Over the past eight years, the Bank of England’s Prudential Regulation Authority has authorised 61 new banks. Of these, it describes 28 as “really de novo UK banks”, including fintech challengers such as Monzo (established in 2016) and Starling (2014). The wider fintech field has even more players. Deloitte, in its research for Ron Kalifa’s recent government-commissioned review of the industry, found that about 2,500 fintech firms are operating in the UK.
But this busy sector has had little effect so far on how consumers and SMEs actually use banking services. The big-five high-street banking groups – Barclays, HSBC, Lloyds, NatWest and Santander UK – still dominate the market.
Consumers’ increasing reliance on online services during the Covid crisis might have seemed like a silver lining for fintech challengers but, if anything, the pandemic has tightened the incumbents’ grip. In particular, they have dominated the market for state-guaranteed bounce-back loans to SMEs because few alternative providers could afford to lend at the low interest rate (2.5%) stipulated by the scheme, according to Innovate Finance.
The big players still rule, then, but the Covid lockdowns have changed some financial habits. Until recently, open banking – in essence, the right to share current account data with fintech payment providers – has done little to boost competition. Yet the government now expects that 60% of the population will be using it by 2023. That matters, because what open banking does is tease apart ‘banking’ from payments, enabling fintech firms to become the first point of customer contact for essential everyday services.
“The core reason that retail banks exist is to carry out maturity transformation. That’s where they make their money,” says Jeremy Takle, co-founder and CEO of fintech firm Pennyworth. By “maturity transformation”, he means that they take deposits, which might be withdrawn at any time, and use these to make long-term loans, which might not be repaid.
“But the credit risk management that banks perform is just as important as maturity transformation,” says Takle, who was formerly a senior retail banker at Barclays. “Investing in someone else’s private debt is risky. Banks pool loans and thereby spread that risk.”
Some peer-to-peer (P2P) lending marketplaces have run into trouble because they’ve failed to act like banks, he adds. “They left mum and pop depositors taking both credit and maturity risk on to themselves. And the remaining spread on that business was too small for the P2P providers to sustain, which is why some have become banks.”
David Birch, an author, consultant and investor in digital financial services, says: “We haven’t yet had a fintech revolution or anything like one. The ‘challenger banks’ are simply more banks. They don’t have a disruptive business model. The essential business model and the cost of intermediation – a key measure of productivity – haven’t changed for generations.”
Despite this, both Birch and Takle believe that current banking business models won’t survive.
Birch explains: “Most customer interactions with a bank occur via payments. That is where the main customer data is generated. So, if you’re talking about the retail financial services business models of the future, which depend on data, you should be talking about payment companies such as Square, Stripe, or PayPal.”
Open banking is, arguably, the first real step towards that future. It means that banks no longer have a privileged position in payments – or in customer awareness. The current account can be treated like a jam jar into which, with the customer’s consent, fintech payment providers can dip. And they can meld that account data with non-financial information to offer a new service.
Some banks – albeit not the market leaders – are closing their current accounts to focus on services such as lending. M&S Bank, for instance, announced in March that it would “expand its range of payment solutions” and continue to offer a credit card, loans, insurance and savings accounts. Some fintech firms, notably Atom Bank, may never offer a current account.
Once real balance-sheet disruption arrives, the minimum efficient scale for a retail bank will fall, probably to below 1 million customers
The rise of buy-now-pay-later credit services “shows how quickly a good fintech alternative can grow”, Birch says. “The merchants are happy to pay not for a new payment mechanism but for new sales. I can envisage merchants starting to offer their own apps with embedded financial services. This is not a radical prediction. When JPMorgan killed off its Chase Pay wallet this year, it advised its customers to use ‘their preferred merchant apps or PayPal’ instead.”
The possible changes are profound, therefore. The International Monetary Fund foresees potential for the “disintegration of the traditional bank business model. Specialised providers of financial services can chip away activities that do not rely on access to balance sheets, while platforms can interject themselves between banks and customers.”
So what could the bank business model of the future look like?
“Turning savings into loans is where the margins are made,” Takle says. “For instance, credit card earnings are made mostly from the interest paid by borrowers. Yes, current account data is interesting and useful, but open banking is enabling customers to share their data in exchange for better services without having to switch accounts. This changes the attraction of managing current accounts. These accounts are costly for banks to operate and customers seldom want to switch, which the first wave of non-banks learnt to their cost.”
Removing that onerous cost base and boosting what a bank offers is, in Takle’s view, where fintech firms need to focus. Software-as-a-service providers such as Thought Machine and 10x Future Technologies are making this possible.
“Once real balance-sheet disruption arrives, enabled by much lower platform costs, the minimum efficient scale for a retail bank will fall, probably to below 1 million customers,” Takle predicts.
He adds that Pennyworth will focus on the “aspiring affluent”: the top 20% of the retail market who have the largest account balances but are “getting poor value and impersonal service from their bank. We want to give them a personalised alternative by putting a digital bank manager in their pocket.”
Open banking – then open finance and, eventually, open data – will enable financial service providers (including the big players) to curate a range of services for their customers without having to build or support these in house.
Tech firms certainly seem happy to leave essential banking functions to the banks. Google, for instance, recently shelved plans to offer a current account with Citigroup to focus on “delivering digital enablement for banks and other financial services providers, rather than us serving as the provider”.
What other developments could shake up the sector? Birch would like the industry’s regulators to instigate further disruption. One way of doing this would be “giving new forms of institutions access to central bank money – the world of decentralised finance”, he suggests.
Such a move could, eventually, do away with commercial banks altogether.
