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Is digital disruption a threat or an opportunity for banks?

Banks have been relatively unaffected by the digital revolution that has transformed other industries – but that's about to change

Despite being heavily dependent on technology, banking has so far been relatively untouched by the digital disruption transforming so many other industries.

Research comparing 10 major sectors, conducted by the Leading Edge Forum (LEF), shows banking well behind entertainment, media, retail, education and healthcare in terms of the effect of digital transformation. Only manufacturing and insurance are ranked lower.

But that’s going to change, and soon.

“The potential for disruption is strong across the entire banking industry value chain. We expect increasingly fierce competition between traditional banking incumbents and emerging financial technology [fintech] players,” says LEF research director David Moschella.

In the UK, a relaxation of the rules around awarding banking licences has already seen a flurry of so-called challenger banks emerging, targeting mostly retail banking. Perhaps the area seeing the most change is payments, with the launch of Apple Pay and other mobile-based services that threaten to disintermediate banks from the consumer spending transactions that generate so much valuable – but largely under-utilised – data and intelligence.

But it’s not only the customer-facing areas of banking that are vulnerable. At the recent Sibos financial services conference in Singapore, the word on everybody’s lips was blockchain – the emerging distributed ledger technology that could radically alter the way asset transactions are conducted and take huge costs out of banks’ back-end processing and reconciliation networks. But blockchain could also drastically reduce the cost of entry for new services to compete against the cumbersome processes that mean it can take days for financial transactions to reach customer accounts.

Lawrence Wintermeyer, CEO of Innovate Finance, the UK fintech association, says that venture capital (VC) investments show where the opportunities for disruption in banking lie.

“The VC money is going into payments, peer-to-peer and – in the UK – to behavioural analytics. In the US it would also be ‘robo-advice’ – algorithmic guidance and advice – where most people don’t have financial advice mainly because providers can’t afford to provide it or consumers can’t afford to buy it,” he says.

Opportunities for new entrants

Following the 2008 crash, banks were protected from disruption by the increased regulation that was put in place to prevent further shocks to the system. Governments worldwide are now realising that excessive compliance is restricting change in the industry, and the rules are being eased to open opportunities for new entrants to create more competition.

The banks – blinkered for so long – are only now starting to realise the threat they face.

“They’re all investing a lot of money, they are desperately trying to understand how to participate, what to do, and they don’t want to miss anything. They know they are not the most agile organisations, especially when it comes to innovation about customers,” says Wintermeyer.

If we don't use data to add value for customers, banks will be disintermediated
Susan HweeManaging director, group technology and operations, United Overseas Bank

“They know they are very good at innovating in technical products to extract margins from the value chain, because that’s what they do. People who work in a bank are not motivated to disrupt internally. They are measured to focus on earnings or the balance sheet or profitable lines. Risk and governance have come into it after 2008 and innovation was a bit of an uncomfortable bedfellow. The banks need all of these things and they are learning.”

For many banks, the response has been to set up teams separate from the traditional IT department structure, and to find ways to better engage with fintech startups whose technologies could offer new opportunities.

“All of the large institutions and banks have corporate venture funds or accelerators. They’ve all got lots of innovation going on either in the guise of accelerators, labs, innovation programmes, digital mergers and acquisitions, and talent scouts, or by partnering with fintech firms,” says Wintermeyer.

Assessing emerging technologies

One global bank doing just that is Wells Fargo – the iconic US firm perhaps best known for its stagecoach and horses taking money across the Wild West of America in the late 19th century.

Global head of innovation and research and development (R&D) at Wells Fargo, Bipin Sahni, says the bank has had to evolve new forms of assessing emerging technologies.

“We see new technologies and bring them into the bank with a really exhaustive proof of concept – we have eight to 10 going on at any time,” he says.

“We do design and some development to showcase the value of what that could bring to us. Some things may not reach production – that’s how it works in R&D – but some things will.”

