In London’s early-morning commuter throng, trainer-clad financial services folk are on their way to work in the big tech centres of Shoreditch and Canary Wharf. Most of them are on their phones, some doing what you might call banking – applying for a loan for their new start-up, shopping around for a mortgage, investing savings in the markets. Only none of them is actually using a bank
to do it.
The digital services they’re using are instead provided by a bewildering array of fintechs, the disruptive start-ups where many of them work. The rest are fulfilled by Amazon or Alibaba.
If you said the names of London’s early 21st century high-street banks to these commuters, they’d all know what you meant – after all, many of the lucrative services the fintechs provide rely on the banks’ balance sheets – but these savvy customers wouldn’t dream of dealing with them directly.
Welcome to the nightmare on Threadneedle Street, a world in which Barclays, long since spun off from its still-lucrative investment banking division, has become like British Gas, a utility stock, a low-risk, low-return investment for pension funds that need a steady dividend and a quiet life.
It may sound far fetched from where you’re sitting now – London’s banks and major financial institutions are among the largest and most profitable firms around, and the sector dominates lists of the world’s largest companies. Indeed, in public most bankers would balk at the idea that they were on the verge of being disrupted and displaced by upstart fintechs. Yet in private, those whose job it is to scan the horizon are getting worried. As a senior figure at one of the UK’s big four banks told Management Today, their greatest challenge – above Brexit, trade wars and the prospect of another crash – is "fintechs and GAFA [Google, Amazon, Facebook and Apple] taking all the profitable parts of banking, leaving us with the expensive infrastructure to run".
Just how likely is this scenario? Now that fintechs have been around for the best part of a decade, promising to do an Uber and disrupt the old-fashioned money merchants of the Square Mile and Wall Street, is it finally time to believe the hype? To answer that question, it helps to first break down what we mean by fintech. Although theoretically anyone could call themselves a fintech, they are best described as tech companies operating in financial services, as opposed to financial services companies that trade on tech. In its latest UK Fintech Census, EY estimated that in 2017 there were 1,600 such companies in the UK, one of the leading global centres for fintech, with London having more billion-dollar "unicorns" than any city save San Francisco.
Roughly half of them operate primarily business-to-business services, helping major financial institutions with digital identification (for example, Onfido), finding fixed-income trading opportunities (Algomi) or keeping compliant with ever-changing financial regulations (Suade). The others you could call challengers. Although what they actually do varies substantially, their investor pitch generally rests on two simple claims. First, that technology allows them to provide better financial options for retail or business customers that have been underserved and overcharged by the banks. Second, that the banks aren’t able to fight back because they are shackled by immense, clunking IT infrastructures, process-driven bureaucracies and unwieldy balance sheets.
Those who see these challengers disrupting traditional banking point to the colossal levels of investment in the fintech sector. Last year, $3.3bn (£2.6bn) in venture capital and growth private equity funding was invested in fintechs in the UK alone, according to industry body Innovate Finance, putting Britain third globally behind the US and China. According to HM Treasury, UK fintech received scale-up capital of £4.5bn between 2015 and 2018, almost double that received by ecommerce at £2.4bn. Britain’s seven fintech unicorns – TransferWise, Funding Circle, OakNorth, Revolut, Monzo, Checkout.com and Atom Bank – now have a combined valuation of $14bn (£11bn), equivalent to nearly 45 per cent of the market cap of Royal Bank of Scotland or Barclays.
As befitting a largely VC-backed industry, growth is impressive. The same unicorns increased revenues collectively by 80 per cent over their last reported trading year, consistent with the 82 per cent growth in the wider industry’s hiring rate, according to recruitment specialist Robert Walters.
Critics, however, retain their doubts, pointing out that venture investment is inherently speculative and that all this growth is coming from a very low base. Using EY’s estimate that the average fintech’s revenues are £5m, HSBC turns over seven times the combined total for London’s entire fintech ecosystem; as for profits, which still elude most fintechs, "the world’s local bank" earned nearly 600 times what the most profitable fintech, OakNorth, did last year.
