Consumer banking in the US is undergoing a transformation. On one hand, there is an evolving regulatory environment that is forcing cost of compliance to soar, on other hand there is rapid shift in consumer behavior. Brick and Mortar retail branches are becoming less relevant, digital usage is rapidly increasing and consumers are becoming more accepting of digital services such as Betterment, Mint & Simple. While Banks are sprinting to catch up, they fail to consider the broader structural changes in the business. The bigger threat is not whether banks are too big to fail; rather if Banks will continue to remain relevant in the future.
Traditionally, the value proposition offered by Banks to their customers included storage and management (investment) of financial assets ($), safety (insurance) and availability of credit, with transaction infrastructure enabling banks to serve these key customer needs.
One of the threats posed by cryptocurrencies like BitCoin is replacement of traditional paper currencies. While cryptocurrencies are still in nascent stage, the variability in enabling technology infrastructure across the various countries is a major hindrance to global acceptance. Most experts agree that threat of cryptocurrencies replacing traditional currencies is relatively low in medium term. However, investment and payments parts of the equation are where the industry is seeing major disruption. Let me articulate some of the emerging threats that banks face today:
Core systems overhaul and organizational problems
Most of the big banks have core systems that were designed in 1960s since then the paper dominated banking environment has been disrupted by the rise of Internet, then mobile and now disruption by wearable technologies on the horizon.
As the Internet became the new normal, banks hired coders to adapt the old systems to work in the Internet era, as mobile banking era took off, banks hired more coders to tweak existing systems further to work with emerging technologies. This is evident in rising technology cost & technology employees in banks over the years. As we leap into the wearable technology era, many banks continue to take the tweaking approach rather than a complete overhaul approach, leaving opportunities for industry incumbents & technology firms to make a move after the regulatory storm settles.
The core system tweaking approach has increased complexity in accessing and processing data, locking key customer data in various silos. Therefore, most banks cannot fully comprehend their customers’ need, which not only translates to loss of potential revenue but also opportunities for competitors to move in and better serve those needs. In an era where a Product Manager at Amazon can change pricing multiple times a day, a fee change in banks takes months to implement.
To put things in perspective, Spanish banks which are better positioned from a systems standpoint spend on average about 40 cents of every dollar in revenue on operating expenses; in the U.S., that average is 60 cents for every dollar of revenue. In 2013, BBVA compass became the first major bank in the US to replace its core system in over 15 years with Accenture Alnova platform. As noted in various media reports, earlier the bank had 26 customer information systems. Now each customer has one file covering all the accounts.
Core system upgrades are multi-year projects that run into hundreds of millions of dollars. Most big banks are still hesitant or slow about taking such a risk. A competent bank de-risks the risk of change by testing extensively and therein lays the organizational risk. There is a big disconnect between the technology and business. Many efforts to ramp up or replace systems are marred with implementation problems arising from miscommunication between business and technology teams. Banks need to simplify their organizational structures to allow for better flow of information between technology & business employees.
To stay relevant in the new world, banks need to either strategically start replacing their core systems and gradually transition to an era of more agile banking systems or start from scratch to design a truly digital bank without any migration of existing customers and then gradually migrate customers to the new bank after tweaking and testing new strategies and systems. A detailed strategic analysis is warranted before deciding on either of the two approaches. However the current tweaking approach is likely to spell doomsday for many banks
Investment Management under Threat
There are two key trends on the investments side-
1. A surge in online/mobile platforms that challenge usefulness of financial advisers by providing computer driven and flexible investment solutions to customers
2. Transparency & simplicity – there is a trend towards simplification of investment products. Companies such as Lending Club, Robinhood & Acorns (a company that automatically invests customer’s spare change) are providing simple solutions that are easier for most consumers to swallow.
Companies that have managed to offer simple to understand solutions that offer better returns (despite lack of FDIC insurance) than traditional banking products such as CDs & MMAs are seeing exponential growth in their customer base.
