What today’s “traditional banking institutions” are and do is the product of a few hundred years of financial evolution. Yet, objectively speaking, there should be no expectation that banking as we know it will continue to exist, let alone dominate the mix of financial services alternatives.
In fact, as the migration to digital services accelerates, a report from Moody’s Investors Service seriously suggests that four forces could determine how much time traditional financial institutions have left.
Even as these institutions struggle to maintain business and stay relevant, central banks around the world have been rethinking how they fit into the future picture.
“We are conducting our lives more and more digitally,” says Stephen Tu, Vice President and Senior Credit Officer at Moody’s, in an interview with The Financial Brand. “The money we have was not built for that. The money that we have as physical cash, the whole payment system, and the whole construct of electronic money that we have right now was built starting in the 1970s. It’s not digitally native.”
The report, “Four Forces Reshaping Financial Landscape Have Potential to Dislodge Incumbents,” delves into four trends:
- Big tech’s advance into financial services.
- The evolution of fintechs into companies able to perform the same functions as financial services firms.
- The growing influence of “stateless money,” such as stablecoins.
- The rapid runup of CBDCs (central bank digital currencies).
Each of these trends could play a part in the eclipse of the economic role of traditional banks and credit unions, according to the report, pushing them out of their traditional role of economic middleman. In some cases, the traditional institutions and the newcomers currently have a symbiotic relationship (at times), but this could easily change.
“What does a bank do, at the end of the day?” asks Tu rhetorically. “The most important value-add is helping society to reallocate its savings for the most productive uses, that is, making credit judgments, making loans, making investment decisions. And here we’re starting to see big techs and fintechs actually getting to that point.”
Further than that, according to Tu, as money begins to evolve past the familiar forms we know, the very nature of lending will change. The possibly widespread adoption of blockchain technology may change where and how lending takes place, for example.
1. Big Techs Continue to Push into Banking Services
As cited in the Moody’s report, the highest valued financial company in South Korea is Kakao. The company started as a social media platform, grew large and started a bank that grew to be the sixth-largest retail banking institution in South Korea.
This demonstrates that the rise of big tech firms as a competitive threat goes beyond the usual suspects, such as Amazon, Google, Walmart, T-Mobile and more. The increasing digitization caused in part by the pandemic has increased the emphasis for big techs to get into financial services, plus the rich veins of data that they can dig into once they offer financial services.
“Offering digital financial services is becoming more a necessity than an optional extra,” the report states, “while consumer expectations for the quality of seamless user experiences provided by tech firms have never been higher.”
As the firm outlines it, the likelihood of any big tech going in for full-scale banking is low. They would generally prefer to avoid significant balance sheet risks and don’t want to deal with the regulatory burden that traditional financial institutions take for granted. Tu says they are much more likely to adopt “narrow banking” — that is, sticking to the low-risk functions of funds transfer and safekeeping of money. These synch well with ecommerce, the report points out.
Tu adds that building up affiliated financial services feeds back into the success of the a big tech’s own ecosystem. One example of this is the JPMorgan Chase Amazon Prime Rewards Visa, which pays the highest rewards for purchase on Amazon. The rewards can be used towards purchase on the site, completing the circle.
A Turnabout Play:
Moody’s suggests tech apps could be used to pool the demand for specific financial products and services across millions of consumers. This would turn financial institutions into suppliers and give the upper hand of negotiation to big techs acting as distributors, much like warehouse stores.
“Switching between financial service providers in a digital marketplace is also likely to be easy and cheap for consumers, particularly as data portability matures,” the report suggests.
“Incumbents will have to compete more fiercely to win clients,” says the report.
Thinking again of Kakao, Tu recommends watching the evolution of Facebook’s Diem Association, which is behind the giant company’s Novi stablecoin.
“Imagine a company that can run a very large, multi-billion social media user base that is spread around different continents,” says Tu, “and has given them the means of payment across that entire network.”
A warning for traditional players from the report: “Many incumbents will adapt to the changing market environment and protect their franchise accordingly. But we expect this challenge to become harder.”
2. Fintechs Keep Evolving, and Begin to Look More Like Banks
In an interview with The Financial Brand, Paul Paradis, Co-Founder and President of Sezzle, the buy now, pay later company, said that, “I would be surprised if within the next 12 months all the large buy now, pay later companies aren’t offering a broader set of financial services to their consumers.”
