Fintech challenger banks expected their own version of Julius Caesar’s famous line: “I came, I saw, I conquered.” The challengers have certainly enjoyed some notable successes, but they remain far short of conquest, and questions are beginning to arise among knowledgeable observers about whether the would-be conquerors are quite as formidable as predicted.
Alan McIntyre, Senior Managing Director – Banking for Accenture, is among the skeptics. In an exclusive interview with The Financial Brand the consultant stated, “I struggle to see how the valuations of some of the pure, narrow challenger bank models are justified at the moment given what we know of the economics.”
That may seem like a bit of good news for the thousands of traditional financial institutions nervously glancing over their shoulders at the oncoming invaders. Some observers go so far as to predict a renaissance of legacy banks and credit unions. McIntyre doesn’t go that far. The widely followed thought leader sees a continued squeeze on legacy financial institutions — smaller institutions in particular — from trends hitting both sides of the balance sheet.
At the same time, big tech firms are expanding their beachheads in financial services. Not only “GAFA” — Google, Apple, Facebook and Amazon — but Walmart, which has quietly become a significant factor in financial services. Will these “outsiders” be the winners?
Or will it be the largest U.S. banks, who have been cutting deals with the big techs and fintechs and investing gazillions in digital capabilities?
Can anyone else but some combination of these giants expect to survive long term? Yes, says McIntyre, but certainly not all current institutions.
In the following report based on a lengthy interview, the consultant outlines several strategies for not only legacy banks and credit unions, but challenger banks as well. McIntyre also predicts what’s next for big tech involvement in banking and describes the growing impact of open banking.
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You’ve spoken of the “twilight of community banking.” That’s a sweeping statement. How do you back it up?
Alan McIntyre: Both sides of their balance sheet clearly are under threat. On the liability side, a key aspect of traditional institutions’ business model is having physical locations that attract deposits like flypaper. But the relationship between a physical network and share of deposits has basically broken down. Simply having a branch on the corner no longer attracts the same level of deposits it used to. That’s why you see some of these smaller institutions get more into brokered deposits — essentially taking deposits where they can find them.
On the asset side of the balance sheet, one of the reasons I have an existential concern for small financial institutions is that they’re getting backed into a corner. And that corner gets smaller and smaller over time. For example, more and more middle-market lending has gone to non-bank players — the KKRs, BlackRocks, Apollos and business development companies of the world — using direct origination techniques. In addition, mortgage lending isn’t a balance sheet business for most U.S. banks, and the credit card business has been consolidated among a few players to a large degree. All this has constrained the asset side of the balance sheet for many smaller financial institutions and made commercial real estate and C&I lending important.
A key factor is that the banking environment, from a macroeconomic standpoint, isn’t going to get much better than it has been over the last three or four years. And yet collectively smaller financial institutions have not grown their balance sheets — assets or liabilities. If they’ve not done well in the best of times, how will they do in the times that are more challenging?
How can small and mid-size financial institutions survive?
McIntyre: There are several options. One is renting their balance sheet. Fee income gets squeezed by technology, but balance sheet income doesn’t get squeezed nearly as much. So a strategy for traditional financial institutions is to rely more heavily on balance sheet income by becoming in effect a “manufacturer” of banking product. This strategy — taking the assets and liabilities generated by others onto their regulated balance sheet — is used by several institutions including Cross River Bank, Bancorp Bank, WebBank and others. I believe the model would be attractive even to smaller players.
Another option is to adopt the specialist model, of which there are many examples. First Republic, Boston Private and Texas Capital operate successfully in the overlap of wealth management and commercial banking. Silicon Valley Bank is another great example of really understanding a customer segment well — in their case the venture capital/investor community — and then being able to scale that and build it out internationally.
“Over time it will be tougher and tougher for small or less-specialized banks to be competitive and generate attractive returns.”
— Alan McIntyre, Accenture
The specialist model can remain viable because digital disruption mostly affects generic products. Things that are driven by expertise are more defensible because they are not easily eclipsed by better technology. For example, knowing how to evaluate a film production company, as City National Bank does, isn’t something that you just copy quickly. It comes from decades of credit risk experience and insight.
With retail banking, while there’s still some level of segmentation possible, overall it’s more easily copied.
Scale is also important. The long-run consolidation of the U.S. banking industry will continue, driven in part by smaller financial institutions getting together to increase their scale. Over time it will be tougher and tougher for small or less-specialized banks to be competitive and generate attractive returns.
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Shifting to challenger banks, how sustainable is their revenue, based largely on swipe fees?
McIntyre: The WeWork debacle and the post-IPO problems Uber has faced will increase the pressure on a lot of these challenger banks to articulate their long-run model.
You are right that the vast majority of their income comes from the interchange and payment transaction fees, and those are declining. More and more of these types of transactions will move to account-to-account payments rather than go over the Visa and Mastercard rails. That will make the economics tighter and tighter. So I think over time the water drains out of that revenue pool.
What options do the challenger banks have?
McIntyre: We think there are essentially three viable models. One is that you become a digital traditional bank, that is, you build a balance sheet.
If you look at the U.K., that’s what Atom Bank is trying to do. Atom didn’t go on a rapid customer acquisition run like Monzo, Revolut and other challenger banks. Atom has grown more slowly but has built its balance sheet. It is trying to get into the mortgage business, for example, and it’s getting into the small business lending market. They intend to build what looks like a more traditional balance sheet.
