Technology take-off threatens bank foundations

Who is the biggest threat to your bank at the moment? It’s a question posed to the chief executive of one of the largest global banks. Without a pause he replies: "Google. Our peers I can handle. We’re in the same boat. But if Google opens a bank, with all their data – then we’re in big trouble."

For now, he is safe. Under US law, not Google, Amazon nor Facebook (the second most potent threat listed by bank executives) can go into the traditional business of taking deposits and neither have plans to do so.

But the bank CEO knows all this. What he means is that things are changing in banking globally. It is no longer a static playing field made up of credit card companies, banks and niche loan/money transfer companies whose behaviour is predictable. Since the credit crisis, and with the explosion of social networks/the cloud/online technology, an increasing number of alternatives to traditional means of finance have emerged. This emergence of nontraditional players has been fast, and lines plotting growth rates in technology are steep. The annual growth rate in mobile payments, for example, is running at about 95%.

The CEO also knows that banks are losing a traditional advantage. The mantra in retail banking has always been: "Know your customer." Banks had a unique view of the spending patterns of their clients. Online transacting, and new technology, is eroding that advantage. "Banks are seeing their turf being attacked from multiple directions," says Samantha Ghiotti, director of Anthemis Group, a consulting and investment firm focusing on financial services innovation. "Mobile network operators, supermarkets, department stores, payment platforms, new joint ventures and start-ups. Even where bank regulation is tight and licences are closed, such as in the US, there are alternative ways of getting into banking. Being a traditional bank is not a happy place to be right now."

Indeed there does seem to be disruption on every level of financial services. Google and Facebook might not be planning to start banks, but they are active in payments – an area that firms such as PayPal and Skrill have already shown to be ripe for expansion. Google has Google Wallet. And Facebook could conceivably expand the payments system that it uses to connect its developers with paying customers.

In loans, alternative providers are springing up across the globe driven by the model of crowdfunding – sourcing loans from individuals or investors online. Tired of being turned away for personal or small business loans, and disheartened with high credit card interest rates, individuals have rallied together online to provide loans to one another at more affordable rates to borrowers and higher interest rates to lenders than from bank cash deposits. More than $1 billion in loans is expected to have been made by the end of this year.

In Europe, where banking laws are less restrictive than in the US, non-banks such as retail outlets are starting up or expanding their banking offerings. Brands such as Marks & Spencer and Tesco are moving into mortgages and even deposit accounts.

Even in trade finance, an area dominated by banks, the cloud and e-voicing is transforming paper into data and new technology platforms such as Tradeshift are becoming a popular trade-financing model for businesses.

Nowhere is this phenomenon more pronounced than in the world of payments.

The growth of the internet has transformed how people shop and transfer money commercially and between peers. It has also broadened everyone’s ability to make transactions beyond national borders.

It is an area that banks and credit card companies should have owned, but alternative means of transacting have been able to creep into the global payments market as banks have been unable to keep up with technology. Firms such as PayPal and Skrill have created a new industry of online payment systems, and other firms are following in their footsteps, such as Google Wallet. Forms of non-cash payment have also sprung up, such as e-vouchers or prepaid cards. These players own some $135 billion of the online payments market.

A look at the broader figures, however, shows that banks are under little threat financially from these new entrants for now. At present $300 trillion-worth of non-cash transactions are made globally a year, says Anthemis Group’s Ghiotti. Only $35 trillion of that is in consumer payments. The rest are wholesale corporate payments between businesses or banks. Of the $35 trillion in consumer payments about $33.7 trillion is by physical consumers going to a store and paying with a card. The remaining $1.3 trillion is online payments. And of those e-payments, $1.2 trillion-worth is executed through some form of bank provider operating in the mix. That leaves $135 billion in non-bank transactions."Are the non-banks eating into the banks’ or credit card companies’ lunch?" asks Ghiotti. "When you put the figures in context you see no, not so much. But the emergence of alternatives to traditional bank services and methods of payment is changing the industry, and those changes are accelerating. Banks are slowly waking up to how they are going to be impacted as the non-bank share continues to grow."