That’s not to say the banks aren’t paying attention to their would-be disruptors, of course, especially as fintechs’ services have matured. For Ian Rand, Barclays’ head of business banking, this began when the start-ups stopped saying blockchain was going to replace banking completely.
"We’ve seen a few too many fintechs that have good ideas but as soon as you start working with them, you realise they haven’t actually spoken to any businesses that might want to use their services," he says. "It’s the difference between a vitamin pill and a painkiller. A vitamin pill’s good for you but you can’t always be bothered to take it. I play this back to fintechs – what’s the pain you’re killing? They’ll say it allows businesses to do A, B or C. But do they want to do A, B or C? Now, we’re seeing them going from vitamin pills to painkillers."
As fintechs have begun to develop products that banks or customers find useful, it has become more common for new and established financial players to partner up. Rand, for example, oversaw a landmark deal last year between Barclays and MarketInvoice, a fintech that provides invoice financing online using superior credit-risk-analysis tools. This dramatically cuts the fixed costs of invoice financing, making it suddenly viable to offer the service at much lower sums to customers who would previously have been denied it.
Alternative finance has been one of the areas where fintech has made the greatest impact. This has been largely a result of peer-to-peer (P2P) lending models – involving equity (players include Crowdcube and Seedrs) and debt (Funding Circle) – as well as credit-risk technology like that offered by MarketInvoice. This, says Katrin Herrling, founder and chief executive of alternative finance platform Funding XChange, has altered the service model for SME finance fundamentally.
"Three years ago, your typical route for finance was to invest a couple of hours in talking to different lenders, including your own bank," Herrling says. "This process would typically take about eight weeks because the banks would want to see your statements and your management accounts. Then they’d have questions for your accountants and would want to see your invoices.
"In many cases, the banks would still find it difficult to assess your creditworthiness, for example, if your business is seasonal or you rely on a few big customers. That’s all been replaced by real-time data, plugging into your cloud accounting software, which completely changes the model. In some cases you can get the money 15 minutes after applying."
The ability to assess risk for unorthodox smaller businesses at speed has enabled alternative finance providers to build a customer base that had traditionally been underserved by the banks. In the past, such would-be customers would either be denied funds or the banks’ decision-making processes would not be able to provide the money quickly enough.
Something similar is happening in other major – and profitable – financial services sub-sectors. OakNorth, which is valued at $2.8bn (£2.2bn), uses proprietary software to offer conventional loans to larger SMEs, while "robo advisors" such as Nutmeg are bringing wealth management to the masses, enabling users to invest in stocks with as little as £100.
The big question with any disruption is not what the challenger does better but why the larger incumbent is unable or unwilling to fight back before it’s too late. So, other than forming partnerships with their fleet-footed competitors, what are the banks doing in response to these tech-driven changes?
"Until a couple of years ago, the banks didn’t mind because these were customers they’d declined," says Herrling. "Now they’re sitting up and saying these are customers we want to work with, bank-grade customers. So the banks are starting to compete and becoming more like fintechs – they’re just not quite there yet."
Rand takes issue with the idea that the banks can’t compete on a technological front, pointing out that even when Barclays partners a fintech, it will have always considered the realistic option of developing the tech itself.
"In the most traditional banking product of lending, some banks will have had to partner third parties to transform their borrowing journey," he says. "We didn’t need to do that. For unsecured loans up to £25,000, for several years our users have been able to click and see a pre-assessed lending limit on their app and draw it down instantly. That exceeds what any fintech can do and we did it on our own."
In that sense, banking is not the minicab industry to fintech’s Uber. With the exception of P2P finance, which does not require a giant balance sheet, fintech business models aren’t radically different. This has led the Clayton Christensen Institute – founded by the Harvard professor who developed the theory of disruptive innovation – to say the term "disruptive" is generally misapplied to fintechs.
