Rethinking Banking
Banking

Rethinking Banking

Thousands of new business models are sprouting up in the finance industry; investors are betting billions on the Fintech scene. While it may be surprising at first glance, traditional banks are among those profiting from this transformation.

Mike Cagney often invites groups of carefully selected customers to his home in San Francisco. Fine wines are enjoyed, gourmet pizza proffered. But Cagney is not hosting a culinary event; his focus is on conversation with his customers. His online financial services company, Social Finance (SoFi), cultivates an especially intense style of customer relationship, hosting more than a hundred such gatherings each year. These events are supposed to move millennials to completely rethink their banking relationships and become lifelong SoFi customers.

It may be surprising to learn that digital revolutionaries rely on (analog) relationship management. But the personal note and the services they provide clearly pay off. Cagney and three other graduates of the elite Stanford Business School started the company in 2011 as a small niche provider in Silicon Valley while they were still at Stanford. Today, according to its own information, it counts more than 85,000 "members," as its customers are known, it has lent more than 7 billion dollars, and its investors estimated its value at around 4 billion dollars at the latest round of financing.

Martial Rhetoric

Initially SoFi refinanced huge student loans at good terms for graduates of top American universities. The SoFi platform connects participants directly, enabling debtors to connect with prosperous alumni who offer them better terms for student loans than the banks do. SoFi now also offers personal loans and mortgages, and institutional investors' funds are supplementing those of private investors. Next up, the company, which is just a stone's throw from the Golden Gate Bridge, has its eye on checking accounts, insurance services, and asset management. 

For the long term, Cagney wants nothing less than to see his "non-bank bank," as he puts it, replace traditional banks. "We're trying to make these guys dinosaurs," he says, with equal parts confidence and media savvy, "and I hope to be the meteor that does them in." None of which, by the way, prevented SoFi from entering into a cooperation arrangement with Credit Suisse so that it can finance those mortgages. Despite the martial rhetoric, the emerging companies increasingly view traditional banks as partners.

What Exactly Do Fintechs Do?

With Cagney's high-flying plans and catchy announcements, SoFi is attracting a lot of attention. But this company is just one of many with similar intentions. Around the globe, thousands of Fintech companies have set about breaking apart the banks' integrated value-creation chain and rethinking and rearranging the individual parts. In the process, they have elbowed out a few intermediaries, as SoFi has done, where debtors and creditors organize themselves. Fintech's goal is to disrupt the financial industry and to secure a part of that market for itself. The tools: new digital technologies, algorithms and data sciences; new business models; simpler, more efficient and more cost-effective services; and financial services tailored to the needs of the new generation of customers equipped with mobile phones and tablets.

Many Fintech startups are plowing the same field. Almost half offer solutions for payments. That's where banks have the greatest transaction volumes to lose. "Due to the numerous new providers, the shift in payments is well under way, particularly in the UK and the US," according to Julian Skan, Managing Director of Financial Services at Accenture, a consulting firm. "A lot of value from payments has slipped away from retail banking, and it won't be coming back to the banking sector."

Credit Suisse works with Accenture, for instance, at the Fintech Innovation Lab, a mentoring program for young business people. Urs Rohner, Chairman of the Board of Directors of Credit Suisse, sees opportunities for traditional banks in the rise of Fintech. "Innovative disruption, in the finance industry as elsewhere, makes existing services available to a much broader group of consumers, whether because of price or improved user friendliness. And they are often combined."

Major Fragmentation

More and more companies and customers, especially younger ones, no longer head to a retail bank first. Instead they use options provided by individual product specialists. Anyone who pays or receives money over the internet or on a mobile phone, anyone who needs a payment system for their online or brick-and-mortar shop – they use services with names like Venmo, Klarna, Square or Stripe. When you want to send funds in a different currency, you turn –to TransferWise, Azimo or WorldRemit. Nutmeg or eToro manages your assets, Betterment or Wealthfront manages your personal finances, and stocks are traded – free of charge – with Robinhood. Looking for a personal loan? Go to Borro, Zopa or Ox. Business loans can be financed online at lending market places like SoFi or Funding Circle.

