Adyen, which means ‘start over again’ in Surinamese, is a Netherlands-based company founded in 2006 that offers an ecommerce platform that seeks to smooth payments and provide shopper-data insights for businesses. In 2017, Adyen, which employs fewer than 700 people in 15 offices around the world, processed more than 100 billion euros for the first time.
Commerzbank is a German bank founded 148 years ago that has about 1,000 branches that serve more than 18 million private and business clients. In 2017, Commerzbank’s 50,000 employees generated 9.1 billion euros in revenue, making it one of Germany’s biggest banks.
On June 24 this year, the day after Adyen listed, the two companies had about the same market value. Three months later, Adyen was worth more than double Commerzbank – on November 1, it was valued 60% higher.
This example shows how investors assess the threat to traditional banking from ‘fintech’, loosely defined as any technological innovation tied to the internet that competes against the services offered by old-style banks. Fintechs are shaking up mobile payments, corporate banking, capital markets, foreign exchange, consumer finance and small company lending. They are doing this by offering internet banking, ‘crowdfunding’, running price-comparison websites, hosting peer-to-peer lending and extending ‘point-of-sale’ loans. Their app banking aims at the heart of savings banks, the transaction accounts, from where people run their lives. In time they could challenge the viability of the branch networks that provide saving banks with their core advantage, a large source of cheap funding and clients for life.
Most fintechs are startups and few, it must be said, are likely to be as successful as PayPal any time soon. Their lack of distribution networks leaves them more nibbling away at niche banking areas, often ones regarded as too risky by banks. The most likely fintechs to challenge saving banks are the tech giants, which come to the industry with distribution networks, much capital, hordes of big data on their customers and are IT savvy.
Whichever sort, fintechs hold advantages over savings banks, which are losing some of their edge in the age of the world wide web. The internet works against banks because it reduces the convenience advantage offered by their branch and ATM networks. It allows for easy interest-rate comparison, which promotes newcomers undercutting banks. The internet makes it simple to switch banks – something that is rare. (A Productivity Commission report this year said that one in two Australians have only ever had one bank.) Fintechs coming to fight against banks are generally free of, or less burdened by, the systemic-based capital requirements and compliance controls that smother savings banks. They are risk-takers free of the hodge-podge systems hampering risk-averse banks. Mobile payments present them with an easy entry into finance, as the emergence of Adyen shows. Their reputations are cleaner. They aren’t a target for populists, nor are they damaged by the criminal allegations that banks face in countries such as Australia. Regulators are encouraging their rise to boost competition.
Fintechs, especially if big tech gets serious about finance, are likely to peck away over time at the oligopolistic industry structures protecting savings banks (without encroaching on the systemic role banks play in the financial system) because they have two key advantages. The first, stemming from their lower costs and the qualities of the internet, is that they can offer higher returns and lower lending rates than can savings banks. This cost advantage means that fintechs could entice away bank customers. The other advantage is fintechs can easily target the fee (or off-balance-sheet) side of banking, which offers returns on equity of about 20% and where about 65% of banking profits are sourced.
The risk is that the traditional global banking industry might struggle to earn a return on equity that exceeds its cost of capital, usually taken as somewhere between 8% and 10%. The best ones will stay profitable, the average ones are likely to just earn their cost of capital. Regulators need to be on guard that some could fail.
To be sure, fintech market share is still small, much fintech growth is incremental rather than breathtaking, and many complement rather than disrupt banks. Some fintechs are floundering and most are yet to be tested by recessions. Conservative US regulation protects US banks from much fintech disruption. Governments everywhere will protect traditional banks in some form because they are vital to the financial system. Traditional banks are cutting costs and have the resources to reinvent themselves as tech-savvy – and possibly much better – banks or financial services. Six large Swedish banks, for instance, launched the Swish mobile payments system in 2012 to enshrine their dominance in that sphere there. Banks have enough capital to buy, and coopt, threatening fintechs. While people might resent traditional banks, they are ‘brands’ that have held their trust over time. Banks have a proven ability to assess credit risk, the core survival skill banks require. Banking virtues – prudent lending, sound risk management, integrity, etc. – will likely hold sway over technology in the long run.
And yet Big Fintechs, and startups to a lesser degree, are capable over time of snapping the traditional and profitable lifelong bank-customer relationship that began when a child or adolescent opened an everyday account. They intend to go after the juiciest fee-income parts of traditional banking. They will lower margins on the balance-sheet-based lending that is the lifeblood of the economy. Traditional banks will have to adjust to this new competition. Being more like fintechs (perhaps, by partnering with them) is probably the best way for savings banks to do that.
In 2004, six men in the UK formed the world’s first peer-to-peer lender, which they named after the acronym for ‘zone of possible agreement’. Since Zopa originated its first loan in 2005, the P2P lender has lent 3.6 billion pounds sourced from 60,000 investors to 311,000 borrowers (in total). Many others have since emerged such that global peer-to-peer lending reached US$64 billion by 2015 and is expected to grow in coming years.
P2P lending has spread because technology allows these companies to be loan brokers – they earn most of their income from organising loans. Due to their cost advantages, P2P lenders have paid their investors up to 7% on loans to take the credit risk, when official rates hover around 1% to 2%. As for borrowers, many who would have struggled to attain loans from banks can now source finance, and at lower rates.
