For the past few decades, digital technologies have been systematically transforming one industry after another. The transformations have generally proceeded along three different stages. First comes the use of IT to improve the productivity and quality of production-oriented, back-end processes. Distribution comes next, leveraging the universal reach and connectivity of the Internet over the past 20 years. The transformation then reaches a tipping point when technology radically changes the user experience, - as has happened with the rise of smartphones over the past decade, - leading to a fundamental disruption of the industry and its business models.
While this digital disruption journey is ultimately inevitable, the pace varies widely across industries. The IT industry has been the most disrupted, - often by its own digital creations in a kind of sorcerer’s apprentice scenario. Over my long career, I’ve seen many once powerful IT companies done in by technology and market changes, and either disappear altogether or become shadows of their former selves.
Beyond IT, few industries have felt the impact of digital forces like media. Everything seems to be changing at once, from the way content is produced and delivered, to the sources of revenue and profits. In less than two decades, the global recorded music industry has lost over half its revenues, while the drop in newspaper advertising revenue in the US has been even steeper. Retail has also been undergoing major changes with the rise of e-commerce, as has telecommunications with the transition to mobile phones and wireless data.
How about the banking industry, which has long been a major user of information technologies, - including back- and front-office automation, ATM’s, Internet banking, data-driven risk management, fraud detection, and mobile financial apps?
In the last few years, FinTech, - short for Financial Technology, - has become a widely used term for technology-based innovations in financial services. FinTech companies have generally been startups looking to disrupt larger companies, although incumbent financial companies have started to establish their own FinTech units. Last October, for example, Citigroup launched the Citi FinTech division, aimed at developing new mobile banking services and business models.
“Silicon Valley is coming,” wrote JPMC CEO Jamie Dimon in his 2015 Shareholder Letter. “There are hundreds of startups with a lot of brains and money working on various alternatives to traditional banking.” Competitors are coming in the payment area as well as in the lending business. “[T]hey can make loans in minutes, which might take banks weeks… there is much for us to learn in terms of real-time systems, better encryption techniques, and reduction of costs and pain points for customers.”
Citi’s report highlights a number of important FinTech trends:
FinTech investments increased 10X in the past 5 years. Investments have risen “from $1.8 billion in 2010 to $19 billion in 2015 - with over 70% of this investment focusing on the last mile of user experience in the consumer space. The majority of this investment has also been concentrated in the payments area and this is where banks are seeing the most competition with new entrants.” Competitors are emerging in established digital markets, such as PayPal and Square in e-commerce, as well as in underserved segments like micropayments and small businesses.
FinTech is targeting the most profitable areas of global banking. Citi Research analysts estimate that over 70% of FinTech investments have been aimed at individuals and small and medium enterprises, segments which account for about half of banking’s profit pool. Given the growing importance of smartphones in financial transactions, it’s not surprising that Business-to-Consumer (B2C) innovations dominate, mostly aimed at improving user experiences.
The US and Europe are at the tipping point. Greg Baxter, - Citi’s Global Head of Digital Strategy, - notes that in the US and other developed markets “We are not even at the end of the beginning.” While really difficult to forecast this early in the cycle, his Citi team estimates that “currently only about 1% of North American consumer banking revenue has migrated to new digital business models (either at new entrants or incumbents) but that this will increase to about 10% by 2020 and 17% by 2023.”
China is already past the tipping point. Top Chinese FinTech companies, - such as Alipay or Tencent, - already have as many, if not more clients as the major banks around the world. “China's FinTech companies have grown fast due to a combination of: (1) high national Internet and mobile penetration, (2) a large e-commerce system with domestic Internet companies focused on payments, (3) relatively unsophisticated incumbent consumer banking, and (4) accommodative regulations.”
Emerging Markets are going through a financial inclusion revolution. Emerging markets are ripe for FinTech disruptions due to “a high percentage of unbanked population, relatively weak consumer banks, and a high penetration of mobile phones.” Kenya has been the leader in mobile phone-based financial services since the launch of M-PESA in 2007, which currently has 23 million active customers in 11 countries. In Somalia, - despite or because of its serious political instability, over 40% of adults use mobile money. For billions around the world, FinTech innovations are their tickets to financial inclusion in the global digital economy.
India is likely the next major FinTech frontier. India represents a major opportunity space for FinTech, given its large population of over 1.2 billion, its low number of banking accounts and its relatively high digital penetration. This opportunity is helped a long by three major enablers: the AADHAR national biometric identity program, which now covers over 900 million people; the Jan Dhan financial inclusion initiative which has already opened almost 200 million new bank accounts; and the ubiquity of mobile phones, with ~ 80% penetration. In addition, India’s central bank, - the Reserve Bank of India, - has been aggressively expanding the banking ecosystem.
Digital payments face intense competition. The payment space is being challenged by competitors from a variety of industries, including e-commerce (Alipay, Paypal), technology (Apple, Google), telcos (MPESA, SoftCard), and merchants (MCX, Walmart Pay). “Although payment is a relatively small part of banks’ revenue pool (~7%), the incumbent banks are at risk of losing important customer transaction data and client relationships.” These competitors are a potential threat to incumbent banks due to their technical, financial and market strengths.
Blockchain could be a catalyst for transforming legacy infrastructures. Payment innovations have mostly focused on the user experience at the point of sale, while continuing to rely on the existing backbone payment infrastructures. But over time, blockchain technologies could start replacing these legacy, proprietary infrastructures with distributed shared infrastructures more appropriate for dealing with the huge scalability and security challenges of the digital economy.
Blockchain could be “a catalyst for the transformation of many existing legacy systems that operate with a high degree of robustness but may not be the most cost or capital efficient way of doing business.” But blockchain is still at the bleeding edge, lacking the robustness of legacy payment systems.
Banks face an Uber Moment. As Jonathan Larsen, - Citi’s Global Head of Retail Banking, - said: “The future of the branches is about advisory and consultation rather than transactions… clients over time will move almost entirely to mobile channels. Banks will look like Uber. Uber has nothing to do with cars. It created an entirely new user experience. It tracks all your transaction histories, expenses, drivers’ ratings and so on. It created needs you never had.”
“What it means to banks is first and foremost the centrality of mobile as the main channel of interaction between customers and the bank. More importantly, there is a diminishing return on physical assets - especially the branch network. I won’t say that banks won’t have a balance sheet in the future, but the way customers interface with the bank will be revamped.”
The diminishing importance of physical branches, the explosive growth of the mobile Internet, and increased competition from FinTech startups are putting huge pressure on banks, - leading to a kind of Uber moment, when technology is making the old ways of doing business obsolete. To survive, banks will be compelled to embrace many of the FinTech innovations introduced by startups and staffing levels could decline by up to 30% over the next 10 years.
“The death of banks has been much foretold in recent decades,” most notably by Bill Gates in a 1994 article where he argued “that the world needed banking services but not necessarily banks…” Since then, “we have seen digital disruption fundamentally erode value across many industries including: music sales, video rentals, travel booking, and newspapers. In each of these cases, incumbents either transformed or became marginalized.”
Is the digital revolution finally reaching the banking industry? Will incumbent banks embrace FinTech innovations before FinTech startups gain scale and distribution? How will it all play out, - fierce competition, an increasing number of partnerships, or some combination of both? There are so many factors at play, that it’s extremely difficult to predict how this digital disruption will play out over the years. But, as Citi’s report says in its very title, all the signs seem to indicate that “FinTech is [Finally] Forcing Banking to a Tipping Point.”