Financial services startups: what’s in it for the banks?

Banks are investing time and money in IT startups, but are they building an IT ecosystem or betting on the next Facebook?

Banks are investing time and money in IT startups, creating an industry segment focused on digitising financial services, but are they building an IT ecosystem or betting on the next Facebook?

Hardly a month seems to go by without a bank launching a programme to support IT startups, but what is the value of this strategy for frugal finance firms that normally spend money only if there is a return on investment and a clear business case?

So vibrant is the financial services IT startup sector that it has generated its own name. Now operating under the banner of fintech, small IT companies are being approached by bank after bank with offers of financial support and mentoring.

Recent investments in IT startups have seen Santander, Barclays, Lloyds, Nationwide and Wells Fargo make commitments.

In July, Santander announced a $100m venture capital fund for financial technology suppliers. The fund, based in London, will invest in emerging fintech companies worldwide, enabling Santander to gain access to the latest innovations in banking.

A month earlier, Barclays launched a startup accelerator programme to access fintech. The three-month intensive programme has attracted 11 new businesses to its Barclays Escalator premises in east London.

Meanwhile, Lloyds Banking Group, MasterCard and Rabobank are providing startups in the European accelerator Startupbootcamp with mentorship and access to pilot customers, industry data, application programming interfaces (APIs) and capital.

Nationwide, Santander, RBS, Lloyds, Barclays, Citi, HSBC and Goldman Sachs will be supporting next year’s FinTech Innovation Lab in London by mentoring financial services technology entrepreneurs during the 12-week programme to grow early startups.

Wells Fargo is the latest bank to launch an accelerator programme, promising mentoring and capital. Up to 20 startups a year, focused on payments, fraud and operations, can apply for the first round of the six-month, semi-annual boot camp until 1 October.

But why are the banks doing this? Is it to make early investments in companies in a growth sector, as you would traditionally expect banks to do, or is it to establish a trusted IT sector dedicated to providing the banks with the digital services their customers demand?

Since the financial turmoil that began in 2008 with the collapse of Lehman Brothers, or arguably with Northern Rock’s demise a year earlier, banks have reined in their spending, with IT budgets cut along with thousands of staff that support  IT.

There has been a paradigm shift in banking IT. No longer does everything need to be built in-house. Third-party suppliers are seen as viable for even the most core IT systems. But it is the digital revolution that is driving the biggest change. Core system maintenance and the challenge of meeting ever-tightening and changing regulation consumes vast amounts of the IT budget. According to research from IBM, 64% of 27 European banks interviewed said that maintaining core banking systems takes up an unusually high proportion of IT budgets.

While replacement of these legacy systems is nowhere in sight, banks cannot avoid investing in apps to provide customers with the services they want.

The IBM research also revealed that the replacement of core banking systems is not on the agenda of European banks, with investments instead being made to maintain current systems and make incremental changes to meet business needs.

Online and mobile banking services, contactless payments, mobile-to-mobile payments and even the use of wearable technology for banking are all being designed, implemented, planned or discussed.

With in-house development no longer a default choice for banks, the digital revolution means they need to find new ways of developing IT. And they can’t rest on their laurels because IT-savvy firms such as Google and Facebook are gaining regulatory approval to offer certain banking services. Although core banking functions will not be attractive to them, they are perfectly positioned to provide information enrichment in financial services.

To keep their dominant position, banks need to introduce digital services quickly.

By investing in IT startups that offer services to finance firms, banks will create an ecosystem of trusted suppliers from which they can eventually obtain products.

The idea of bank appstores is an example. Digital banking services from trusted suppliers can be made available to customers via app stores – and there are already examples. French banking giant Credit Agricole has created an app store to provide banking apps to customers and get ideas from customers for new banking apps. 

The Credit Agricole Store is a platform that puts developers in touch with the bank's customers. Customers can download any apps they want and make suggestions for new ones. The store currently offers 21 apps and received more than 100,000 visits in its first three months. There are apps for balance checking and fund transferring, as well as one to help visually impaired people use the online banking interface.

This is an example of a new way to outsource software development.

Rik Turner, financial services analyst at Ovum, says that although there is still a lot of in-house work going in at the big banks, this is mainly around core banking systems. “But where they have small teams doing skunkworks to see if things work, it makes more sense to look at external suppliers,” he added.

Turner says that by investing in startup programmes, banks can help to develop and guide a group of suppliers, to which it can then go for the products of development work. “If they can be shareholders, they might get better deals and could influence technology direction,” he said.

Robert Morgan, director at outsourcing consultancy Burnt-Oak Partners, believes banks have a more traditional interest in the IT startup community. “They are investing in these IT companies early on because if they are successful, the returns are very high for a small investment,” he said.

The banks need only one success out a group of startups and the returns are huge, Morgan pointed out.

One source in investment banking said the main reason for banks investing in IT startups is to gain access to the technology, but that the investment and possible returns help to justify the spending. “I have been directly involved in investments into startups at more than one bank and it has always been the IT teams doing this,” he said. “They are trying to get access to technology that they know they would never be able to develop in-house.”

The investment and a stakeholding gets around strict controls on spending at banks, the source added. “IT teams would not be able to get the budget for open-ended projects that may not yield a return. But to get around it, you treat it as an investment that might get a return and give you new technology.”

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