How fintech is transforming the consumer experience
With fintech start-ups all the rage, we look at how these companies are disrupting the status quo of the payment and lending industry, and how we think the banks will react.
The evolution of banking
Banking first emerged around 10,000 years ago as hunter-gatherer societies started to domesticate plants and animals1. Since then, banks have embraced technology in order to keep pace with the ever-changing world.
As technological advances continue to challenge traditional banking models, the banking industry will continue to adjust and adapt to meet the needs of investors, customers and regulators.
One of the more important technological advances in banking was automated teller machines (ATMs), introduced in London in the late 1960s as a means to allow customers to simply access their cash after banking hours. ATMs have since evolved to take deposits, make payments, transfer money between accounts and today, get financial advice.
Shortly after ATMs were introduced, the age of internet banking began2. Fast-forward a few decades and internet banking evolved to mobile banking around the same time as the launch of the first iPhone3. As can be seen in Figure 1, in 2015 almost half of customers with mobile phones used mobile banking services during the previous year, nearly double the percentage just four years earlier.
The growth in mobile usage indicates an evolving preference of how customers transact and how banks deliver products. This is a function of improved technology, millennial preferences as well as boomers’ and GenXers’ increased comfort with electronic transactions, particularly through mobile banking apps. It also highlights the proliferation of mobile devices, which far exceeds the access to computers at the time internet banking was introduced in the 1990s.
As the data in Figures 2 illustrates, consumer preferences for transacting at a bank branch is steadily declining across product offerings. This is consistent with banks’ examining the ‘best-use’ for their branches and the steady decline in both number and size of the branches as digitisation increases. In the early 2000s, bank branches began to shrink with square footage declining by 50% - 65% as banks moved more products and services online, particularly to mobile applications. Given this trend in the evolution of product delivery, we believe that the number of branches will decline by half over the next 10 years as banks look to gain operating efficiencies and keep pace with customer preferences.
Current disruption – payments and lending
Payments – part one of the consumer experience
As accumulation led to “excess” over “need,” there emerged a desire to safely and securely transfer value. Originally, exchange was direct; bilateral negotiations with assets backed by physical assets (e.g. the gold standard). This concept was abandoned for fiat currencies whose value was based on government decree.
Although paper notes or cash has not significantly evolved for hundreds of years, cheque technology has advanced from the early days of physical delivery, to magnetic ink character recognition (MICR), to today’s image-capturing to increase customer convenience and reduce costs. Credit/debit card technology has also steadily improved to meet the need for increased security, the way in which people use their credit cards and card functionality has remained relatively stable, until just recently.
In 2014, Apple launched Apple Pay which promised to transform the way in which payments were made, capitalising on consumers’ migration from cash payments to noncash payments (Figure 3). Consumers’ existing credit cards are replicated on an Apple device using near-field-communication technology, allowing them to pay for goods in a retail environment using just their phones.
In addition to card payments to merchants, consumers also wanted an efficient way to pay other individuals without waiting for a cheque to clear or carrying around cash. Fintech firms have sought to fill this void, as Paypal and Venmo allow consumers to send money to each other using aliases that represent users’ accounts. The banks have responded with their own versions, with an example being Chase’s ‘Quick Pay’, and more recently the introduction of Zelle by a consortium of banks, which allows customers to move money instantaneously between banks. In fact, the uptake of Zelle has been swift, with consumers sending $75 billion in 247 million transactions using Zelle during 2017, a 36% and 45% increase in dollar and transaction volume, respectively vs 2016. We expect this trend to continue, especially as more banks join the consortium.
In the US, the volume of mobile app-based payments has been increasing steadily at a rate of 40% from 2015 to 2016, but in China the volume has quadrupled over the same period5. We expect that the US will continue to embrace digital payments, but uptake maybe slower than other countries, in part, due to higher tax regime. Recently lowered taxes in the US, could further speed the decline in cash-based payments.
