You can blame it on the 2008 economic crisis, the current pandemic, the latest technologies, AI, industry initiatives to boost innovation and competition, Facebook’s Libra, CBDCs projects, or on Donald Trump … but digital transformation in banking and payments is inevitable.

What’s going on with (the legacy) banks?

Banking is one of the business sectors most resistant to technological disruption. Small wonder, as consumer inertia in financial services is high. The typical bank customer has generally been slow to change financial-services providers. At industry events we often hear the joke that one is more likely to change their partner than their bank.

If we were to characterise banks, their main features would include1:

  • they are highly regulated institutions
  • they generally hold a monopoly on credit request and issuance
  • they are the major repository for deposits, which customers identify with their primary financial relationship
  • they continue to be the gateways to the world’s largest payment systems
  • they generate enormous amounts of investments capital

But things are slowly changing. The financial crisis has eroded trust in banks. The advent of smartphones enabled a new payment paradigm as well as personalised customer services. The ubiquity of mobile devices began to undercut the advantages of physical distribution that banks enjoy.

Large banks are investing considerable sums of money in new apps, chat bots, and APIs. Many banking executives consider that they have met their organization’s digital needs in that they have developed a mobile app. Most of these efforts are fruitless. They are merely replicating, by
technological means, the consuming model that financial services used many years ago.

Let us take, for instance, what happened with bank branches during the lockdown: they got closed as their customers were no longer on the streets. By shifting their presence online, they forced the banks to adapt. The ones prepared for the digital era had already activated their digital channels (by promoting the ability to cash a check remotely, conducting person-to-person or intrabank transfers, video chat with a banker, deploying virtual banking assistants, etc.). Thus, customers could bank from home. Other banks weren’t equally prepared.

Rather than treating digital technologies as an afterthought, legacy banks need to completely rewire their ethos and mindset for the upcoming digital age. In Doing Digital: Lessons from Leaders, Chris Skinner talks about the need for banks to rethink their products and services, to restructure and fundamentally redesign their core system. A bank must change its fabric, and foundation to become digital over the next 5 years.

A new wave of ‘bank disruptors’ are coming

A new wave of disruptors are coming with a mission to make ‘clunky and dated bank’ better. Many businesses are going remote and need to adapt to the online environment, especially during this Covid-19 period. This fact is stressed by the huge amounts of dollars invested in ‘regtech’ and in onboarding solutions to help financial institutions meet heightened regulatory requirements.

Fintechs focus on doing brilliantly one thing that the banks do terribly. Those that target the retail market (consumer finance, mortgages, lending to small and medium-size enterprises, retail payments, and wealth management) are offering users services in real time, anywhere. Others, like Macropay2, are solving pain points for retailers that want to offer the right payment mix to their target audience to capture the same seamless user experience. Furthermore, many of them are serving SMEs but also the unbankable – the people who cannot be served for a number of reasons by legacy banks.

Many SMEs have been forced by current societal changes to close their business due to lack of cash flow (with the most affected being those working in the services and hospitality segments). How do banks deal with struggling SMEs? They leave them queuing for loans only to deny them in the end. What about challenger banks? Tide and Starling Bank seem to be able to provide the right service, with money from government-backed loans in the account in a few hours.

On the negative side, we have stories like Wirecard, in which a promising Financial Institution, with a strong reputation, had committed accountancy fraud. Customers concerned that the challenger banks do not have the staying power of the incumbent high street banks, turn their backs on Monzo and Revolut as fears mount over profitability.

McKinsey3 describes fintechs falling into four broad categories:

  • new entrants, startups, and attackers looking to enter financial services by developing new approaches and technology.
  • fintechs set-up in-house by an incumbent institution – institutions invest internally in technology to improve performance and face down competitive threats from the outside.
  • large technology companies offering financial services of their own – to enhance existing platforms (e.g. AliPay supporting Alibaba’s ecommerce offering) and to monetise current user data or relationships.
  • infrastructure providers that offer physical technology and software to institutions, to improve risk management, and to boost customer experience.

The drawback for the first category is the cost of customer acquisition. The majority of fintechs must build the most important asset of any business, the customer database, from scratch. Banks already have them, and, in most cases, startups find it difficult to acquire them cost-effectively. However, for the third category, ‘bigtechs’ have a major customer acquisition cost advantage, relative to that of smaller fintechs’.

When banks and fintechs’ powers combine – ‘coopetition’

To scale up, many fintechs partner with major banks if their business model is to be viable. As McKinsey mentioned, successful fintech attackers will embrace ‘coopetition’ to find ways to engage with the existing banking ecosystem. For example, Lending Club’s credit supplier is Web Bank, and
PayPal’s merchant acquirer is Wells Fargo.

Banks like JPMorgan Chase (USA), BBVA and ING (Europe), and DBS and CMB (Asia) have already grasped what financial services provision looks like in a digital economy and are reaping the benefits. A strategy for these banks has been to partner with or purchase startups and fintechs. On its way to digital transformation, BBVA launched its API Market. This way, the bank gets a wide network of third-party customers accustomed to using its products via nonbanking channels, building up customer familiarity with its services across different platforms. Moreover, by engaging with external developers via its sandbox to ensure they find its APIs useful, BBVA has cemented its access to a broad range of new developments.

Saving the last dance for the consumer

It is all about customer service. As Penry Price (Vice President of Global Marketing Solutions at LinkedIn) said: ‘Fintech firms are finding success with a customer-centric focus that fills in gaps left by traditional firms. These gaps opened the doors to fintechs.’ Still, he added ‘Trust in traditional firms remains important to customers.’

  1. McKinsey & Company
  2. The Paypers
  3. McKinsey & Company