E-commerce is growing fast. According to Anthemis Group, 10 years ago it accounted for about 1% of retail transactions in Europe; now it’s around 10%.

Online payments platforms are keen to play down the idea that they might be a competitive threat to the banks. Rather, they say that although banks will have to adapt to the new environment, through partnerships the online payments platforms offer the banks efficiencies.

Dan Schatt, head of financial innovations at PayPal, says banks have been slow to update their models in three markets: cash, cheques and cross-border – it is there that online systems can benefit banks.

Cash is decreasing as a method of payment, and mobile technology that will enable smartphone users to pay with their devices is certain to accelerate that decline. By 2020, the $300 trillion figure of non-cash payments globally is expected to reach almost $800 trillion, for example.

Cash will remain the most frequent mechanism of transaction for the foreseeable future, but it’s one that banks lose money on. Banking customers typically avoid paying ATM fees, while branches are often loss-making. One analyst estimates that 40% of current accounts at Bank of America lose money, while at JPMorgan Chase the figure is around 25%, in both cases it is because balances aren’t high enough to cover the cost of maintaining the accounts.

Schatt says: "The banks have to offer ATMs, which they may charge fees for, but most people will draw out several hundred dollars at a time and dole it out in small amounts, which doesn’t add much to bank revenue." He says PayPal enables banks to instead convert these customers that are costing the bank money to transfer cash online instead. "Using our payments systems a customer could go to their child’s soccer game, want to pay the coach for a uniform and just go online on their phone and transfer the money to the coach instantly. If customers are encouraged to have signed up to PayPal then we can help banks cannibalize cash transactions by converting them into electronic transactions." Schatt adds that cheques are costly and time-consuming and rather than dealing with paper, it is simpler and more cost-effective to have customers pay using their email or phone number for a small charge.

Where PayPal and its peers have perhaps made the biggest leaps, and where the banks are simply unable to keep up, is through their cross-border capabilities. US banks have just a 3% share of the money-transfer market, having lost out to wire transfer companies such as Western Union and MoneyGram. And now online payments companies are building up share too. People are travelling more and the internet has enabled consumers to reach smaller merchants beyond their borders. Those merchants can be in countries with few banking services, or they might prefer to reduce the cost associated with accepting credit cards. It is preferable for them to set up an account with an online payments company. Similarly consumers often feel more comfortable when dealing with foreign merchants via a service such as PayPal or Skrill since their bank details are kept hidden. Both firms have exhaustive anti-fraud technology and security measures.

Nilesh Pandya, chief financial officer at Skrill, says that by partnering with firms such as his, banks can increase the transaction volumes they manage and, therefore, revenues. His firm, for example, has more than 120,000 merchants on the platform, including Skype, which is based in Luxembourg. "If every customer had to pay Skype in Luxembourg, the FX fees would be very high. We stand in the middle and have people uploading currencies onto our platform in their local currency, thereby reducing their cost to use the service. With banks, our key partners can benefit from our aggregating transactions across multiple merchants and using the partner bank to process these transactions, thereby driving incremental volume to the partner bank."

Another way that online payments systems are changing the way people transact is through digital or mobile wallet. By signing up with PayPal, for example, customers can register several cards that can be used for transactions, as well as cash. And so customers have the option of paying for services by a choice of payment methods, or by using all of them at once.

"We offer our customers with Bill Me Later a seven-day grace period when they can decide how they want to pay. We are looking at other ways to engineer credit so that consumers can smooth out cashflow," says Schatt.

Pandya adds: "It is simply taking what happens offline with the banks and putting it online."

Essentially the ease of the digital wallet, and ultimately the mobile wallet (where all payment options are available on a mobile phone) will increase the number of transactions being made by consumers, allowing online payment systems to turn a profit. Money is made in the small spread on the interchange and so online systems want as many transactions as possible. They therefore need as many merchants and consumers signed up to their platforms as possible. And so it makes sense for the online payments systems to not pitch themselves against banks, which can ultimately link them up with millions of customers.

"Hopefully it is a win-win for everyone," says Pandya. "Our focus is not on becoming a bank. While we do hold some cash for our customers – around €262 million at the end of 2011 – the individual balances tend to be a small portion of the monies the customers and merchants hold in their own bank accounts that they like to use."

