Predictions about the death of banks because of more technologically sophisticated competitors have been greatly exaggerated. But the growth of technology has been a double-edged sword for U.S. banks. On the one hand, technology has helped banks generate additional revenue, reduce expenses, and manage risk exposure in a more proficient manner. But it has also opened the door for a myriad of competitors, both large and small. These competitors are called fintech companies, an amorphous catch-all term that seeks to generalize the interplay between financial firms and technology. We believe this interaction between banks and fintechs is highly varied depending on the precise type of business that is being affected.
At this juncture, we don't expect larger banks to become defunct because of competition from more technologically savvy competitors. That said, even larger banks acknowledge technology is a key strategic differentiator for long-term success. However, banks' margins could be clipped as less traditional competitors move in more meaningful ways into some of their business lines.
But smaller banks, and community banks that don't have the resources of the larger banks, are at a distinct competitive disadvantage. Although recent legislation has attempted to assist smaller banks by removing some of their regulatory burden, smaller banks' inability to keep up with technological initiatives poses a serious threat to their ability to compete. Technology is allowing both larger banks and fintech players to move into more specialized areas, such as small business lending, that heretofore had been the domain of local banks. The Federal Deposit Insurance Corp. (FDIC) is cognizant of the technological threat and has recently been holding forums for small banks, focusing on emerging technologies, including new and innovative delivery channels, and how to enhance customer experiences. But it's unclear whether this will be enough to keep smaller banks competitive.
For the banks we rate, we believe most will be up for the challenge and should be able to implement an effective technology strategy to remain relevant. Some regional banks that are smaller in size may lag, and over time if threats to their business prove to systematically undermine it, we could reevaluate our ratings. For example, we could downgrade a bank if we witnessed a loss in market share, lower profits, and less-diversified business lines because of their lack of a prudent technological response, if these banks rely too heavily on one distribution channel due to technological threats in other business channels, or if a bank relies too heavily on an inorganic fintech partner to generate revenue.
Bank Business Lines Under Attack By Fintech Competitors
Fintech companies have already made some inroads into traditional banking. According to Accenture, fintechs and challengers have taken 3%-4% of market share from traditional banks in certain business segments. Some of the main areas where banks are currently facing business pressure are as follows.
Technology has facilitated the growth of digital deposits, so banks no longer need to rely as heavily on branches to accumulate deposits. This has leveled the playing field, enabling a host of digital players to compete for deposits. For years, a handful of digital banks have offered accounts that attracted consumers through high yields and digital convenience. Without branch networks, those companies--including American Express, Discover Financial, Ally Financial Inc., Synchrony Financial, and more recently, Goldman Sachs Group Inc.'s Marcus--have been able to accumulate significant increases in deposits using a digital platform, offering higher rates than peers. It remains questionable whether these deposits are sticky, as we believe many of these customers can move deposits quickly based on rate sensitivity. Still, deposit growth rates of banks offering online deposits is impressive and has turned out to be a competitive threat to the traditional means of gathering deposits.
Some banks have responded to the digital threat by offering their own digital platform, including Citigroup Inc., JPMorgan Chase & Co., PNC Financial Services Group Inc., and Citizens Financial Group Inc. We believe it is a necessary step, and a prudent management move, to offer digital deposits to stay relevant, as by doing so, it protects deposit market share. The strategy also helps banks expand deposit footprints in new regions without the expense of building branches.
But at the same time, an online deposit strategy could cannibalize existing deposit channels and thus could result in the need to raise rates at a quicker pace than previously had been necessary (see "U.S. Bank Interest-Rate Sensitivity Tracker: The Rise In Deposit Costs Accelerates," published Dec. 5, 2018). So although an online deposit strategy will help banks maintain deposit market share, it will also likely result in lower margins, all else equal.
Within the payment space, consumers continue to mostly initiate electronic payments with bank-issued credit and debit cards, sending funds mainly through the open-loop networks of Visa and Mastercard or the smaller closed-loop networks of American Express and Discover. Banks collect fees from merchants when consumers use the cards they issue.
We expect most consumer electronic payments to continue to flow between banks through the existing card networks' "rails" at least in the next few years (see "The Future Of Banking: Five Fintech Expectations For Business And Consumer Payments And The Ratings Implications On Banks And Nonbank Financial Institutions," Feb. 13, 2019). The ubiquity of the card networks with consumers and merchants makes disrupting the current system difficult. Many fintech advancements (e.g., mobile card readers, QR codes, and contactless cards) are also facilitating payments via banks cards rather than replacing them. Still, there are many existing and new players looking to disrupt the system, and we cannot rule out significant changes to the industry over time. PayPal is one nonbank player that has established a material market position with consumers, as well as merchants who accept PayPal payments. PayPal still relies to a degree on the card networks as well as banks, but transactions on the PayPal system can diminish the economics for banks, depriving them of fees they would have otherwise collected on a card transaction. PayPal's person-to-person (P2P) payment services, including through Venmo, also helped spur the banks to launch their own P2P system of Zelle.
