The banking industry used to enjoy strong barriers to entry, such as low customer switching, which protected it from the threat of new entrants and, in turn, allowed it to earn high returns on capital over extended periods.In the years 1980 to 2006, for instance, annual global banking return on equity (RoE) averaged 16 percent.
Digitization is changing the industry’s dynamics. Cloud computing is lowering the cost of doing business. Improvements in mobile technology are rendering banking anytime, anywhere and accessible over any device. Big data is making it possible for firms to draw major insights into customers’ lives from their transaction and other data. And social media is providing the opportunity to inject a social context into banking services.
For this report, we have interviewed 11 new entrants into the banking industry to understand how they are taking advantage of digitization to launch disruptive new business models. What we learned is multi-fold, including that:
- banking provision is stratifying, with new entrants offering discrete banking services at lower costs and with better rates
- business models built around offering transparency and helping customers to manage their finances can be highly successful
- leveraging social media and big data can help firms to get a clearer picture of their customers’ lives as well as help them to determine customers’ creditworthiness
- digital-only banks can be truly viable
- transplanting a retailing model and mindset into the banking industry can work
- embedding financial services within a social network, where peers share information and advice, can produce impressive results
- many gaps still exist in either the types of financial services that customers would like to consume or in the way they are delivered.
But, perhaps the biggest finding is that traditional banks can succeed in the digital age. They have great assets, such as large customer bases, access to rich transactional data and the ability to offer integrated financial services. However, they must find a way to leverage these assets. In particular, they should concentrate on ridding themselves of legacy (legacy technology and processes), on developing a balanced multichannel delivery model, on deepening their data analysis capabilities and, lastly, on playing a larger role in their customers’ lives.
While much of the fatalistic talk about banks’ futures is overdone in our view, the threat from new disruptive, digitally-enabled business models is real and banks need to act quickly if they are to succeed in the digital age.
The banking industry is changing
It is commonly recognized and widely discussed that digitization is changing the banking industry. In particular, it is acknowledged that digitization is opening up the industry to new, and potentially non-traditional, competitors.
Our intention with this report has been to try to bring greater clarity to this discussion. Firstly, we have looked at the factors that are driving digitization of the industry. Secondly, we have examined and interviewed several of the new entrants to the industry to understand how they are exploiting digitization to launch disruptive new business models.
Lastly, we have tried to interpret our findings and distil them into a set of imperatives for traditional banks if they are to succeed through this digital revolution and withstand the threat from these new entrants. In compiling the report, we have drawn on the experiences of a much larger population of companies than firms just using Temenos software; in fact, the majority of companies interviewed are not Temenos customers. In doing so, we hope to have gathered findings and recommendations that are of general and broad import.
Warren Buffett once said, “in business, I look for economic castles protected by unbreachable moats”. This analogy encapsulates his investment strategy of investing in companies and industries that can easily repel competitive threats, through the existence of strong entry barriers or sustainable competitive advantages, and so earn high returns on capital over sustained periods.
The banking industry used to be protected by an unbreachable moat. If a new bank wanted to start up, it would have to obtain a banking licence; a process which in most countries is arduous, time-consuming and requires the applicant to set aside large amounts of capital from day one. A new entrant would also have to make a heavy investment in IT systems (which the UK Office of Fair Trading once suggested could make up around two-thirds of start-up costs1). In addition, a new entrant would have to build a network of branches in order to service their customers. Lastly, even if a start-up managed to do all of the above, it was far from certain that it would be able to attract significant customer numbers – according to the Centre for Economics and Business Research, even as recently as 2003, annual customer switching rates were only around 2 percent in many developed markets.
Consequently, few new banks or other market entrants were created and, together with other factors such as high leverage, created the conditions for sustained periods of very high returns on capital. In the period of 1980 to 2006, for instance, the average annual Return on Equity (RoE) for the global banking sector was 16 percent.
The Moat is disappearing
Nonetheless, the situation is now changing and technology is playing a pivotal role in stripping away these barriers to entry…
1 Office of Fair Trading November 2010, “Review of barriers to entry, expansion and exit in retail banking”