The promise of fintech in banking

As noted in my first post, fintechs have rushed to fill in the gap between consumer expectations of banking and the often sad reality of banking. But what is banking, exactly? In this post I look at the overall market for consumer banking services, disaggregate the bank stack, and analyze the opportunities for fintechs in each layer of the stack.

The opportunity

We know that customers — and millennials especially — are hungry for banks that serve them better. According to Business Insider, incumbent banks risk losing 11% of their retail customers if they don’t repair the relationship, resulting in a loss of $344B in deposits and $16b in revenue.

There’s also a whole slew of people who aren’t part of the consumer banking market. According to a survey by the FDIC, more than 25% of US households were un- or underbanked in 2017. These households either don’t have a bank account, or, if they have one, still use services like payday loans outside of the banking system. Some of these households don’t have enough money to keep in an account; others don’t trust banks. These un- and under-banked represent a tremendous opportunity, both a large market for companies willing to understand prospective customers with different needs, and a social impact opportunity to connect more than 32 million households to the broader financial system — and that’s just in the United States.

Disaggregating the bank stack

Let’s make sure we’re on the same page: what is banking? And where could fintechs leverage their particular strengths and advantages to provide a cheaper, more secure, easier to audit, or otherwise better service than traditional banks?

• Distribution: Before the coronavirus crisis hit, pushing business to shift online almost instantly, legacy banks relied on brick and mortar branches, direct mail, and product cross-selling. We’ve all gotten credit card applications in the mail and seen ads for other services on our paper statements. Traditional banks are working on building a digital marketing footprint to replace — or at least complement — their former reliance on a physical catchment area around their branches.
  Fintechs are often digital-only and focused on a niche demographic, say: parents (Current), folks with an uneven banking history (Varo), people in recovery (True Link), seniors (also True Link), freelancers (Azlo, Lili, Oxygen, and several others). They often rely on generous referral programs, based on the hypothesis that their business can grow with significantly lower customer acquisition costs (CAC) — after all, they don’t need to bear the overhead of physical branches, a serious advantage over legacy banks. The challenger bank playbook is predicated on a better ratio between CAC and lifetime value (LTV.)
• Products: Traditional banking products have long been both indistinguishable and opaquely priced. If you’ve tried to get a mortgage, you’re familiar with the struggle: ARM or 30-year fixed? What about points and PMI? Do these even make a difference, and is it worth shopping around? Challenger banks are speaking directly to consumer frustration with fees on services that seem like they should be standard, e.g. payments and transfers. Many are doing away with these fees completely, refusing to charge overdraft fees, transfer fees, or minimum balance requirements. For example, Robinhood was a pioneer in offering zero commission trading to its clients in 2013. By late 2019, legacy brokerage firms Schwab, ETrade, TD, and others all followed suit. [More on incumbents in Post 7.]
• Processes: Some legacy banking operations are still paper-based, and many banks still operate in an environment restricted by internal and external regulation. Fintechs can build processes from scratch, resulting in digital-first, automated, and/or AI-powered processes that often use new or different types of data. This is what Lending Club, Prosper, and other P2P loan providers did for personal and business lending, and many others have done with all-digital account opening.
• Legal & Compliance: Similarly, legal & compliance often limits incumbent banks. After the excesses of the financial crisis, legacy banks’ compliance teams may still be cautious about offering services that aren’t clearly covered by existing regulation. Challenger banks may be less gun-shy in forging forward — as mentioned in post 1, most challenger banks are effectively renting another bank’s charter in order to operate at all. This can provide an opportunity for fintechs to build compliance programs that address products or markets that banks aren’t nimble enough to tackle. Fintechs have the compelling chance to be able to carefully build their compliance program in order to address their real risk in response to a defined risk appetite, unencumbered by historical inefficiencies and outdated compliance systems. For business-minded compliance leaders, this also provides the opportunity to leverage technology in order to avoid the cumbersome customer experience that is often unavoidable at legacy banks. Fintechs that see legal and compliance as a strategic advantage get to create companies that will leap over their competitors when regulators inevitably engage deeply in the industry. [More on bank charters in post 3, and on L&C as an opportunity for fintech in post 4]
• Technology: Underpinning all of this is technology. According to Quartz, “Common Business-Oriented Language — the ancient computer code better known as COBOL — was developed in 1959 as a business-focused standard programming language, and is still relied upon by banks around the world. It’s responsible for $3 trillion in commerce in the US every day. As of 2014, 92 of the top 100 banks, as well as 71% of the companies in the Fortune 500, were still running COBOL programs on mainframe computers.” Reuters has a some striking numbers on the continued prevalence of COBOL:

Fintechs, unencumbered by legacy systems and massive operations that require round-the-clock support, can build in a way that is optimized for rapid product development and deployment, new use cases, security, transparency, information aggregation, and smoother customer referrals.

For example, Personal Capital was one of the first to offer users an aggregated view of their accounts at different institutions — a simple but then-novel and useful feature. Over the last few years, however, it’s become a standard offering for most online banking platforms.

But wait, there’s more!

Open banking, a.k.a. EU Directive PSD2: Open banking gives individual users — not banks — control over their data. That aggregate account example you just read about? Open banking would allow users to pick and choose banking products no matter the institution that created them. So you could seamlessly benefit from the best rate on your mortgage, the highest APY on your savings account, and the most interesting investment offerings, all in one place. Open banking has shoved open the door to massive innovation in banking, with fewer restrictions or scale requirements, changing the game for fintechs. In 2019, Visa acquired Plaid, a financial services API company, for $5.3 billion. UK-based Railsbank, an open banking API and platform that provides regulated and unregulated companies access to global banking, raised a $10M series A last year, and launched its credit-card-as-a-service in the US last month. Railsbank’s first US client? A challenger bank targeting high-earning professionals.

A final twist: European Invaders

In the last 12 months, neobanks N26 and Revolut have entered the US from the UK and Germany. They’ve come in strong, with large home-market consumer bases from which to extract and observe customer data, experiment, and iterate. Will their insights translate seamlessly to the US and allow them to sweep the crowded US market?

Many thanks to Simone Garreau for her contribution to the Legal & Compliance section of this post. Keep an eye out for more insights on fintech risk from Simone!

This post is the second in a series covering the revolution taking place in banking. Post 1 pointed out the drivers of disruption of traditional banking. Post 3 will examine whether a bank charter is really necessary for banking. Post 4 takes a look at the fintech party happening in the banking back-office. In Post 5, I look at how Big Tech has crept into banking services. I analyze all of these new players’ tactics at getting into digital banking in Post 6, and take a close look at incumbent banks’ attempts to fight back in Post 7.