This article was published in American Banker on June 27, 2022.
The banking system for the past decade has sidestepped the sorts of crippling crises that used to be commonplace. In the past two years alone it has passed three major tests of its resilience. The immediate future looks good, too: interest rates are heading higher, which should boost profitability in coming quarters.
On the face of it, the US banking industry seems like it has hit a rare, extended period of calm and prosperity.
But underneath this placid surface, big shifts are taking place that are changing the industry as we now know it. A new and larger finance industry is emerging from the ground up — one in which traditional banks, insurers, and asset managers aren’t nearly as dominant as they used to be.
In 2012 these incumbent firms accounted for 90% of the total value of the financial services industry; today their share is just 65%, according to new Oliver Wyman research (State of the Financial Services Industry Report, titled The Tectonic Shift Between Risk, Data, and Technology). Big technology companies, as well as financial infrastructure and tech companies and various others, now account for fully 35% of the industry’s value.
Finance and tech business models have been converging for years, of course, but the pace is accelerating. Businesses providing digital wallets, embedded finance, digital identity, digital assets, central bank digital currencies (CBDCs), climate data, and Metaverse offerings are sprouting up everywhere. While the top incumbent firms have increased their shareholder value by about $1.3 trillion over the past decade, according to Oliver Wyman research, the non-incumbents have increased their value by $3 trillion.
To be sure, many newer entrants are facing stiff headwinds at the moment. These “digital asset” firms took off like rockets over the past few years, amassing a collective peak value of $400 billion in early 2022, according to Oliver Wyman research — but they are now undergoing a serious shakeout reminiscent of the internet stock collapse of 2000. Still, just as Amazon, Ebay, and Google emerged from the dotcom collapse, valuable, defensible business models are emerging from the current finance-industry retrenchment.
The good news for banks is that they are strong enough now to not only defend themselves from this challenge but to embrace it.
That’s because banks have passed three major tests in recent years. First, the pandemic created far lower credit losses than expected, allowing the financial system to play a vital role as an economic shock absorber rather than be an epicenter of crisis.
Amid the war in Ukraine, meanwhile, the financial system has served as the main deliverer of economic sanctions policies — and is absorbing losses without any signs of contagion risk so far.
And financial services firms are also playing a leading role in the climate crisis, making ambitious net-zero commitments and pouring huge investment into helping corporate and retail customers achieve their own net zero transition plans over the coming years.
Many large banks believe they have caught up on digital transformation. To their credit, they have significantly increased the quality of services delivered through mobile apps, closing the gaps in customer service and retaining customers, and have digitized internal processes to make their operations more efficient.
But the banks that thrive in the next decade will make an even bigger pivot now — and if they can do so, the opportunities will be huge. The banking and financial services industry of the future will be split among three main services — risk intermediation, value technology, and connected data — with some other possibilities worth exploring.
Risk intermediation is the traditional role of financial firms: matching those who have the money with those who need it. The lenders take some financial risk along the way — credit risk, market risk, interest rate risk, and so on. This is the core of the incumbent industry.
The problem is that risk intermediation services require enormous capital, and during the past decade of ultra-low interest rates they have been in low-growth mode. No doubt the shift to rising interest rates will change this and lead to better returns for risk intermediation services. But the business is mature if not saturated — so growth will happen only when a rising tide lifts all boats.
Value technology, meanwhile, is technology that is being used to deliver new services to end customers, rather than just improving an operation or function. The industry has experienced a 10-year explosion of growth in payments and transaction-related services, most of which were garnered by merchants including big tech companies such as Alibaba, Amazon, and Ebay, as well as new players like Paypal, Square, and Circle.
Now, focus is shifting toward monetizing new technology such as digital assets, tokens, and decentralized finance. At the same time, both incumbents and new players are looking for winning models in wholesale services such as through banking-as-a-service.
Connected data consists of services that use data or connect with different data sources across ecosystems to create value for customers, such as helping them manage their financial wellbeing or making it easier to manage logistics, real estate, mobility, health, and so on. Initiatives like open banking have not yet led to the sort of data-sharing explosion we project, but the acceleration in growth in wallets, financial life coaches, embedded finance, and so on all show that the potential from connected data services is starting to be realized.
There are other possibilities as well. With so much change afoot, it is possible to conceive of strategic moves that could accelerate these value shifts even faster through some combination of cooperation and competition — or “co-opetition.” A big tech company that is served by a utility bank, for example, could conceivably amass a $1 trillion balance sheet. A big tech in strategic combination with a giant international bank could build banking dominance in all of its non-domestic markets. The possibilities are limitless.
But to capture these future spoils, banks will need to pivot aggressively — now.