The Real Digital Challenge In Banking
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This article was originally published in the Autumn/November 2021 edition of International Banker.

Much has been written about the impact of digitisation in finance and banking, and one could assert that the banking industry is starting this debate from a pole position. For decades, bank processes have been highly digital. Since the 1960s and ‘70s, banks had been frontrunners in leveraging computers, being one of the first industries to build large mainframe systems and establish sizable IT (information technology) departments, benefiting from the fact that banking is about information rather than physical goods. The efficiency gains were massive and allowed today’s landscape of internationally active banks, markets and financial infrastructure to emerge. Banks also were early in using technology for client interface, such as deploying ATMs (automated teller machines)—highlighted by Paul Volcker, former chair of the US Federal Reserve, as the last useful innovation in banking—and allowing clients to access banking services electronically long before the internet even appeared.

In that sense, banks should already be digital powerhouses, but they are not. In reality, despite the significant efforts of incumbents, digitisation is today more associated with big tech and fintech (financial technology) challengers—i.e., with companies that did not exist when banks had already computerised the majority of their business. The banks’ headstart on information technology has become their Achilles’ heel. In the early 2000s, owing to cost pressures after the dot-com bubble’s burst, the willingness of banks to invest in IT subsided. Existing platforms were deemed “good enough”, and budgets to address “technical debt” were scarce. While investment in specific areas, such as risk or trading engines, continued, the core platforms on which banks relied were kept largely unchanged, given the substantial complexities and risks associated with large adjustments. These core systems may be rock-stable, but they are difficult to adapt to a world that relies on real-time processing and data interfaces across firms. However, for a large bank to replace these systems is a multi-billion effort that might enable innovation in the future, but this alone does not provide any immediate added value. Accordingly, banks have shied away from such investment, and some have tried to substantially scale down such initiatives because of time and cost overruns. Rather, most banks have pursued a more gradual approach, which, while manageable, will keep them exposed to legacy constraints much longer.

Cost-sensitivity led to another important paradigm shift. Information technology was seen as an operational commodity and cost centre, and it emerged as a primary target for outsourcing and offshoring initiatives. Banks have stopped being preferred employers for IT talent, particularly when pristine technology companies pay significantly more and offer a better work-life balance, agile environment and thriving ecosystem. While banks have tried to replicate such conditions with incubators and internal innovation hubs, these often offer the uncertainty of startups but without their agility.

The complex regulatory environment is another deterrent for innovative staff, as tight procedures and safeguards that are necessary in light of financial risks turn off those who are used to developing and implementing by trial and error. Compliance requirements also come with substantial cost that constrains and slows down investment, a hurdle that new entrants do not face, at least at the beginning of their journeys. Today, most of the financial industry has lost its ability to compete for top IT talent against technology providers that have slowly emerged as strategic threats to incumbents, especially in the areas of big data, artificial intelligence and machine learning.

As a result, more and more banks are left with rather outdated information technology that still performs but does not allow for rapid innovation. They compete against new market entrants starting from scratch, at first concentrating on simple product portfolios supported by IT systems they build to purpose without legacy constraints. Challengers tightly integrate information technology into product-development and management processes as opposed to just being at the receiving end of business requirements, which remains the way of working for many incumbents. Another important factor is investor sentiment. These days, most European banks trade at a price-to-book ratio (P/B ratio) below one, while technology innovators enjoy skyrocketing multiples even before they post their first earnings. The ability of banks under close regulatory scrutiny and capital pressures to invest into potentially risky but innovative projects is much more constrained than that of a startup, which could close down after a few years if its ideas turn out not to be viable.

Today, financial institutions are increasingly turning to cloud providers for their IT needs, obviating the need to invest in and maintain basic IT infrastructure, mitigating cybersecurity risks and thereby reducing capital intensity and cost.

For incumbents, several strategies are available, but each comes with its own drawbacks. For example, under the greenfield approach, an incumbent selects clearly defined client and product segments to start afresh on a “green field”. This allows for building products, information technology and even brands without being bound by the constraints of the existing landscape while still being able to leverage the balance sheet and market standing of the parent bank, something that takes years if not decades to build and is, therefore, not available to a new market entrant. Results mostly have been mixed. Several European banks have set up online banks or brokers and significantly expanded their market shares without cannibalising their core brands. That said, merging the “green” with the “brown” fields is difficult, although several players have targeted replacing traditional elements of their business models as soon as their greenfield ambitions proved workable, similar to a reverse takeover.