PayPal, when it was X.com, did have ideas of becoming a financial supermarket and offered money market funds, but Schatt says the model was killed as it was too onerous to become a bank in every jurisdiction just to drive deposits. However, PayPal is encroaching on the credit card business. In August the firm announced that it would be moving from online to offline with a partnership with Discover Card to bring PayPal into stores in the US.

Pandya says he believes there will be only a handful of digital payment providers that will become the leaders in the industry. It is not an easy business to get into. Yahoo tried and gave up. Going cross-border requires a level of expertise around legal frameworks and how to handle them – for example, what to do about online gambling, which is illegal for US citizens. Anti-fraud technology is also essential. Furthermore there is a scale that is required. "We have over 25 million customers online, so it’s naturally easier to go to merchants and talk to them about partnering with us," says Pandya.

Although the emergence and growth of online payment systems might not directly affect bank revenues, some consultants say that banks need to be smart about how they interact with digital wallet providers.

"PayPal and its peers have inserted themselves between the customer and the bank and put their brand in the middle," says Colin Kerr, industry solutions manager for banking and capital markets at Microsoft. "That is what is a concern for the banks – it is the extent to which these payment companies will take control over the customer relationship."

Peter Olynick, card and payments practice leader at Carlisle & Gallagher Consulting Group, agrees."Banks fear that if they lose their interaction with the consumer, they could end up becoming a commodity just competing on price," he says. It’s no longer about satisfying the customer, he says: "Forty-eight percent of bank customers we surveyed said they want to use mobile wallets, and 80% of those said they would consider a firm like PayPal, even though a large majority of those say they are satisfied with their current banks."



His firm is working with banks on how to position a strategy around payments. "We are advising our clients to add flexibility, offer shopping features and target client payment options based on purchasing behaviour, not just on demographics."

Banks need to make a move, says Joe Pagano, director in worldwide banking and capital markets at Microsoft: "Customers are voting with their feet. They like their bank, but they want convenience; and convenience and simplicity will be at the centre of the winning value proposition in the marketplace. The banks know about financial services better than their telco counterparts and better than new market entrants – this is their opportunity. There are so many ways in which they can now innovate. This is the opportunity to reinvent themselves in terms of customer experience."

Despite the growth of online transactions, for many bank customers that experience still revolves around a brand and a branch. But many bank brands are horribly tarnished, while penny-conscious management teams are considering the cost/benefit of maintaining branch networks when so much activity is moving online.

Retail outlets in Europe are moving into mortgage provision and deposit accounts with and without the help of banks.

In July, UK retailer Marks & Spencer opened a bank inside its flagship store in London’s West End. It is on the third floor, has individual sofas, ATMs, and cash and cheque depositing machines with convenient handbag hooks and frosted glass dividers for customer discretion. There is a uniformed host to greet you who will provide you with a pager if there is a wait to see a personal banker; you can continue with your shopping and be buzzed when your turn comes. Loudspeakers are positioned and tuned to play inoffensive music at a level that offers privacy to conversations between banker and customer, and every piece of furniture in the bank can be purchased. All the details were chosen by M&S customers. It is a marvel to behold – a bank created entirely for and by the customers of the retailer. And it is becoming something of a trend. M&S now has seven in-store branches and plans to open 50 before the end of 2013.

UK supermarkets are joining in. Tesco, for example, which has been offering financial services for several years, is piloting in-store banks at two of its branches at the same time as moving into mortgage provision.

Colin Kersley, chief executive of M&S Bank, says it is inevitable that more retailers will move into in-store banking. "There used to be over 450 building societies in the UK and they supplied local competition to bigger banks at the time. That number has reduced to just 60 and the element of choice for consumers has gone. Now there is a need for more banks, but instead of building societies they are going to come mainly from retailers." Kersley says retailers make perfect sense as banks: "The footfall in banks is falling, whereas we have 12 million customers a week. People like to shop whereas they may not enjoy going to a bank, and retailers tend to have their premises in more convenient locations." Retailers also have a foot in the door when it comes to their customers’ finances. Virtually all large retailers are in the card market, for example.

