by Dr Constantin Gurdgiev, Adjunct Assistant Professor of Finance with Trinity College, Dublin
In a number of recent posts, we looked at fin-tech innovation disrupting current status quo in financial services, including the challenges that fin-tech poses to the traditional banking models,1 and at the shortcomings in the traditional equity valuation models applied to modern banks.2 In today’s world of highly interconnected markets, cross-referenced products and business strategies the two sets of problems are closely co-integrated: disruptive nature of fin-tech itself creates new risks and new channels for their transmission, feeding into the value of bank shares.
This problem is being indirectly and partially addressed in the growing debate on the strategic evolution of the banking sector business models, as exemplified by the recent paper from McKinsey & Co.3 Most of this debate is focused on the demand-driven innovation in the sector, perhaps reflective of the fact that the sector is still trying to catch up with exogenous innovation, rather than lead the innovation curve.
Source: Channy's Creation Blog
According to the authors, “If the last epoch in retail banking was defined by a boom-to-bust expansion of consumer credit, the current one will be defined by digital. This will include rapid innovation in payments and the broader transformation in systems enabled by digital technologies. The urgency of acting is acute. …Revenues and profits will migrate at scale toward banks that successfully use digital technologies to automate processes, create new products, improve regulatory compliance, transform the experiences of their customers, and disrupt key components of the value chain.”
Not surprisingly, “institutions that resist digital innovation will be punished by customers, financial markets, and – sometimes — regulators. Indeed, our analysis suggests that digital laggards could see up to 35 percent of net profit eroded, while winners may realize a profit upside of 40 percent or more.”
None of the above would be surprising to this blog’s readers. The idea of digital platforms as disruptors of the status quo in retail banking is hardly new.
What is new, however, is the pace of disruption. The majority of analysts expect peaking of the ongoing technological disruption in the banking sector somewhere closer to 10-12 years from today. McKinsey suggests there is much more urgency for the incumbents to act. Per study, “banks have three to five years at most to become digitally proficient. If they fail to take action, they risk entering a spiral of decline similar to laggards in other industries.” And more: “Within the next five years, digital sales have the potential to account for 40 percent or more of new inflow revenue in the most progressive geographies and customer segments. By 2018, banks in Scandinavia, the UK, and Western Europe are forecast to have half or more of new inflow revenue in most products coming from digital sales… Among bank products, savings and term deposits, as well as bank services to small and midsize enterprises, are expected to see more than half of new inflow revenue coming from digital by 2018.”
The point is that the changes considered by McKinsey research are, at best, the tail end of the innovation curve in the sector. And an added point is that modern banks are at the tail end of this innovation. Digitisation of payments, deposits and some of the commoditised transactions is already under way, as McKinsey admit. But the study fails to consider another disruptive wave – migration from the traditional banks-led intermediated lending to peer-to-peer lending platforms. It also fails to consider the subsequent threat: creation of more digitally-enabled direct lending markets.
Source: Google Wallet
Take, for example, the corporate lending environment.
Through the early 2000s, some 70 percent of all lending to larger non-financial corporations in the EU and almost 50 percent of the same in North America took place via banking lending channels. The balance of lending was carried via corporate bond markets and private intermediation. By mid-2010s, the shares of corporate bonds markets and private intermediation have grown to roughly 60 percent in the US and to nearly 50 percent in the EU. In part, these changes are driven by the shrinking credit supply via the banking channel in the wake of the Global Financial Crisis. But in part, they are enabled by technological innovations in the financial markets that reduces the cost of debt issuance to companies and facilitates debt instruments placement across more platforms and for smaller issues.
These trends are even more dramatic for SMEs lending, especially at the smaller loans end of the market – loans that traditionally carry more lucrative margins for the banks. Here, a shift toward peer-to-peer lending and non-traditional private equity have witnessed potential lenders moving their liquidity to direct lending channels, such as Funding Circle and Linkedfinance, and some are now raising funding for peer-to-peer lending platforms in the traditional equity markets.4
The net effect of the above is that traditional banks, even the ones that embrace peer-to-peer lending participation, suffer at both ends of the transaction margin. Peer-to-peer lending saps cheaper deposits from the banks, pushing up deposit rates or increasing banks’ reliance on inter-bank financing. This pressures banks’ lending margin on the funding end. At the same time, as peer-to-peer platforms evolve, cost of loans issued directly to businesses is falling as well, shrinking banks margins on the revenue side.
The problem here is bigger than in digital payments disruption precisely because while the banks can, by embracing digital innovation themselves, at least preserve the market share of transactions even if losing out on the margin side, they cannot defend their market shares and margins in the technologically disrupted lending markets.
Which brings us to the starting point of this post. If McKinsey projections are correct and the disruptive technology impact window is as narrow as 3-5 years, and if the disruption arising from this technology is broader-based than McKinsey research suggests, traditional banks will require very significant future investment into fighting their way out of fin-tech-induced squeeze on their margins, revenues and market shares. Good luck pricing this investment using the old pre-disruption valuation models.
References
1. See Fin-tech Innovation: Unraveling Retail Banking Model
2. See Where the Models Are Wanting Part 1: Banking Sector Stocks and Modern Investment Theory and Where the Models Are Wanting Part 2: Banks Networks, Risks and Modern Investment Theory
3. “Strategic choices for banks in the digital age“, Henk Broeders and Somesh Khanna , McKinsey & Co, January 2015.
4. See: Wall Street storms UK peer-to-peer lending groups and Hargreaves Lansdown enters peer-to-peer to challenge 5pc rates