However, looking at the aggregated data conceals some critical trends. For one, older consumers with bigger wallets still find financial advisers relevant. One explanation for this is that older consumers tend to be risk averse and studies have shown that financial advisers are better at minimizing risk than they are at maximizing investment returns. Banks understand that they cannot match the lower cost and speed of innovation of online platforms. Further, acquiring customers with smaller wallets spreads financial advisors over a larger population. Thus, most banks are trying to acquire customers with bigger wallets while keeping those with lower wallets away by raising balance requirements for monthly fee waivers and benefits
With bigger banks focusing on older, wealthy and ultra-wealthy segments, the much larger younger emerging affluent and mass market segments are more accessible to online platforms. This strategy adopted by many banks may control the bleeding in the short run, but will younger users who adopt online platforms seek financial advice when they graduate to wealthy and ultra-wealthy segment in the long run is something that doesn’t have a clear answer.
Another idea for banks to consider is gamification of financial advice. Leveraging the HR Block type model, wherein banks provide training & online infrastructure for a monthly fee to independent advisors to lend investment advice to bank’s customers. These advisors could be rated with their average portfolio returns available publically. This essentially twists the segmentation approach to a self-selection approach wherein customers with bigger wallets can self-select advisors with better track records. This approach can also partially counter the assault by online investment firms such as Robinhood and Betterment
New Revenue Streams and Product Simplification
The only thing that is constant is change. When I look at current product offerings across Banks, I see resistance to evolve product offerings. For example for Checking Accounts there are usually 3 offerings catering to Mass, Emerging and Affluent segments with pre-defined monthly service fee structure. The fee for other services such as Non-Bank ATM use or Wire Transfers is consistent across Products. This approach has essentially converted most banking products into commodities wherein most customers base their decision on either convenience or lower price.
Banks should learn from Telecom companies that offer customizable plans to customers to differentiate themselves. Banks should offer a base product and allow customers to add or remove specific features such wire transfers or foreign transaction fee. This will allow for leaner infrastructure and thus, lower costs while providing a more engaging, tailored experience to customers.
Banks have also missed diversification opportunities, especially in the authentication and security space. For customers, protection of their financial assets is a top-most priority. The authentication space is seeing some really promising innovation for example, a company called Nymi, authenticates users by their heartbeat via an electrocardiogram (ECG) through a wrist band. This authentication system is being considered by a British bank for customer authentication.
If banks had taken a lead in development of such a wearable device and a supporting ecosystem that not only served the purpose for authentication but also that of a health & fitness tracker, they could have seen their fraud losses go down, while seeing their customer engagement go up.
Such a device, coupled with a supporting ecosystem could have helped banks generate other revenue streams. For example, banks could have partnered with insurance companies to share health & fitness data for their customers to provide lower rates or benefits (with customer’s consent of-course). Banks could also have partnered with retailers to integrate loyalty programs and speed up payment processing through such a wearable device. This wearable device could essentially replace store cards that banks offer to customers, while providing much richer customer data to banks
Threat to Payment Ecosystem
Many banks rushed to support Apple Pay as it launched in the US. Similar payment systems have failed to gain traction in the past because of point of sale execution failures. However, Apple with its loyal brand following is a credible player in the market. Most banks saw supporting Apple Pay as a defensive strategy. However, they fail to see the threat of large volumes of transactions flowing out of the traditional banking system.
Let me try and elaborate this by painting a picture. Consider the following scenario. Assume that over the next 2 years, we see a major surge in adoption of Apple Pay at both customer & merchant level. Next, Apple launches a currency which is pegged to dollar called “Apple Bucks”. i.e. 1 Apple Buck = 1 Dollar. Customers can purchase Apple Bucks which will get loaded on their mobile devices. Next Apple announces a deal with Starbucks wherein all Starbucks stores accept Apple Bucks. Starbucks in return gains data that is free of noise and gain more relevant insights on its users that allow it to better segment & target the coffee drinking population.
Right now, Starbucks loyalty program is a one size fits all approach. In the Apple bucks world, Starbucks can offer different deals to frequent & not-so-frequent Starbucks customers. Essentially, this drives a major chunk of transactions to flow out of the traditional banking systems. Starbucks can then choose to cash Apple Bucks back into dollars and can hand pick the bank that can process transactions at lowest possible rate. The altered customer & seller power paradigm is in contrast to the individual transaction based traditional interchange fee model.
Now imagine Apple making deals with multiple big retailers across the globe or what if Starbucks vendors started accepting payments in Apple bucks. The scenario I described does not consider Apple launching its own Bitcoin like cryptocurrency. The impact on bank revenues in all these scenarios will be huge. Whether Apple, Google or Facebook will decide to make such a move in the near future is something that’ll be interesting to track.
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