Another avenue for an incumbent is to acquire an innovator. The advantage for the incumbent is that the innovator will have already gone through some reality checks, including providing the first evidence of strategic and technological feasibility, acquiring an initial but growing client base and passing muster for investors that provided seed capital. An acquisition might be attractive to the innovator for growth through access to the acquirer’s balance sheet and scaling up. The concept is similar to that of the pharmaceutical industry, as we have seen recently in the forceful development of the COVID-19 vaccine: Often too risk-averse and not agile enough to develop revolutionary treatments, large pharmaceuticals have specialised in screening the market for promising drug innovators that, in turn, need the size and experience of multinational incumbents to get their drugs through expensive testing and approval processes and bring them to market. Transposing this model into the world of finance is challenging. Not only are those acquisitions difficult to integrate, as such integration might cause the target to lose its edge, but also, given the high valuations of proven challengers, acquiring them might be difficult for capital-constrained banks—in particular, if investors of the latter do not see such moves as value-enhancing.

Quite a sea change is happening beyond the client interface. The time of banks building their own information technology has long ended, except for the largest players, and even then, the dawn is imminent. Today, financial institutions are increasingly turning to cloud providers for their IT needs, obviating the need to invest in and maintain basic IT infrastructure, mitigating cybersecurity risks and thereby reducing capital intensity and cost. However, the development does not stop here. Increasingly, banks subscribe to services by third-party providers in areas regarded as their core competencies, including client-relations management, investment advice, risk engines, compliance models, accounts maintenance and payments. This development is accelerated by the drive towards artificial intelligence (AI) and machine learning (ML), which all need data pools so big that even larger banks cannot produce them without tapping external sources.

What is more, the size of necessary investments, talent scarcity and need to scale will make it difficult for a single bank to justify building such capabilities on its own as opposed to relying on service providers that serve several financial institutions as clients. Again, with this approach come significant risks. First, it deprives the financial institution of the ability to differentiate itself from its competition. What might not be as important in risk and compliance becomes an issue as soon as the services sourced from the outside start to constrain product design or client interface. Second, the bank becomes dependent on third parties, which is problematic: Skills that are outsourced will gradually disappear from the institutional knowledge, depriving the bank of its ability to steer and monitor its providers. There is also the risk of “vendor lock-in”, which—together with the ability of providers to scale—might cause “the tail to wag the dog”. In the end, innovative providers might become the principals of banks that have been reduced to commodities.

In light of these developments, it might seem that the future of traditional financial institutions is bleak, but it is not. There are important value propositions that technology providers, including the biggest ones, are not and may never be able to offer.

Partnerships and joint utilities can be solutions in which the potential for differentiating is limited and where scale is king. Successful examples include financial infrastructure providers and payment systems, of which many have emerged as coordinated efforts with banks and other financial firms, such as brokers. Today, efforts in the areas of wholesale digital currencies or the recently unveiled European Payments Initiative (EPI) follow such a coordinated approach. However, establishing such initiatives and keeping them afloat are not easy tasks, as consortium members might decide to free-ride or behave opportunistically. Anti-trust concerns may become relevant as well. Still, such efforts deserve a benevolent or even encouraging attitude from policymakers as long as they promote the public good, such as financial stability or strategic resilience.

In light of these developments, it might seem that the future of traditional financial institutions is bleak, but it is not. There are important value propositions that technology providers, including the biggest ones, are not and may never be able to offer. First and foremost, clients entrust banks with their money and personal information. As long as this trust exists, banks enjoy a significant competitive advantage over the many technology providers, some of which are under regular attacks, given data abuses and protection failures. Fintech challengers have already realised that clients are unwilling to accept the sometimes dismal customer-service attitude found in the ecommerce and digital-services sector. But this also has important lessons for traditional financial firms: They would be ill-advised to replicate practices that at first sight seem to be acceptable in the digital world, such as refusing to provide clients with access to human staff if they so desire. Also, they should resist compensating the service providers on which they rely by “paying with the data of their clients”; they ultimately are responsible for defending their clients’ interests as they partner with external technology and service providers. On the other hand, a strategy that relies on regulatory red tape to keep new competitors away will not work in the long run. The financial firepower of challengers and their investors is just too big, and regulators will continue to adjust the rules to facilitate such competition, as was done with the European Union’s (EU’s) Payment Services Directive 2 (PSD2). As long as there is a level playing field on financial safety and integrity, there is simply no political justification for not encouraging competition.

In the future, banks as institutions will still play a role in providing core functions and services for the entire economy. However, even the largest players will increasingly need to rely on third-party providers not only for commodity services but in core areas of competency. Still, their roles as trusted financial intermediaries will not be successfully challenged as long as they provide competitive services in those areas in which they can differentiate themselves from old and new competitors and deploy the necessary investments in targeted ways.