“The holy grail for banks is to become the best at ‘fintegration’.” – Andrew Wolberg-Stok, Global Head of Emerging Platforms and Services at Citibank
Disruption vs. Incumbency
Will the trendy and nimble fintech disruptors bring the incumbent banking system to its knees? Or will big banks – aided by brand recognition, capital markets efficiencies, regulatory compliance, and outright size advantages – co-opt the best fintech disruptors?
While some initial winners and losers are already evident at this early stage, the majority of players should step back and assess the complementary efficiencies offered by their opponents. Each side offers a menu of strengths and weaknesses. In many cases, this means one side is strong where the other is weak, and vice versa. By integrating complementary strengths, both sides can capitalize on their best practices and minimize weaknesses. This co-opetition and integration could offer improved customer experience, elimination of redundancy and bureaucracy, and increased profitability.
Any service provider that is extracting more value than they provide will eventually be disrupted.
Emerging fintech companies are out-innovating the slower moving banks. Fintech is winning with UI/UX, application development, segmented services, and most importantly, speedy distributed ledger transactions. The rise of technologies such as blockchain are disintermediating security, validation, and clearing mechanisms. Three day holding periods will soon clear in minutes. Payment systems that move trillions of dollars per day will be gutted as the frictional cost of movement, distribution, and verification approach zero. Bank fees will be slashed, transparency will increase, and security should improve. However, while the fintech innovation train is producing fantastic early results, the industry simply does not yet sufficient scalability to universally implement these services. High burn rates, slow customer acquisition, and immature capital markets pipelines are capping fintech’s impact.
While the big banks have been slow to adapt new technologies, they still lead in scalability, capital markets efficiencies, customer service and acquisition, and historical brand trust – four capacities that fintech does not yet provide. Chris Larsen, the co-founder of Prosper and CEO of Ripple, argues, “To be successful [in financial services], you need to reconcile three key domains: tech, capital markets/risk mitigation, and compliance.” Fintech predominantly leads in tech and banks lead in capital markets/risk mitigation and compliance. Fintech disruptions provide improved service, however they have not been around long enough to demonstrate time-tested credit models, mature capital markets, or the standard regulation that mitigates trust concerns. While the disruption has begun, systemic impact will be negligible until fintech can scale with banks or banks can integrate fintech.
Co-Opetition Success Markers
McKinsey’s insightful December 2015 analysis of the fintech industry identified six key markers of success and imperatives for banks. Based on McKinsey’s success markers (quotes excerpted below), here’s how fintech and banks can best position themselves for success in a rapidly evolving marketplace:
- “Advantaged modes of customer acquisition.”
Fintech startups are but a small fraction of the financial services industry. Venture capital funding is spread thin over the sector. Each fintech competitor is competing for customers against other fintech participants and also with the big banks. Without a large customer acquisition infrastructure, the competition for customers is tough and expensive. Existing large bank customers have built trusted relationships with their banks, sometimes over generations. Banks also have a trust advantage from global brand association. Moving monies to less trusted and higher risk fintech startups will happen slowly except in cases where fintech can demonstrably prove solid risk aversion.
- “Innovative uses of big data.”
Fintech is able to test and apply new credit underwriting models that use new metrics. Many of these models would not pass large bank regulatory muster and will be difficult to integrate until regulation adapts. These new credit models will be tested over time, some will succeed and some will fail. During the experimentation phase, banks will begin to adapt their legacy systems to absorb the fintech winning strategies.
- “Segment-specific propositions.”
Fintech can select specific sector and service offerings while banks must offer a suite of services to compete with their historical competition. Both scenarios have benefits and drawbacks. Picking a single sector or service line allows for fierce innovation and best practice product delivery. However, a suite of integrated services allows customers internal efficiencies and convenience. The overhead associated with the suite of services is significant and fintech can provide segment specific services at a much lower cost.
- “Leveraging existing infrastructure.”
Fintech is reaching a full pipeline within its current capital constraints. They will need to, “find ways to engage with the existing ecosystem of banks…for example…Lending Club’s credit supplier is Web Bank, and PayPal’s merchant acquirer is Wells Fargo.” Off-loading risk and supply to the capital markets will be a necessity. This problem can be solved best through integration.
- “Managing risk and regulatory stakeholders.”
The fintech industry is largely unregulated. Some companies such as Gemini are differentiating themselves by operating in a fully regulated environment. However, the unregulated service providers will soon attract the gaze of oversight and they will need to be prepared to deal with the red tape and compliance costs. Inevitable business operation failures will also add fuel to the regulatory fire. Not every startup will become a unicorn. Investors and customers will lose money and endure stressful breakdowns in service. If regulation is done right, it will allow innovation and competition to exist while protecting customers and investors to a reasonable degree.
The Giants Have Awakened
Banks realize they must innovate. JP Morgan has hired thousands of internal technology developers. Goldman Sachs and Santander are developing blockchain technologies. Other banks are aligning strategic partnerships, buying startups, or funding accelerators. In 2015, mergers and acquisitions in the fintech space totaled more than $4 billion and this number is expected to grow.
Immediately, bank sales forces and customer service infrastructures can be deployed. “Collaboration rather than competition between banks and fintech can help startups overcome typical challenges of balance sheet capacity and distribution reach,” says Lloyds’ Rodriguez-Sola.
Major global consultancies realize that fintech and banks must both continue innovating on their areas of strength and integrating with their competitors to minimize weakness. Co-opetition will be the next story of this saga. Banks realize that building on fintech markers of success will be their salvation from the legacy system drag of their architecture. Talk of co-opetition and integration benefits is all well and good, but many internal accelerators and integration efforts have fizzled and failed. This is a space to watch closely in the coming year.
Banks and fintech are set for some interesting pairings; however, care must still be taken to select the right fits. Swiping right in a large field of entrants may seem to produce a hot match, but a hot match does not guarantee a successful marriage. A few shotgun weddings have already ended in disaster. Thoughtful planning, diligence, and attention to culture during the integration process will be paramount for developing e-harmonious financial services outcomes.