Separately, large tech companies like Apple, Google, Samsung, Facebook, and Amazon probably would like to mimic the success of online payment services AliPay and WeChat in China and have also launched digital wallets, interposing themselves in consumer payments. Banks have already experienced some margin pressure, as hardware makers such as Apple and Samsung facilitate card payments and participate in the economics of the transaction.
In the event that a fintech finds a way to disrupt the dominance of the existing card networks, there would be major implications for the current players in consumer payments, including banks. Still, we don't believe this is a near term event.
Various lending segments
In terms of areas of loan growth, fintechs have been stepping into niche businesses--largely areas banks have moved away from, either because banks don't have the processes or scale to engage with the customer in a cost-effective manner.
Fintechs, for their part, are able to offer customers a better user experience and lower price because of a lack of legacy infrastructure, such as branches. According to S&P Market Intelligence, prominent digital lenders' origination volumes in 2017 were up 30.1%, to $41.1 billion, and are likely to grow at a still healthy compounded annual growth rate of 12.4% to $73.7 billion by 2022. Although the growth rate is impressive, the absolute size of loans outstanding by digital lenders is still very modest compared with the banking industry total of roughly $9 trillion.
The specific lending areas that have been most vulnerable to fintech competition are:
- Personal loans,
- Student loans, and
- Loans to small and medium enterprises (SMEs).
How Banks Have Responded To The Fintech Threat
Since fintechs are fundamentally diverse, there has not been a single game plan in regard to the banks' response to threats from technology companies. Many banks have strategically opted to increase what they are spending on technology, combine in-house teams in partnership with a fintech company, or acquire fintech companies. The below provides more detail into the banks' response so far.
Banks are upping what they spend on technology
On aggregate, total spending on technology across the banking industry is expected to increase by an average of 4% each year over the next three years, according to data from the advisory firm Celent. For the top 20 banks (when the information has been disclosed), we have compiled technology spend as a percentage of revenue and we have also looked at patent formation. Sometimes technology expenses are reported and embedded in other line items (such as software and equipment), so the full picture may not be complete. Overall, we believe the larger banks have a distinct advantage because, given their higher revenue base, their absolute technology spend is much higher than smaller regional banks.
One prime example of banks' successful spending on in-house technology is the development of mobile banking applications to help enhance the customer experience. Banks have also rolled out digital mobile applications, and small business and personal loan platforms.
Partner with a fintech company
Many banks have chosen to partner with fintech companies (see table 2). Positively, partnering enables banks to grow revenue in areas that banks lack lending expertise or scale, and post incremental income as a result. Fintechs also benefit from a partnership because it diminishes the costs of customer acquisition, helps monetize innovations in financial services, and overcomes the barriers to expand services across state borders. In addition, a fintech company benefits from gaining access to a more stable funding via a bank partnership and can use the bank's network to help grow their customer base.
Negatively though, from a bank's perspective, a fintech partnership could confuse the branding of a bank. And over time, a bank could be relegated to the role of back-end processor while the higher value, front-end business gets extracted away. In addition, by partnering with a fintech, a bank can lose the valuable direct contact with its customer, along with the personal data of its customer base.
Banks' Advantages And Disadvantages Versus Fintech Companies
We see a myriad of advantages for banks as stand-alone businesses versus fintech competitors. But fintechs as stand-alone businesses have some advantages, too (see chart 3). Basically, if bank management teams believe they don't have the expertise to develop a certain technology in-house, they will seek a suitable partnership.
Tech Titans Are Likely Banks' Biggest Threat Over The Long Term
Tech titans like Apple, Amazon, Google, and Facebook have so far dabbled into the banking space in a limited way, largely in the payments space. In the lending space, Amazon provides working capital loans to merchants operating on its platform, with a very timely decision processes, using Amazon's insight into the merchant's cash flows that enables the company to offer their clients tailor-made repayment schedules.
One of the big threats of the tech titans is their reach and visibility. Unlike smaller fintechs, they can use their already established large customer bases and digital talent to extend their corporate brands into banking. They also have strong balance sheets with enormous investment capacity. These players have already proven their ability to quickly develop and implement technical innovations. Banks could face the biggest competitive threat from activities where barriers of entry are low, such as transaction revenues, which is already underway.
But there does not appear to be any appetite right now for these large tech companies to take on a full-fledged banking license, collect deposits, or make loans to their customer base. We believe this is due to regulatory hurdles and an aversion to take on credit risk. Something that could entice these companies into furthering their banking presence is it would give them the ability to generate additional data from financial customers, which would enhance advertising and open brand new revenue streams.
Tech Will Remain Front And Center
Technology will remain one of the key focuses of the banking industry in the years to come. Changes in technology move rapidly and, to stay relevant, banks must adapt. Banks that use technology well can enhance their business models and even bring new tools to some thorny problems, such as monitoring anti-money-laundering. But circling around the healthy profits of the banking industry is a growingly ambitious group of tech companies, large and small, that already and over time, will continue to nibble away at bank margins.