There is excitement about fintech eating traditional finance. The incumbents are institutions with legacy systems and older-generation leadership while the new-age challengers are building models on open APIs and have modular, scalable platforms. In the new world, customer engagement is expected to hold the audience captive—this is expected to create a strong distribution pipeline via which products of increasing complexity can be sold.
A publication by the Boston Consulting Group earlier this July, “Banks Brace for a New Wave of Digital Disruption” talks about the need for the banks “to redefine themselves and change how they operate”. However, it adds an important caveat: “given the fundamental strength of many leading multinational banks, banking’s inherently high barriers to entry, and the extent of the industry’s recovery since the 2008 crisis, we’ve concluded that many traditional banks—far from fading into the background—will actually gain strength in the coming years”.
Financial services firms have been able to weather the digital onslaught even as software has been eating the world. In the case of fintechs, (a) the ease of access and engagement for customers, (b) customer-friendly user interface and user experience (UI and UX), (c) possibly lower costs of acquisitions and transactions, and (d) backing by large pools of very patient (and perhaps lenient) capital, have helped create profound changes.
However, such moves have still not overwhelmed the financial services companies. I posit three reasons for the same.
Consumer versus products vector
Fintechs are playing the consumer-engagement segment—the idea is that once the consumer is hooked, a solid distribution database/pipeline can be used to sell him/her anything (whether fund transfers, flight tickets or mutual funds). Banks and NBFCs, on the other hand, are typically good at developing a financial product that they know is regulatorily compliant, and that they can sell (current account, savings account, loans, cards, insurance, etc.)—once they have a customer with one product, they try and ‘deepen’ the relationship.
Most financial services companies are structured as product companies (with relationship managers typically being coordination points) while fintechs are inherently “customer-oriented” where products are introduced once initial engagement builds and sustains. It is not a priori obvious whether focussing on the product vector or customer vector will be the dominant, winning strategy.
Introducing increasingly-complex financial products for customers to serve themselves can be challenging for a couple of reasons: (1) an aware customer for one product (say, insurance) need not be an expert for another (say, a brokerage account), and (2) as complexity increases, customers may prefer some advice, hand-holding and want a “do it for me” approach rather than “do-it-yourself”.
Store of value versus medium of exchange
The product design strategy of a financial service firm revolves around ‘maturity transformation’, ‘liquidity transformation’ or ‘risk transformation’. Banks take current, savings and demand deposits that offer, practically, immediate liquidity to their liability customers while offering longer-dated, somewhat more illiquid loans to their asset customers. This change in maturity and liquidity allows the bank to earn an interest spread between its cost of funds and its yield on advances, or in industry parlance, build a net interest margin (NIM) book. A life or a general insurance company is able to convert the idiosyncratic risk for an individual and pool it to reduce the risks for all.
Fintechs are not geared towards such business models which impose significant capital commitments. They are hence not regulatorily equipped to generate value in the course of such transformations. Their focus is a lot more on the immediate ease of processes and transaction experience for the customer.
If we see these as the two aspects of the definition of currency, financial services companies play in the ‘store of value’ aspect while fintechs are in the ‘medium of exchange’ segment. If fintechs are unable to enter the ‘store of value’ aspect because of balance sheet or regulatory constraints, legacy financial services firms may be better positioned to maintain their ability to generate NIMs.
Financial services firms could hence, develop a partnership strategy with fintechs on both sides of their balance sheet (assets and liabilities) and transactions to give their customers modern experiences. However, they should also have confidence that they have the regulatory licence, social trust and capital for such value-creating transformations.
Just as rules on e-commerce (marketplace vs inventory-model) and digital taxation (as part of BEPS) have come in, it is but a matter of time when regulators get into the market-impact dynamics of fintechs. The Congressional hearings on Libra of Facebook are simply the most high-profile deep-dive on fintechs: this has the potential to spread to other segments.
Regulators of fintechs (as they emerge over time) may start to consider many types of conditions on them; for example, (a) companies may be required to be credit-rated to derive some assurance on continuity (especially, given the large losses that many of them currently run), (b) be required to list, (c) have fragmented shareholding (as is the case for banks), or (d) to serve a certain portion of social-good transactions (like a proportion of rural monthly active users, MAUs, or a certain percentage of overall transactions for such clientele), etc. Data localisation, privacy laws, etc may also impact the fintech ecosystem.
Such regulatory changes may get triggered abruptly. It will be prudent to consider that some of these changes will impact not just the fintechs but also financial services firms: it is best to remain prepared.
Financial services companies will definitely need to work on their digital strategies which should be about people, processes and technology—they need not necessarily involve replicating a fintech. Partnerships between financial services firms and fintechs can be symbiotic: large platforms and databases of legacy firms can meet newly-imagined UI and UX. Fintechs may not eat finance—they can work together to make each other more efficient and engaging.