Lending – part two of the consumer experience
Like payments, the practice of lending has been around for centuries. The first loan contracts existed at the dawn of civilisation and can be traced back 3,000 years from Mesopotamia. Over millennia, credit has funded agriculture, world exploration, railroads, and revolutions.
The financial crisis increased the need of peer-to-peer (P2P) or crowd-funding models, as the availability of credit declined for nearly every category of consumer loans. Concurrent with the pullback of traditional forms of consumer credit, computing power and improved underwriting algorithms made the P2P model scalable. P2P firms facilitate the meeting of predominantly retail lenders and borrowers. This decentralised lending model offers financing services online and runs with lower overheads than traditional financial institutions. Examples of P2P lending firms include Lending Club and Prosper. The result is lower rates for borrowers and higher rates for lenders than would be typically offered by traditional debt investments.
While still small relative to regional banks, the alternative lending platforms, which primarily include unsecured personal lines of credit and exclude credit cards, have increased in volume from $11.7 billion in 2014 to $35.2 billion by the end of 2016. According to research from PwC, P2P platforms in the US issued $5.5 billion of loans in 2014 and estimates the market could reach $150 billion or more by 20256.
While growth has been steady, with the exception of Quicken, virtual lenders have struggled to take significant market share from the $13 trillion traditional consumer loan market7, despite having steadily outperformed their bank counterparts in the eyes of consumers. Figure 4 shows this fact as average promoter scores, which indicate customer satisfaction, have been significantly better for marketplace lenders vs traditional credit providers. Instead, as highlighted in Figure 5 below, the lending pie has continued to grow, which suggests that virtual lenders are attracting non-traditional customers into the financial system.
Although technology has been a constant factor towards lower costs and increasing convenience, we remain skeptical that tech companies will take significant market share from incumbents due to funding structure. As observed during the financial crisis, wholesale-funded finance companies are very vulnerable to liquidity shocks. While a banking license would improve funding characteristics, the strict regulatory burden and supervisory oversight would impose significant financial and operational costs, reducing the inherent efficiency advantage they have over the brick and mortar banks.
One potential exception that GE, Target, General Motors and others obtained, but Walmart failed to get approval for, was an industrial loan company (ILC), which allows a corporation to engage in banking activities, from gathering deposits to making loans. ILCs are approved by Congress and (if deposit-taking) the Federal Deposit Insurance Corporation (FDIC). They are regulated by the FDIC and the state it is incorporated in. However, the corporate parent is not subject to the rigour of Federal Reserve Bank oversight. For instance, the corporation would not be held to comprehensive capital analysis review (CCAR) standards, leverage or liquidity requirements, giving it a cost advantage over traditional bank holding companies.
Furthermore, the cost advantage also puts a large corporation with an ILC in direct competition with community banks, which often makes it hard for local politicians to approve ILC applications. This could explain why we haven’t seen a significant uptick in ILCs, even as Square and SoFi pursue one.
We highly doubt ILCs approvals are forthcoming for large corporations such as Amazon, Apple or Google due to oversight and/or system concerns. This is in light of the repeated denials of Walmart’s ILC application, due to FDIC moratoriums on ILC formations at the time and Congressional angst for fear that Walmart would harm small community bank competitiveness.
Yet another complicating factor is loan servicing, particularly in unsecured consumer credit. While algorithmic underwriting has improved, loan servicing remains an art and - if done improperly - leads to significant delinquencies and credit losses. Over the last 30 years, retailers such as Sears, Macy’s, Target, Best Buy and Nordstrom started consumer credit businesses only to eventually abandon them to banks after significant credit losses. Early fintech results appear to prove our “art” thesis, as can be seen in Figures 6 and 7. While fintech companies have targeted “near prime” borrowers, their delinquency rates have tended to be worse than both banks and traditional finance companies.