Each new product and each new service must offer some advantage over traditional options. One advantage is that they generally are integrated into a longer consumer chain. One example is Uber, the California mobile ride request company based in San Francisco, also a Fintech company. With one click, everything is taken care of: request, ride, pay, get a receipt.

In spite of the ease that these individual services offer, there is one undeniable disadvantage. Where in the past a person had one bank that was responsible for all money matters, the Fintechs expect an individual to be willing to use untold numbers of different services and products. That doesn't appear to bother a lot of people and companies, especially younger ones. They are used to fragmentation on their smart phones, where even the smallest need is covered by a separate app.

Investments Tripled

Investors at least are firmly convinced that Fintech companies, with much ambition and few constraints, will change the industry. Gold rush fever prevails. According to Accenture, worldwide investment in Fintech more than tripled in 2014 alone, reaching more than 12 billion dollars.

It's no wonder that Fintech has developed into one of the most active investment fields for risk capital lenders. Goldman Sachs estimates that startups could challenge established financial services providers to the tune of up to 4.7 trillion dollars in sales and profits of 470 billion dollars annually. A company that captures a market share of less than one percent could still claim a handsome business. 

So that's why investors are putting billions into thousands of companies whose valuation on paper skyrockets, in the hopes that one or the other candidate proves to be a jackpot. In 2010, 220 venture capitalist companies invested in Fintech startups. By 2015, CB Insights, a market research company, had almost 900 active investors. Top venture capital companies, like Sequoia Capital, Union Square Ventures, Index Ventures, Greylock and Benchmark, are concentrating on the following areas: offers relating to payments, financial bookkeeping for individuals, lending and digital currency like Bitcoin and its centerpiece, the blockchain. All transactions are registered in a global database, which facilitates infallible exchange of values, not just the bitcoins themselves.

The Procedure

All of these emerging companies pursue similar strategies. They concentrate initially, like SoFi, on parts of banks' value creation chains. When they've had a certain success, they quickly expand their offering to include entire business models that can pose a real danger to banks.

Even some representatives of the establishment are beginning to sound like Silicon Valley raiders in suits. "Many conventional banks are going to fall by the wayside," according to Francisco González. "Those that make it will no longer be 'banks,' but software companies, competing with the digital players and with a completely different value proposition." Last year González, Chairman and CEO of Banco Bilbao Vizcaya Argentaria (BBVA), a major Spanish bank, predicted that up to half of banks around the world would disappear in the wake of this digital disruption.

One look at Amazon's transformation of the retail sector, Airbnb's disruption of the hotel industry, and Uber's blow to the taxi industry shows that banks had better take these ambitious upstarts seriously. "Other – typically unregulated – industries have reset consumer expectations when it comes to the customer experience. This results in pent-up demand within financial services. The incumbents, however, are preoccupied with other activities and this opens the door for new entrants," says James Dickerson, Program Director, Fintech Innovation Lab, Accenture, in London.

Banks were able to avoid the violent upheavals of digitalization for quite a while. So according to Dickerson, "Banks have not been forced to innovate to compete like other industries have because the regulator has shielded them. In addition to that, this industry is much more complex than, say, transportation, retail or music and therefore more difficult to disrupt."

In fact, reality has relativized investors' high expectations. The challengers are still in the starting blocks, and very few Fintechs have been able to conquer noteworthy market shares.

No Tsunami

And even as aggressive attackers from California's technology valley who want to turn the industry on its head make their pronouncements, Accenture consultant Julian Skan takes a more relaxed view on Fintech. "We don't think this is a tsunami that will destroy the sector." Skan certainly believes that digital transformation holds the potential to reduce the role and relevance of traditional banks, but at the same time those banks could, like the startups, use that technology to create faster, better and cheaper services. "We have always felt that this will depend on speed, that the value will be created largely through the existing banks, and that the faster they adopt the technology, the better their first-mover advantage will be."