"As trust in banks plummeted and the choice of banks diminished it has given retailers the opportunity to take that foundation of the card business and expand it into banking," says Kersley.

From a business perspective, many of the financing arms of retailers need to move into banking to grow. Kersley joined M&S Money in 2008. "The world was changing and with the dissolution of Northern Rock and Lehman Brothers it was obvious that the monoline business had to be revisited," he says. "We were in cards and general insurance and we started to think about how we could grow the business. We also had a great brand and a profitable business but you don’t build relationships with credit cards, you build that with a current account."

M&S surveyed more than 4,000 customers when designing the bank, and the vast majority said they wanted in-store branches in addition to online and telephone banking.

Kersley says that even with the cost of in-store branches, M&S Bank expects to break even in the next two years. M&S Money has 3.7 million customers who could convert to the bank; there are also 12 million regular M&S shoppers, many of whom do not have any M&S Money products. The retailer has been thoughtful in offering shopping discounts, coupons and rewards to its bank customers as part of their banking experience as a compensation to banking fees. The bank is also researching a mortgage offering with its customers.

Setting up a bank is not without its challenges and it is here that the traditional banks might have some leverage in the new retail-to-banking world. Tesco bought out Royal Bank of Scotland’s 50% stake in Tesco Bank in 2008 and the bank is now wholly owned by Tesco Financial, but M&S Money does have a traditional bank behind it. It is wholly owned by HSBC but operates as a joint venture arrangement between HSBC and Marks and Spencer. M&S Money retains its own board. HSBC benefits from a 50% share in M&S Money’s profits, and so one might assume that it has some cushion against a new competitor in the UK banking industry.

Kersley says that having the strength of the global bank as support on analytics and building systems was crucial. Tesco Bank, by contrast, although offering loans, savings accounts, and now mortgages, does not yet offer current accounts. Perhaps the complexity and costs of building systems might be a reason for that. A Tesco Bank spokesman was vague, saying: "We’ll closely align our entry into [current accounts] with the implementation of new industry-wide systems to help customers switch current accounts more easily."

Kersley says he expects more retailers to compete with the banks, although not necessarily on deposit accounts. "Some will choose mortgages or loans instead, but there will certainly be more competition. It will be healthier for customers to have a broader choice than just the traditional banks."

What does all this mean for the banks? It has been heralded as the big move to bank disintermediation, implying that the banks will be somehow eased out of the financial services sector, or that their revenues will be under pressure from these new entrants. It’s not so cut and dried, however. Banks are still where the final transactions are being made. The problem is that they are losing their interaction with customers. And with advances in mobile technology, banks will find it even more difficult to remain relevant beyond being the back end of a transaction.

Financial services firms are having to rethink their systems and platforms, how they interact with consumers and businesses, how they can partner up with emerging alternatives, and where to invest to position themselves for the onslaught of offline to online transacting. Christian Laang, founder of Tradeshift, says: "Banks have been accustomed to owning all of the transactions, and all of the data and technology around financial services. They have been used to having a full relationship with the customer. But technology is uprooting that control. Most are being forced to choose – will they be the service provider or the infrastructure producer? And they are choosing the former and leaving the latter to firms like ours."

Laang followed the example of the Facebook and LinkedIn models in May 2010 and created a platform where companies can connect for invoicing, purchase orders, catalogues and payments. It is now active in 190 countries with more than 120,000 members, including the UK’s National Health Service, and is adding 2,000 customers a week.

But there are positives to be found for the banks. For one, as fast as technology is moving, it will be decades before credit cards as a form of payment will be wiped out. Ghiotti points to cheques, for example, as an indication of how financial services seem to hold on to antiquated methods of payment. And secondly, the new entrants are in some cases providing more business to the banks. Tradeshift’s ability to speed up and record invoicing, for example, has enabled banks and other third parties to more readily provide financing in the supply chain.

And in the long term, could we see the ultimate tie-up between banking and the new, booming technology firms? As one senior executive at a leading global bank said to Euromoney recently: "Apple could buy us with their spare cash."