Banking 2030, Part 3: Banking Innovation is Paramount Even as Regulatory and Competitive Pressures Mount

Special Report: In 2024, the banking industry will need to face down immediate pressures on multiple fronts, including increased regulatory scrutiny, proliferating competitive threats and fickle consumers. It would be easy to put innovation on the backburner. But the radical reinvention of everything from core technologies to customer relationships, often in partnership with new players, will be key to both meeting short-term challenges and pursuing long-term prosperity.

The regulations that rose from the ashes of the financial crisis of 2008 were, and are, crucial for maintaining financial stability. But they have also consumed substantial resources that might have been used elsewhere – specifically, to pave new paths to banking innovation.

According to TD Bank estimates, the six largest U.S. banks expend over $70 billion annually on compliance-related staffing, systems and controls. As founder and chief executive of Launchpad Capital Ryan Gilbert says, “running a bank is an expensive endeavor, largely due to the costs associated with compliance.”

Policymakers have been working to tailor regulations based on bank size and risk profiles, but progress has been slow. Smaller banks, in particular, grapple with disproportionate compliance costs relative to their earnings, placing them at a competitive disadvantage.

Did you miss the first two parts of this series? Read Part 1: The New Realities of Banking and Part 2: The Seismic Forces Shaping the Industry

Emerging areas of finance, such as cryptocurrencies and embedded finance, blur traditional banking boundaries, introducing additional regulatory uncertainties. The evolution of oversight in these areas will profoundly impact banks’ latitude to explore new business models and revenue streams. A harmonious balance between financial stability, consumer protection, and room for responsible innovation is the elusive goal of “smart regulation” that banks and regulators should strive for.

“Running a bank is an expensive endeavor, largely due to the costs associated with compliance.”
— Ryan Gilbert, Launchpad Capital

Guiding technology-forward regulations can empower banks to harness innovation, enhancing security, transparency, and customer value. Regulators should seek thoughtful oversight that encourages innovation while safeguarding against excessive risks instead of attempting to prevent the recurrence of a once-in-a-century financial crisis.

Banks face a growing challenge to their market share from alternative lending platforms, which poses an existential threat, as noted in McKinsey’s 2023 Global Banking Annual Review. Over 70% of the growth in global financial assets since 2015 has shifted away from traditional bank lending, finding its way into private markets, institutional investors and the realm of “shadow banking.” Near-zero interest rates have enabled private equity firms and non-bank lenders to offer lower-cost loans. With its digitally savvy consumer base, the fintech sector has further accelerated this transition, particularly during the pandemic.

Amanda Peyton, chief executive of fintech startup Braid, offers insights into this shift: “Running a bank comes with high costs, including compliance, and banks need to achieve scale.” The substantial compliance burdens and legacy technology systems put banks at a disadvantage compared to more agile competitors, especially when interest rates decline.

“Shadow banking” has allowed non-bank entities, such as private equity firms, to fund investments while avoiding the capital requirements and transparency obligations placed on regulated banks. This shift has moved risks outside the formal banking sector, raising concerns among regulators. Private markets operate with less visibility and oversight compared to their public counterparts.

According to McKinsey, these trends fundamentally threaten the traditional banking business model. In response, McKinsey argues that banks should focus on several key strategies:

  • Adopting cutting-edge technologies like artificial intelligence (AI) to improve efficiency and offset legacy costs.
  • Identifying strategic balance sheet opportunities, particularly as interest rates rise, such as in commercial lending.
  • Scaling transactions and payments businesses through mergers to compete effectively with fintech companies.
  • Enhancing distribution channels by seamlessly integrating services into customers’ daily digital lives.

Adapting risk management approaches to thrive in the new competitive environment.

McKinsey emphasizes that banks cannot afford to become complacent during the current profitability rebound. Significant technology adoption and business model evolution are imperative to seize the opportunities of the coming decade. Banks can thrive amidst the Great Transition by strategically leveraging their balance sheets, transforming distribution models, and emphasizing understanding and serving their customers.

As the banking industry undergoes structural transformation, adapting and embracing change will be paramount to survival, particularly in building relationships, fostering collaboration, and strategically using data.

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Relationships Still Matter – A Lot

Even as banking becomes increasingly digitized, the enduring importance of human relationships in finance cannot be overstated. For significant financial decisions, such as loans and wealth management, customers want nuanced advice and, most importantly, trust—qualities that transcend digital convenience. As Patrick McKenzie (the strategic advisor to payments firm Stripe) points out, specialized sales roles will continue to be crucial, as consumers often require education and guidance on complex financial products.

