. In addition, this is an area which requires significant trust in the institution’s expertise and robustness. However, if some of the developments described above start to emerge, and in particular the growth of non-bank held accounts following the issuance of CBDC, this is another area where new entrants could apply automation and business logic to address customer needs.
Increasing shareholder value
Finally, banks with investment banking divisions are also engaged with supporting corporate clients in the issuance of equity (shares) or debt (bonds) to finance expansion, and helping them to manage the balance of financing for their firms. Corporate Financiers also advise on mergers & acquisitions (M&A) and demergers, management buyouts, takeovers and joint venture financing. This role is largely advisory and, while strongly related to the trading activities, is ringfenced from trading via a “chinese wall” to avoid insider information about upcoming deals reaching the trading floor.
While in theory much of this could be automated or taken out of the hands of banks, we believe that the low maturity of relevant algorithms in comparison to the complexity of the activity means it will be some time before a viable alternative to human intelligence driven corporate finance is likely to emerge. The main existential threat to corporate finance is not disruptive fintech, but increasing regulation, which may eventually lead to the need to spin off advisory activity and ringfence it more effectively from trading divisions.
So, in summary, we don’t think banks are dead yet, but there are a number of areas where significant disruption is likely to soon affect the industry, some others where the emerging competition requires significant maturity development, and others where the competition is yet to emerge. Based on recent movements and developments, we anticipate the first wave will emerge soner than many incumbents are currently anticipating:
Enemies at the gate
- Trade Finance/Smart Contracts
- Smart Contracts for Mortgages and secured loans
- Peer to Peer lending
- Mobile payments and e-wallets
- Identity authentication
- Blockchain-enabled payments
- Core Bank issued Digital Currencies/current accounts
- Robo-advisors/online brokers
- ID Validation
- Cash Management
- Corporate Finance Advisory
So while payments, account management and trading will continue to underpin traditional banking for some time, the longer-term horizon looks threatening. Banks are developing strategies to respond to these threats, which we’ll cover in future articles, but we believe that if responses are not made quickly, these threats will become existential.
*NB we are including Building Societies and Credit Unions under this broad bracket for this analysis; comments applying to Banking products and services also apply to these.