This ties in with the Moody’s observation that more and more fintechs are broadening their financial activities. “Fintechs have evolved beyond their initial single-service offerings,” states the report. “Payment providers have gained massive scale and are naturally extending into deposits. Others are launching business models that reach into the core services of financial incumbents.”
While SoFI broadened its menu substantially and bought a bank charter, others just keep encroaching. Moody’s points to PayPal as a company that has steadily added to its quiver, more and more resembling a bank.
“The broader fintech industry is evolving beyond single-service business models. Increasingly, fintech companies are seeking to perform the core functions of financial institutions, such as assessing financial risk and return, and pioneering creative, innovative business models.”
— Moody’s report
Some of the fintechs’ encroachment has been accomplished through banking as a service, which could be seen as a distribution option for traditional players to tap. However, once the consumer sees the brand, rather than the actual provider, as the service, then the bank behind the curtain could in time be replaced. The environmentally focused fintech Aspiration started out using BaaS from what was then Radius Bank but shifted strategies and tapped an alternative structure to replace that relationship.
Some fintechs have found better mousetraps, and, in a twist, have started selling their expertise to banks. One example cited by Moody’s report is Upstart, which uses artificial intelligence to evaluate traditional and nontraditional credit criteria. The company has started selling its service to traditional financial institutions, including Customers Bancorp and Patelco Credit Union, for select purposes.
3. Stablecoins: Cryptocurrency Without Volatility?
“Cryptocurrencies have attracted a lot of attention but they have not yet proven to be a viable medium of exchange,” states the report. “This is due to scaling hurdles posed by a truly decentralized blockchain and volatile price fluctuations that suggests they may be as much a focus of investment speculation as a store of value.”
Addressing this weakness of “traditional” cryptocurrency is the relatively new wrinkle of “stablecoins.” These are forms of crypto that carry values that rise and fall with a governmentally issued currency that serves as their index.
To be clear, the stablecoin is not issued by the government that issues the actual currency. The latter just serves as a means of setting the value of the cryptocurrency that is issued as a stablecoin. This electronic “scrip” would typically be accepted in some form of ecosystem.
“The promise of such decentralized finance, or DeFi, if realized, would enable true instant, peer-to-peer financial transactions,” the report says, “allowing people to bypass traditional financial incumbents and rendering many of them obsolete, potentially even central banks.”
The report adds this concept remains a wildcard, but that much capital and research has been going into making a secure, decentralized and stateless stable cryptocurrency work.
“Although much of the talk about blockchains may be a solution in search of a problem, only one stateless currency needs to succeed in order to reshape the landscape.”
— Moody’s report
Tu says that part of the appeal of the stateless stable currencies is that the costs of transacting in traditional currencies could go away. In a world that is increasingly digital, he says, the various charges that are added on to transactions that take place in electronic forms of originally physical currencies become less acceptable. Interchange charges, for example, are part of the friction of the existing system.
4. CBDCs: Central Banks Are Getting the Wakeup Call
It’s a basic “money and banking” fact that commercial banks “create” money through extending loans through a multiplier effect applied to banking deposits. That role for banking goes by the boards with cryptocurrency.
As the Moody’s report portrays it, many central banks in smaller countries have grown comfortable with the idea of issuing their own central bank digital currencies (CBDC). And now their larger brethren are catching on.
“The private sector realized that there’s room for improvement,” says Tu, “and they took action and innovated. Central banking authorities are recognizing that and they want to remain at the center, retaining monetary sovereignty.”
“Incentives to develop CBDCs have gained strength since the outbreak of the pandemic, which has accelerated digital migration, made physical cash a perceived vector of health risk and highlighted financial inclusion flaws in the financial architecture during a time of societal hardship,” the report says.
One risk, for traditional banks and credit unions, would be the perception of security.
“Upon introduction of a CBDC,” the report explains, “a meaningful portion of depositors may switch to holding their digital cash in CBDC for its safety and transparency, leading to a partial migration of deposits from commercial bank deposits to CBDC.”
The report suggests that there could be efficiencies and benefits from bypassing the traditional “middleman” — banks. But those institutions would be forced to revise their business strategies. In addition, each dollar put into a theoretical Fed CBDC dollar would not be in the hands of banks or credit unions for lending. Roughly, it would be like consumers massively switching to direct purchase of Treasury securities instead of maintaining financial institution deposits.
As Tu explains the four forces, any one would be a challenge, but the confluence of all four will challenge many of the fundamentals of what makes traditional institutions work.