It was not just a loss of confidence in traditional institutions that has accelerated the pace of change but some fundamental changes in the world we live in. The information age brought in its wake unprecedented connectivity and networks. The ability of the average consumer to have instantaneous access to vast amounts of data and to communicate in real time with others has been an absolute game changer. Social networking and peer-to-peer networks complete the picture, disrupting both traditional forms of distribution as well as product development cycles.
It is against this backdrop that we need to consider the future of banking. Heavy and costly marketing and sales structures for customer acquisition and building trust characterized old school banking. Bank branches were often modeled as “cathedrals of money” to give customers a sense of safety and security. Once a customer was locked in, switching was often difficult due to artificial barriers placed by both regulators and the banks themselves. Institutions developed mass-market products with little thought for the use cases or indeed the end user. Customization was available only to the privileged few. The model relied on a large up-front investment in acquiring customers with an annuity-type revenue stream over the lifetime of the customer through transaction fees as well as fees based on assets under management. Behind all of this was a vast investment in branches, back offices, compliance and regulation and sales forces.
The old school banking system bundled a number of different elements:
· an infrastructure business run as a utility;
· a high-value, high cost-customer relationship business focused on turning knowledge of the customer into custom services; and
· a product innovation business with its entrepreneurial culture, innovation and related R&D costs.
Over time, most institutions have converged on this same strategy. As a result, innovation in the industry has been virtually non-existent. When an industry sells the same product to the same customer base, the products themselves become a commodity; this is where we are today. Competition has led to eroding margins (particularly in a low-interest-rate environment) while legacy costs remain the same. These low margins led to banks speculating to improve their bottom line, and we all know where that ended up.
The good news is that a new wave of early-stage companies has emerged, and thrived, taking advantage of the dislocation caused by the financial crisis. We at Anthemis have been fortunate to back many of these pioneers, including Simple, Movenand Betterment. These new companies have three things in common:
1. the lack of costly legacy infrastructures;
2. a focus on customers when designing products; and
3. low-cost digital distribution.
On the latter point, I always liken this to what Amazon did to the book-selling model, by initially using a digital distribution model for a physical product and then digitizing the product itself so that the requirement to have a physical infrastructure disappears. What is fascinating is that financial institutions have traditionally used a physical distribution infrastructure to distribute entirely digital products!
Many of these companies leverage existing legacy infrastructure and innovate on top. For example, even though Simple and Moven own the customer and take deposits from them, the deposits themselves sit with regulated banks. This allows them to concentrate on the customer and the distribution layer while outsourcing the regulated/ infrastructure pieces to traditional players. This is essentially an unbundling of the traditional banking structure; now different parts of the value chain are run by distinct organizations working together.
A number of additional factors have contributed to this rapid change. Increasing interoperability and hyper-connectivity are allowing customers to switch providers easily and therefore disrupt the original model of high acquisition costs with long payback periods. Therefore today’s competitors need to acquire customers cheaply in order to survive.
Peer feedback and referrals are changing how “relationships” and trust are built, replacing the need of costly marketing, branding and relationship managers. This is now spilling over to the corporate banking world as the use of networks to compare and contrast has moved into the realms of SME and large corporate customers.
The revenue model itself has started to shift from high-value low-frequency to very low value but extremely high frequency, with micro-fees providing recurring revenue, undercutting the traditional banking margins and fees.
Technology is also displacing the need for proprietary high-cost networks, dramatically lowering the barriers to entry. So, the differentiator is no longer going to be the infrastructure a customer has access to (this becomes a given due to the ubiquity and availability of underlying infrastructures) but the product itself and how this product fits the customer’s needs. Indeed, the real innovation happening today is the creation of a data-centric customizable product that relies on technology and not human intervention to serve a customer. The advantage is that this shifts traditional high-cost infrastructures to low-cost models where the marginal cost of production tapers off rapidly.
So what does that mean for traditional institutions? One only needs to look at incumbent models that have been disrupted by new models (book-selling, photography, etc.) to see what happens if incumbents do not evolve. First and foremost has to be an unbundling of the current model with a focus on part of the value chain, be that infrastructure, distribution, or product innovation. Indeed we have always argued that these businesses need to be separate as the returns on capital employed are dramatically different for the three pieces. For example, infrastructure businesses require significant investment and should be stable and low risk and provide utility-like returns — in practice low double-digit returns on capital employed. On the other hand distribution and product innovation are inherently riskier businesses and therefore should provide venture-like returns. So incumbent institutions need to pick their spot.
Ultimately this specialization will see some institutions becoming infrastructure players with scale, stability and security at the heart of their proposition, while others will choose to become product factories with significant R&D spend, and still others will focus on distribution and the customer interface. A few players may be able to compete in multiple parts of the value chain but the vast majority of the industry is likely to have to choose where to play.
Underlying this theme is the concept of true “cooperitition” where institutions may both cooperate and compete with each other. For example, incumbent institutions may have selective distribution of their own while partnering with other companies to give them access to their underlying infrastructure. Ultimately this behavior will be driven by harsh economic realities – you need to feed the machine for it to survive.
None of this philosophy is particularly new to Anthemis. When we set up in 2009, we saw the traditional vertically-integrated banking structure stratifying into distinct horizontals (in much the same way the IT “stack” has now stratified into hardware, software, connectivity, etc.) with different people playing at different levels financed by appropriate risk capital. We are now starting to see a real movement in this direction as severe economic conditions start to pinch the incumbents. We do not see a Kodak-like demise for the incumbents. But we do expect a relatively rapid retooling and repurposing by organizations to embrace this new paradigm. Ultimately it will be those with the gumption to go out and really adapt their models to reflect the change that will reap the greatest rewards and steal a march on their competitors.
Udayan Goyal, who has completed over 200 deals in the fintech space, is founder of Anthemis group, a company focused on reinventing financial services for the 21st century. He was formerly the managing director and global head of financial technology advisory at Deutsche Bank in the London-based global Financial Institutions group. Prior to that, he had specific responsibility for developing the pan-European specialty finance practice of Credit Suisse, with a focus on financial technology.