But such lending has its challenges to become more than a tiny fraction of total credit provided by the financial sector. Because they earn revenue from arranging loans, P2P lenders have less incentive to assess risk as conservatively as do banks whose balance sheets are at risk. As such, in the US confidence was lost in P2P lending when prominent lenders revealed that they weren’t verifying all lenders. In China, many P2P lenders have collapsed.
Crowdfunding, which describes when a project is funded by appeals to lenders over the internet, is in a similar position as P2P lending – expanding but facing challenges to become more than a minor industry. While much is charity-based, about US$20 billion has been crowd-raised for business lending worldwide. Demand is such that Australia in 2017 passed laws to govern crowd-sourced investing and in January this year ASIC granted its first crowd-sourcing funding intermediaries when it licensed seven companies to offer ordinary shares in companies via their platforms. But most crowdfunding is for businesses that banks consider too risky, it largely only appeals to millennials and faces the catch 22 that it will only take off when a liquid secondary market is developed for these securities.
‘Neobanks’, which exist only in cyberspace for their customers, are similar lesser threats to banks. Among the first such neobanks were Atom Bank, Monzo Bank and Starling Bank of the UK that were founded only from 2014. These are app-only banks that hold formal banking licences, offer no-fee prepayment cards, plus everyday accounts that offer attractive rates. In Australia, Xinja Bank and volt bank were the first (restricted) licensed neobanks and more are coming. But their reach is small and saving banks can launch similar services.
Worldwide, when other online-based lending such as point-of-sale loans are included, alternative lending reached US$380 billion in 2017 – a minor fraction – and is forecast to hit US$502 billion this year and more in coming years. Even if this optimistic projection proves true, start-up fintechs are unlikely to make much dent in the market hold of traditional banks in the foreseeable future – their borrowers are likely to be those rejected by banks.
As they have shown with payments, smaller fintechs, however, are better placed to attack the lucrative non-balance-sheet-based services offered by banks. In Australia, for example, the ASX-listed OFX has transferred (typically converted) more than A$125 billion via more than one million transactions in any of 55 currencies since it began as OzForex in a garage on Sydney’s northern beaches in 1998. OFX claims it conducts these transfers at rates that are 70% cheaper than those offered by traditional banks.
Rakuten, the Japanese word for ‘optimism’, was founded in 1997 and is now Japan’s larger e-retailer through its Rakuten Ichiba site. Of its two other arms, one is internet finance, which includes Rakuten Card and Rakuten Bank, that, being founded in 2000, is Japan’s second-oldest online bank and one that provides lending and insurance among other services. The emergence of this and other successful platforms is the real fintech threat to traditional banks.
Big Tech has already invaded finance especially in China. Alibaba’s Ant Financial and Tencent dominate cashless payments in largely cashless China and offer financial services via app including money-market funds – Ant’s 2013-launched Yu’ebao (Mandarin for ‘leftover treasure’) is the world’s largest fund with US$268 billion at the end of March.
In the US, Facebook branched into payments via its Messenger app in the US in 2015 and extended this service to European users after securing an ‘e-money licence’ in Ireland in 2016. Amazon conducts e-payments (amazon pay), offers an online deposit facility (amazon cash), lends to small business web listers (amazon lending), and offers insurance (amazon protect). The e-retailer performs these and other financial functions without a banking licence.
Big Tech is well armed to further assault traditional banking. These mega-profitable and ambitious companies have the capital to invest. They are self-evidently tech savvy and have billions of people who already use their networks to target with financial products. They possess vast hordes of Big Data gleaned from their billions of users, which shatters the information advantage banks used to hold on their customers.
While the Big Fintech threat is still in its infancy, European banks worry the introduction of ‘open banking’ regulation that was passed in 2015 with a two-year lag before enforcement will encourage big platforms to scour for the most lucrative parts of their businesses. They fret that, over time, Big Fintech will upend banking the same way the platforms have disrupted retail and media. Under the law, if customers grant permission, European banks must allow third parties including tech companies, retailers and even rival lenders access to accounts.
Banks are responding to the threat of Big Fintech (and smaller fintech). They are closing branches because they can see that physical reach is no longer an asset in the age of digital banking – HSBC has reduced its UK branch network by about a third to about 625 in recent years. But they can see that’s not enough. Francisco González, executive chairman of Spanish bank BBVA, warns the platforms will “replace many banks” and “authorities (need) to bring order to this massive change” that could “pose risks to financial stability”. Regulators, in effect, will soon need to weigh the trade-off between financial stability and innovation and competition. Perhaps before long, they will need to inflict regulatory controls on the financial arms of platforms.
To stave off Big Fintech, Royal Bank of Canada, that country’s biggest bank, intends to become an ‘ecosystem’ or platform that offers non-bank services. The bank is considering plans to help entrepreneurs register start-ups – even by providing branding, letterheads and business cards – to help people sell their homes, buy a car or rent their home on Airbnb. In short, the Commerzbanks of the world might become more like the Adyens, even with the help of the Adyens, to stave off the Adyens.
Published by Michael Collins, Investment Specialist, Magellan Group
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