Factories or supermarkets: post-pandemic banking

As we move into the inter-pandemic period, there is an interesting discussion to be had about whether the changes induced by the COVID-19 crisis are short- or long-term and to what extent those changes are an acceleration of existing trends (as I think they are, largely) or new directions for the sector. Ron Shevlin wrote an excellent piece in Forbes highlighting one element of strategic change, saying that “the new normal marks the end of fintech experimentation”. He went on to point out, somewhat harshly, that banks have used fintech partnerships as a way of convincing themselves that they are innovating rather than actually doing anything transformational.

I completely agree. I gave some seminars to bank management on the impact of technology on the business a couple of years ago, and to set up a narrative to help the executives frame my approach, I said that I thought the “fintech era” would run through to 2020 when it would be overtaken as the shared paradigm. My prediction, which I stand by, is that we are leaving the fintech era and entering the open banking era. The virus may have accelerated the transition between the eras, but it was coming anyway.

TGB Banking Eras gs

In the open banking era, fintechs will not vanish, but they will innovate and operate in a different way. They will not need to partner with incumbents, since they can use open banking infrastructure to get access to their customers’ data that the banks have, and their costs to market should be reduced through the use of standard interfaces. This means that the fintechs will be able to focus on the customer journey and user experience to bring new products and services into the market.

So what, then, should the banks focus on? At this year’s (sadly virtual) Paris Fintech Forum I hosted an interesting discussion with Simon Paris, the CEO of Finastra. Simon rather kindly reminded me of my predictions about what we now call open banking in the Centre for the Study of Financial Innovation (CSFI) report on “The Internet and Financial Services” back in 1997.

(As an aside, I remember that when the CSFI held a twenty year reunion to discuss this seminal report, it was interesting to see just how much of the report was spot on about the impact of the internet but I was spectacularly wrong about one particular point: I thought that digital TV as well as mobile would become a commerce channel. What actually happened, of course, was that the mobile became a permanent second stream for commerce.)

Anyway, Simon and I were discussing the split between the manufacturing and distribution of financial service, so I thought it might be useful to post my short and high-level recap of the strategies available to banks across this split.

Factory Reset

The techfins are the technology companies who embed financial services to make their own products more attractive but whose business model does not depend on margin in those financial services (as that Economist article noted “Amazon wants payments in-house so users never leave its app”.). The fintechs are companies who embed technology to make their own products more attractive and whose business model depends on margin in those financial services such as one of my favourite companies, Wise).

The techfins (as opposed to the fintechs) are more than happy to have banks, for example, do the boring, expensive and risky work with all of the compliance headaches that come with it. What Big Tech wants is the distribution side of the business, as shown in this old diagram of mine. They have no legacy infrastructure (eg, branches) so their costs are lower and the provision of financial services will keep customers within their low-cost ecosystems. If you use the Google checking account and Google pay then Google will have a very accurate picture of your finances. A very accurate picture indeed.

Open Banking Basic Options Updated Colour Picture

The business model here is very clear. What Big Tech wants isn’t your money (the margins on payments are going down) but your data and just as Big Tech has made ecosystems impervious to competition, so it could cross-subsidise (with data as well as with money) its financial services products to raise such a barrier to competition that no newcomer will be able to spend enough to gain traction. Hence the evolution of bank-as-a-platform for other financial services organisations to bank-as-a-service (BaaS) that Simon and I were discussing: it will be non-financial distributors who get the products into the hands of the people. Kids opening their Next bank accounts will neither know nor care that the actual account is provided by Barclays.

That’s why I have bored audience senseless repeatedly telling them that when people talk about “challengers”, they should be talking about Microsoft and Nike not Monzo and N16. If Big Tech takes over consumer relationships, banks will end up having to give away margin but, far more seriously and far more unrecoverably, data. As Andrei Brasoveanu of Accel said, if Big Tech gets hold of the distribution side of the financial services business, then the manufacturers of financial services products will be “utilities, providing low-margin financial plumbing”. Well, that’s the lucky ones. The unlucky ones will be wiped out in a wave of manufacturing supply-chain consolidation and factory closures.

[This is an edited version of an article that was first published on Forbes, 26th June 2020.]

What fintech revolution?

You may have missed World Fintech Day this year. It was 1st August, a date chosen by (amongst others) my good friend Brett King. It was a day to take some time to congratulate an industry that has achieved… well, what exactly? What is there to celebrate when the truth is that we haven’t yet had a fintech revolution or anything like one. The “challenger banks” are just banks, they haven’t brought new business models or changed market dynamics.

If you think I’m being harsh, take at look at this survey of almost 800 companies that has just ranked financial services as one of the least innovative sectors of the economy! We all expect the pharmaceutical companies, to pick an obvious example, to be more innovative than banks. And according to this survey, they are. But even the textile industry is more innovative than banking, where business models and the cost of intermediation (which I would see as being a key measure of productivity) haven’t changed for generations. Yes, fintech has brought financial services to hundreds of millions of people in developing markets, but it has yet to transform developed markets.

Even the textile industry is more innovative than banking, where business models and the cost of intermediation haven’t changed for generations Click To Tweet

Why has nothing happened?