Sahni runs Wells Fargo’s global accelerator programme, which looks to make small but strategic investments in promising startups. He cites mobile, data analytics, and application programming interfaces (APIs) as key areas of focus at the moment

“In our accelerator programme, we get access to so many companies. You'll hear more of us collaborating with companies like that and with interesting startups. You have to think about where we can add value to a customer. There are so many smart people outside the bank and we want access to that,” he says.

Susan Hwee, managing director of group technology and operations at Singapore’s United Overseas Bank, also cites data analytics as a prime area where banks must get better or face major disruption.

“If we don't use data to add value for customers, banks will be disintermediated,” she says.

Legacy systems

But intent is one thing – the reality for most banks lies in inflexible, complex legacy systems that make it difficult to pivot towards becoming agile, fast-moving technology adopters. Their emerging startup rivals don’t have to deal with the hindrance of legacy IT.

“Legacy will always be there,” says Sahni. “How do you define legacy? In my mind even Java is legacy. Banks have created abstraction layers between the mainframe and mid-range systems – that is the Java layer. If Java is legacy, what’s new? That's mobile and APIs, but you have to break those technology silos. It’s about how you architect your technology stack.”

The Royal Bank of Scotland (RBS) is perhaps a prime example of an institution that suffered because of its complex legacy estate. A major IT failure in 2012 led RBS into a major rethink and simplification of its systems – costing billions of pounds – and a desire to adopt new technologies more quickly.

In one area of its business alone – payments – RBS had 142 different systems and 38 payment gateways.

“Over a three year period we will take 142 payment systems down to fewer than 20. We will take our payments gateways that connect us to the outside world from 38 down to eight. We will start to have a new payments architecture from the second quarter of next year onwards,” says John Lyons, head of strategy and commercial services for RBS’s payments business.

Read more about digital disruption in banking

RBS is following similar principles to Wells Fargo, in testing out new technologies to assess their potential before making serious investments.

“Some large organisations have failed to make progress and move their architecture on because they are in a piecemeal way trying to justify disparate investments. That’s how you can end up with 142 systems and nobody holding a route map for what you’re working towards,” says Lyons.

“We have innovation investment that tests out proof of concepts to see what the benefits might be to the customer. We have realised that you need to spend money on discovering what the new world is about.”

Lyons says RBS has re-engineered its approach to investment and development to avoid the “traps of the past”.

“Our ethos is about getting some proof of concepts built, grounded in resolution of customer pain points, building new experiences, and let’s see if they work. Then let’s promote them into light engineering, let’s not get the big wave of technology governance or reject it early on because it hasn’t been built to service millions of customers at 99.99% availability,” he says.

“Let’s first get it into engineering at low cost and see if it works. Then we are in a position to commercialise it, and that’s the point at which we make the business case to take it forward.”

Lessons from retail

So how real is the threat to established firms in banking from the emerging new entrants and fintech startups? The lessons from retail and media suggest that some big names will fail, others will embrace digital disruption and thrive, while a few new players will grow in significance. Regulatory barriers will continue to protect incumbents. But the big advantage that existing banks have is the extent of their customer relationships.

“We have a great client franchise and relationships – they are difficult things for smaller innovative companies to get,” says Lyons.

“[Innovative companies] make us think differently, and they push us in the way we use technology. We’ve invested in a scouting team to understand the market, to look at what VCs are doing, and we have people on the ground in Silicon Valley. It's an opportunity because it’s stretching everybody's thinking.”

Wells Fargo’s Sahni agrees that size, for banks, is an advantage: “Are startups going to take away all our market share? I don’t see that happening. Banks of our size offer many products and an integrated service offering – one company giving you one service. Five years from now, how many of these companies will still be around? But you know we will be around.”

In Wells Fargo’s case, he is probably right. But the boardrooms at failed retail giants Woolworths, Blockbuster and Comet probably thought so too. Banks have come late to the digital bandwagon, and many are embracing it wholeheartedly. But history tells us that not everyone will survive the dramatic changes in the industry to come.

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