Instead of funding or servicing loans, we believe the fintech disruption will focus on the supply chain or credit origination, earning origination fees and sales gains. As such, we believe fintech companies will continue to look to partner with banks and other traditional lenders and serve as a conduit rather than a manager of the assets.
The consolidated banking system affords incumbents capital to invest organically and via acquisitions. We have already started to see banks buy technology or partner with fintech companies, with nearly every large bank announcing either a partnership or purchases of small, niche fintech companies that lend, aggregate customer data, market products, price shops, provide software security, etc. JPMorgan’s partnership with OnDeck and Digital Asset Holdings, Bank of America’s ventures with Microsoft and Cardlytics, as well as Capital One’s many small acquisitions of fintech concerns are all examples. These partnerships highlight banks’ willingness to proactively look for ways to improve customer convenience and operating efficiencies while steadfastly protecting their turf. At these early stages, we view these partnerships and small acquisitions as relatively inexpensive forms of research and development that provide banks with the ability to eventually develop even better services in-house.
Along with the customer-facing investments to improve product delivery and customer experience, banks have been exploring and testing ways in which technology can improve back office operations. To that end, the use of distributed ledger technology, a concept introduced by blockchain9, could significantly reduce back office costs in accounting, receivables and payables processing, trust and custodial services, trade finance, and trading operations. While we see significant costs associated with fully integrating distributed ledger technology, cost savings generated by its adoption could transform the industry.
Since the financial crisis, every bank has implemented some type of cost-cutting programme. We view this technology as potentially the mother of all cost-cutting programmes, especially when combined with the efficiency gains being achieved in front-end platforms (see Figure 8). We could easily see operating efficiency ratios (dollars spent/dollars earned) decline by as much as 10-15pts, falling to the low-to-mid 40% range across the system from the roughly mid-to-high 50% range today. The net result will be lower operating costs that will flow to both shareholders in the form of higher returns on capital and customers via improved transaction execution, product delivery and security.
Conclusion: win-win for fintech and banking
We view disruption as the latest term for disintermediation. The industry has done – and will continue to do – a good job adjusting and adapting to its environment. This next round of disintermediation will benefit the banking industry by steadily and efficiently improving its product offerings and its ability to deliver those products to its customers.
The financial wherewithal of the largest banks will likely lead to significant industry consolidation over the next five years as the smaller banks will not keep pace with the speed of the advancement and thus will cease doing business or be acquired by competitors. The survivors will be well positioned to buy technology companies that improve the organic development of customer facing technologies, while steadily improving operating efficiencies that are already starting to reshape how banks deliver products.
The benefits will trickle down to consumers through faster, more transparent and secure products and services, to shareholders through higher returns on capital and to regulators through leaner, simpler and more efficient operations. We see the future as a win-win with a symbiotic relationship between fintech and the banking industry.
1. The Origins of the Modern World: Fate and Fortune in the Rise of the West. Rowman & Littlefield, 7 Dec 2006.↩
2. Banking and Finance on the Internet, John Wiley and Sons↩
3. The first Apple iPhone was launched in 2007↩
4. Federal Reserve publication: The Federal Reserve Payments Study 2016: https://www.federalreserve.gov/newsevents/press/other/2016-payments-study-20161222.pdf↩
5. Wall Street Journal publication: https://www.wsj.com/articles/chinas-mobile-payment-boom-changes-how-people-shop-borrow-even-panhandle-1515000570↩
6. PWC publication: Peer Pressure: https://www.pwc.com/us/en/consumer-finance/publications/assets/peer-to-peer-lending.pdf↩
7. Bloomberg, New York Federal Reserve ↩
8. Deutsche Bank: “State of the US Consumer.’ February 26, 2018↩
9. Blockchain is the technology that underpins cryptocurrencies such as Bitcoin and Ethereum↩
10. Morgan Stanley publication: Banking at the Speed of Light: https://www.morganstanley.com/ideas/global-banking-equities↩