Well, there’s a story that I tell at seminars now and then about a guy who was retiring from a bank after spending almost his entire working life there (I heard the story a couple of times from a couple of different people but as far as I know its earliest written form is in Martin Mayer’s excellent book “The Bankers“).

The guy in question had risen to a fairly senior position, so he got a fancy retirement party as I believe is the custom in such institutions. When he stepped up on stage to accept his retirement gift, the chairman of the bank conducted a short interview with him to review his lifetime of service.

He asked the retiree “you’ve been here for such a long time and you’ve seen so many changes, so much new technology in your time here, tell us which new technology made the biggest difference to your job?”

The guy thought for a few seconds and then said  “air conditioning”.

It’s a funny story, but it’s an important story because it includes a profound truth. Robert Gordon’s magisterial investigation of productivity in the US economy “The Rise and Fall of American Growth”, shows very clearly that the introduction of air conditioning did indeed lead to a measurable jump in productivity, clearly visible in the productivity statistics. Of course, other technologies led to improvements in the productivity of banks and the wider financial services sector. Computers, for example. But it took a while for them to transform anything (we all remember Robert Solow’s 1987 “productivity paradox” that computers were everywhere except for the productivity statistics) and the figures seem to show that those improvements slowed to a standstill a couple of decades ago.


with kind permission of TheOfficeMuse (CC-BY-ND 4.0)

In the last decade, the smart phone revolution does not seem to have been accompanied by any increase in productivity at all and it’s not just because half the workforce are playing Candy Crush and the other half are messing around on Instagram instead of doing any useful work. It is, as Gordon notes, because the technologies are being used to support existing products, processes, regulation and institutional structures rather than to create new and better ways of delivering financial services functionality into the economy. So while there are individual fintechs that have been incredibly successful (look at Paypal, the granddaddy of fin techs that is going gangbusters and just has its first five billion dollar quarter), fintech has yet to fulfil its promise of making the financial sector radically more efficient, more innovative and more useful to more people.

I can illustrate this point quite simply. While I was writing the piece, I happened to be out shopping and I went to get a coffee. I wanted a latte, my wife wanted a flat white. While I was walking toward the coffee shop, I used their app to order the drink. The app asked which shop I wanted to pick up the drinks from, defaulting using location services to the one that was about 50 yards away from me. Everything went smoothly until it came to payment. The app asked me for the CVV of my selected payment card, which I did not know so I had to open my password manager to find it. After I entered the CVV, I then saw a message about authentication. What a member of the general public would have made of this I’m not sure, but I knew that they message related to the Second Payment Services Directive (PSD2) requirement for Strong Customer Authentication (SCA) that was demanding a One Time Password (OTP) which was going to sent via the wholly insecure Short Message Service (SMS). Shortly afterwards, a text arrived with a number in it and I had to type the number in to the app. The internet, the mobile phone and the app had completely reinvented the retail experience whereas the payment experience was authentication chromewash on top of a three digit band-aid on top of a card-not-present hack on top of a 16-digit identifier on a card product that was launched in a time before the IBM 360 was even thought of.

Thomas Phillipon of the Stern School at NYU carried out a very detailed analysis of the US financial sector back in 2014 and found that the unit cost of financial intermediation was around 1.87% on average (which is a lot of money). This adds up to a significant chunk of GDP. Indeed, calculations seem to indicate that the finance sector consumes about 2% excess GDP. What’s more, these costs do not seem to have decreased significantly in recent years, despite advances in information technology and despite changes in the organization of the finance industry.  Earlier World Bank work looking at the impact of bank regulations, market structure, and national institutions on bank net interest margins and overhead costs using data from 1,400 banks across 72 countries tells us why: tighter regulations on bank entry and bank activities increase the cost of intermediation.

To put it crudely, Moore’s Law and Metcalfe’s Law are overcome by the actual law and the costs of KYC, AML, CTF, PEP, Basle II, MiFID, Durbin and so and forth climb far faster than costs of transistors fall. This observation in fact shows us the way forward. As technology has driven down the costs of computing and communications, the costs of shifting bits around has collapsed. But financial services is — as it should be — heavily regulated and the costs of that regulation have rocketed. The net result is that fintech has not brought about a revolution. If there is going to be such a revolution, if new technology is allowed to create new business models and new market structures, and if those new structures are to reduce the costs of intermediation, then we need the regulators to create the space for innovation. And perhaps, just perhaps, they have: open banking is the first step on an open data road that may ultimately not only revolutionise payments, banking and credit but… everything.

Banking Bubbles no attribution

@dgwbirch The Glass Bank (2020).

We all understand that the future competitive landscape is about data, so the regulators can make an more innovative platform for enterprise by opening up access to it and then providing new kinds of institutions to curate it (such as the Payment Institution in the European Union and the Payment Bank in India). This kind of regulatory innovation may allow fintech to deliver what it promised and lay the groundwork for some actual challengers. So, this World Fintech Day, let’s celebrate fintech for what it is going to bring as we move forward into the open banking era, not for what it has achieved so far.

[An edited version of this piece first appeared in Forbes, 1st August 2020.]