Gilbert argues that physical proximity and community connections give smaller banks a distinct advantage over “large institutions sitting in the Ivory Tower.” In an era where digital interactions can sometimes feel impersonal, community-oriented banks have the unique ability to foster trust and deeper relationships with their customers.

Fletcher Jewett, founder of the strategic advisory firm Jewett & Co., echoes this sentiment, emphasizing the value of relationships in banking at different scales. He notes, “Relationship banking is very profitable at a community bank level, but not at a big bank-level because the larger banks are prisoners of the capital markets where they need to hit quarterly earnings targets.

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They know they should invest in relationships, but the market doesn’t reward them. The CEO of a large bank is hired to knock out a 15% return on equity, to clip the coupons for the investors, and not drive the bank into the ditch. It’s almost like a utility. Whereas your community bank has an incentive to forge partnerships and relationships.”

Ironically, even high-net-worth customers with significant assets don’t necessarily receive the attention they expect. Jewett cites one extreme example of one of his clients who, in 2009, during the great recession, had $440 million in CDs held by a major money center bank but who, in 120 days, couldn’t get approved for a $400,000 loan.

To make a statement, he moved all his assets. “At the end of the day, did it really move the needle or the bank’s earnings? It didn’t.” Perhaps such an extreme case of client neglect happens only during periods of financial upheaval. Still, instances where the top 1% of banking clients, effectively little fish in a big pond, receive less than stellar customer service are not uncommon. Such examples underscore the disconnection that can occur even in traditionally relationship-driven aspects of banking.

Despite such instances, the broader data still points to the significance of physical banking interactions in many customer segments. Evidence indicates that retail branches play a central role in banking despite the rapid pace of digital adoption. According to a McKinsey survey, 60% of U.S. consumers still prefer to open accounts in person. While the in-branch experience may evolve with the incorporation of more remote advisors and reduced reliance on physical real estate, the fundamental importance of relationships remains unchanged.

Why Consumers Still Go to a Branch:

Interestingly enough, three-fifths of consumers in the U.S. still will go to a branch to open a new account.

Major life events, such as generational wealth transfers, underscore the enduring need for trusted financial advisors and bankers. As Gilbert emphasizes, these moments present significant opportunities for banks to deepen relationships by offering holistic, personalized guidance on legacy planning. In an increasingly complex financial landscape, human connections and expert advice remain invaluable.

To maintain connections with existing clients and build new relationships, he suggests that banks focus on college recruiting to identify and attract the best and the brightest into the industry.

Bank-Fintech Collaboration Will Be Key

Collaborations between traditional banks and fintech companies represent a pivotal avenue for accelerating innovation and modernizing the banking experience. These partnerships enable legacy institutions to swiftly bridge digital gaps and upgrade technology while tapping into new capabilities. Simultaneously, through bank alliances, fintech companies gain access to distribution channels, monetization opportunities, and regulatory cover.

However, it’s crucial to recognize that fintechs should approach banks as collaborative downstream partners, not adversaries poised for disruption. The most successful fintech firms have established close partnerships with banks from the outset.

 

According to McKinsey research, deals between banks and fintechs have tripled from 2018 to 2021, underscoring the recognition among banks that collaboration is essential for accessing innovation. As Angel Rich, founder and chief executive of CreditRich, suggests, these partnerships can create “a beautiful win-win situation where we are able to leverage a traditional large financial institution, Fortune 100 company, and they are able to leverage our innovation, our connection with diversity and our growth in the payments platform.”

By combining their distinctive capabilities and forging strategic alliances, banks, and fintech startups can overcome shortcomings and capitalize on shared strengths. The path forward for banks involves proactively seeking collaborations with promising fintech partners that allow them to deliver new digital experiences and remain competitive.

In response to this trend, some banks have established dedicated divisions to manage fintech partnerships and investments. Those institutions resisting collaboration risk falling behind in an industry that is rapidly evolving.

Next — Part 4:  The Path to Delivering Fully Integrated Banking Experiences

J.P. Mark is an equity research analyst and the founder of Farmhouse Equity Research, LLC. Prior to launching his own firm, J.P. was Managing Director and Director of Research for Wells Fargo Securities, a Vice President and Senior Equity Research Analyst at Dain Rauscher Wessels, as well as holding research roles at the investment banking firms of Montgomery Securities and Robertson, Stephens & Company in San Francisco.

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