Monzo, on the other hand, went for customer acquisition numbers. But we don’t think that they built a balance sheet. The average Monzo account has a few hundred dollars in it. The question for them, and others with a similar model, is: Can they build enough scale and keep lowering the cost to make the basic transaction banking model profitable for each customer? And then maybe add premium content on top, like the Spotify model where you get people to upgrade to a subscription model with more bells and whistles.
“My view has always been that becoming a pure platform business is economic suicide for a bank because you essentially give up the balance sheet.”
The third model — of which the best example is Starling Bank in the U.K. — is to try and build a marketplace in which you are an intermediation point for many products and services. Rather than building everything yourself and trying to hold the core transaction accounts, you’re the marketplace through which your customers connect to insurance, wealth management, small business accounting and more. You don’t own those services but you’re the point of integration. And you earn money every time those products and services are clicked through.
I’m skeptical, however. My view has always been that becoming a pure platform business is economic suicide for a bank because you essentially give up the balance sheet. If you’re a new entry like a Starling you can try it because you don’t face the cannibalization risk. But if you’ve already got a balance sheet, the click-through fees and ad revenue have to make up for the net interest margin on a $50,000 loan. I think that will be challenging.
What is your sense of how things will play out for challengers?
McIntyre: I think the models at the moment are going to struggle to be profitable. Ultimately these guys will either need huge scale at relatively low margins or they’ll have to build more of a traditional balance sheet model where they build the assets and liabilities and make the spread off of them.
“I struggle to see how the valuations of some of these challenger banks are justified given what we know of the economics.”
In the U.S., an interesting comparison is between Chime, which is trying to be a Monzo-type transaction banking challenger, and Marcus, part of Goldman Sachs. Marcus is a digital bank and has assets and liabilities. In and of itself Marcus is not carrying the economic weight of Goldman Sachs Bank. They can use Marcus as a funding mechanism or customer-acquisition vehicle for other products and services.
But with the pure, narrow challenger bank model — where it’s a savings account, checking account, and maybe a simple consumer loan — I struggle to see how the valuations of some of these banks at the moment are justified given what we know of the economics.
Clearly the challenger banks have option value. If you’re Revolut, for example, and you’ve got ten million customers, you can potentially do a lot with them. And if you’re smart, have great customer ratings and great branding, investors trust that you will do something with all that in the future to generate more profitability, and they will give you credit for that option.
It’s just not clear to me at the moment what that option is. And the fact that the core business isn’t profitable indicates that the option may not be worth much.
How large a role will the big tech companies play in banking?
McIntyre: Google, Amazon, Facebook and Apple are all going to continue to experiment with financial services. A key question is: Will it benefit their core business? I don’t think banking will be a primary business for any of them. None of them want to be a regulated financial institution.
For Amazon, payments clearly is an attractive area. The more of your life that runs through Amazon the better the data quality is, the more they can internalize that. So I do think the speculation around Amazon having a checking account will happen at some point but it will be along the lines of the Google Citi deal. That is, partner with someone and launch the equivalent of an Amazon transaction account.
“Some of the things Walmart is doing in financial services are just as important as what Amazon is doing.”
The whole Amazon data-driven business model is transferable to banking. See what you’re spending on, and then give you a better option.
Apple’s reason for bringing out the Apple card with Goldman was to make the iPhone more attractive.
With Facebook, I struggle a little to see the connection in what they’re trying to do with Libra, because Facebook is an advertising-based business model.
The move with Google and Citi is interesting with respect to the U.S. market, but the place to look at Google is not in the U.S., but India where Google Pay is the largest digital wallet. Google is going to use markets like India to see how much it can front-end financial services.
We talk a lot about fintech and big tech, but some of the things Walmart is doing are just as important and just as influential in the U.S. as what Amazon is doing. Walmart Pay is essentially the number-one digital wallet in the country. With more internalization of payments they learn more, adjust costs and become more intimate with their customers. It’s an enablement of their core business.
What impact will all these developments have on traditional institutions?
McIntyre: The impact will be the fragmentation of the deposit base. Banking is no longer monogamous. The idea that you have a single bank that you run your financial life through is going to become less and less common.
Consumers are saying, ‘Okay, I can have my bank account but then I can have a Monzo or a Revolut or a Chime or a Dave or something like that sitting on top of it. And I can also have my Robinhood app and I can have my PayPal app.’ Rather than have all their marbles sitting in one place they’re going to spread them out. Maybe their payroll’s still going to enter their Bank of America account, but every month they take some of that out and put it in their Walmart Pay account or their Starbuck app.
Will open banking magnify the changes you describe?
McIntyre: Open banking is about the delayering of the industry — separating pieces of the value chain. As a consumer I don’t need to get my overdraft line of credit from the same people that provide my checking account. Open banking relies on information sharing and the flow of information between different players.
Open banking is also about consumer data rights. In Australia, for example, open banking says if you want to connect to this player we’ll put in some requirements, but essentially your bank account information is your data. You can share that with whomever you wish.
“It’s easy to say to consumers, ‘We can’t share your data because it’s not secure.’ But that’s not a long-run position banks can take.”
In the U.S. we’re going to go down that path as well. It’s easy for an institution to say to consumers, “We can’t share the data because it’s not secure.” But that’s not a long-run position financial institutions can take.
I do think banks and credit unions must have stringent controls over how data is shared. Banks are still trusted far more than the tech companies to look after your data. That’s a key advantage that banks can’t afford to give up.
But instead of just not sharing, they could say, “We want to share your data. Here’s the format and here’s the security that goes with it and this will protect you.” Tokenization technology would allow specific data to be shared without access to the private information. There is a lot of activity going on in that area.