Many startups and banks are taking note. They have now moved from confrontation to cooperation. Both sides could derive great benefit from these developments. Banks can profit from the Fintech's knowhow, their agility and proximity to young customers by integrating Fintech's innovations in their own products. On the other side, Fintechs want to make use of the established banks' expertise acquired over centuries, their familiar brands, gigantic customer base, licenses and, not least, their customers' trust.

Even startup entrepreneurs – by definition, optimists – know that this will help them improve their poor odds of survival. According to the statistics, 80 to 90 percent of all technology startups disappear within a few years of their founding. One study by Stanford and the University of California at Berkeley concluded that a massive 92 percent of tech startups failed within the first three years. Young entrepreneurs have an even harder time in the strictly regulated financial industry than in other sectors.

"Frenemies"

As a result, Fintechs and banks are increasingly going over to the "frenemies principle", as illustrated by the cooperation between SoFi and Credit Suisse. A rival (enemy) you depend on becomes a business partner (friend).


Credit Suisse manages its own Fintech investment fund, Credit Suisse NEXT, which, for example, was the leading investor in a 165 million dollar financing round for Prosper, a peer-to-peer lending platform. (Peer-to-peer refers to an arrangement in which private individuals are connected directly with each other, not as conventionally, companies connected with private individuals.)

Urs Rohner, Chairman of the Board of Directors of Credit Suisse, says, "In the end, cooperation remains the most promising option, both for established banks and for innovative startups. It helps by reducing increasing cost pressures and by increasing the efficiency of process flows, and all of this helps increase the longevity of your business."

Other banks are cultivating frenemy relationships with Fintechs too. JP Morgan Chase, for instance, recently merged with On Deck Capital, a peer-to-peer lender, in order to offer loans to small businesses over the internet. Canada's Scotiabank, together with investors like Santander and ING, is investing 135 million dollars in Kabbage, a step aimed at opening the path to cooperation between the trio of banks and the American operator of a platform for small business lending.

Taulia, a financial supply chain company, is cooperating with the Royal Bank of Scotland and has obtained risk capital from BBVA Ventures. "The global reach of BBVA in Europe, North and South America will support Taulia's global expansion over the coming years," said Markus Ament, a German co-founder of San Francisco-based Taulia, who like so many young entrepreneurs wears a beard out of biblical times. "Banks finally now see that parts of their traditional business are at risk. Smart financial institutions are now engaging, either through investments, partnerships, or by their own internal incubators to drive innovation."

Even TransferWise, a startup whose peer-to-peer platform allows users to transfer funds to a different currency area at fees lower than banks, is allying with banks. The London-based company's email welcoming new members still declares, "Congrats on waving your bank bye bye." Nonetheless, in December TransferWise entered into an initial agreement to work with LHV, Estonia's largest bank. TransferWise members can now use its services through the LHV app and website. More such agreements are expected to follow in Europe and the US since transfer technology can be set up through online market places, mobile communications operators and any number of other digital services.

Fintech Is a Top Priority

The lion's share of investments is made in startups in Silicon Valley, New York and London. By contrast, Switzerland and even Germany are still developing countries when it comes to Fintech. There are hundreds of startups in Zurich, Geneva and Berlin, and incubators and Fintech experimental laboratories are supported. So to some extent banks are investing and entering into cooperation agreements with startups, or networking with them to pick up on their initiative.

But outside the US, the action is on the banks of the Thames, in startup districts like Soho, Tottenham and Shoreditch. More than half of all European capital invested in Fintech companies is in those three areas. London is an attractive financial center, with its relaxed regulations, countless financial experts and developers, a startup culture similar to Silicon Valley that has developed over decades and the large-scale venture capital scene and international flair to go with it. The fact that Prime Minister David Cameron long ago made promotion of London Fintech a top priority hasn't hurt either. The British prime minister supports the UK Fintech 2020 Manifesto issued by the London-based Innovate Finance, an association of Fintech companies that aims to attract eight billion pounds for the industry and create 100,000 new Fintech jobs.

If George Osborne has his way, London will become "the global center for Fintech." The UK's Finance Minister announced in November that London is "good at both fin and tech." We are still waiting for comparable pronouncements from Germany and Switzerland.