Many retail challenger banks, particularly the "neobanks" (fintech lingo for the most purely digital first), rely not on classically disruptive business models but on the incumbents’ peculiar inadequacies, which, they argue, are fundamental and unavoidable. By bypassing the older banks’ burdensome IT systems, the likes of Monzo, Starling, Atom and Revolut believe they can adapt faster to what customers actually need.
TransferWise, founded by Kristo Käärmann (l) and Taavet Hinrikus in 2011, is now one of the largest cross-border payment companies by volume
"It’s very hard for the existing, large financial institutions to adopt new technologies because of their creaky IT systems. They’re quite old but they’re very reliable – but that means everyone’s terrified of touching them," says Nick Kingsbury, a venture capitalist at Amadeus Capital Partners, who has worked with numerous fintech companies. He relates how one of them approached a non-UK bank about testing a piece of technology.
"They said they’d provide an API for us to get access to their infrastructure and that it should be done in four weeks," he says. "Six months later, they still hadn’t got it ready. It never happened because they couldn’t get their act together. Even though it was ostensibly a way of transforming a business process at that bank, they couldn’t because the infrastructure was too inflexible."
At present, this sluggishness hasn’t been sufficient for the neobanks to offer services radically different from those of their big rivals. They may be "digital first" but mobile banking is not solely the preserve of fintechs. While it’s true that the challengers have far higher net promoter scores – Atom Bank leads the pack with a +75 rating, while some big banks like HSBC actually have negative scores – the jury’s out on whether this will be enough to overcome the inertia that is so characteristic of the sector (retail banking customers are notoriously reluctant to change banks) or whether the banks will up their game before it’s too late.
Payments and fund transfers
The area of payments has been a target for disruption since the early days of PayPal and continues to take the lion’s share of fintech investment, while in fund transfers, digital, bank-to-bank propositions are slowly eating away at the more lucrative offline wire transfer services, run off the global credit card infrastructure by the banks and specialists such as Western Union. This development is being led by the likes of London-based TransferWise, which has grown rapidly since its foundation in 2011 to become one of the world’s largest online cross-border payments companies by volume.
The advantage for challengers here is not that they’re the only ones capable of offering this cheaper technology – Western Union runs the largest digital transfer service – but rather that their competitors are reluctant to cannibalise their own businesses because a complete shift from offline to online would be so damaging to profit margins.
Despite this, the incumbents are still standing. Although it is hard to know exactly how much profitability banks have lost from their payments and fund transfer businesses, we can see that Western Union’s share price is the same as it was four years ago, while MasterCard’s and Visa’s have both more than doubled. If the existing players were losing a significant amount of business, this wouldn’t be the case.
On the surface, it would seem our anonymous big bank director is getting overly anxious about the fintech threat while the likelihood of all-out disruption remains a bad dream. Despite rapid progress and loud noises, challenger fintechs are still very small and have enjoyed most of their success in only a handful of very specific subsectors. But complacency would be ill advised. Most of the barriers to entry that once protected the banks – regulatory approval, the need for great balance sheets and bank branches – no longer exist. This means they are facing genuine competition from a new breed of rival that moves faster and has deep pockets. And unless the fintechs’ growth rate slows – and it shows no sign of doing so just yet – the balance of power inevitably may shift.
"It’s one of those things where you need time-lapse photography to see what’s going on," says Kingsbury. "Whether it’s Monzo or Revolut or TransferWise, the impact is barely noticeable to the incumbents but it’s going to increase rapidly. It may take 10 to 15 years but it will be profound."
The bankers’ nightmare may become a reality even sooner if, after years of speculation, the US tech giants finally become involved in finance. After all, companies such as Facebook, which just launched its own crypto-currency Libra, or Amazon, which has already offered a few billion dollars in loans to SMEs on its marketplace platform, are uniquely placed to enter the sector, whether on their own or in partnership with fintechs – a prospect that has the sector abuzz with speculation.
"They really don’t know much about talking to regulators," Michael Kent, CEO of payments company Azimo, told CNBC at fintech’s Money2020 conference recently. "There’s a lot of talk of partnerships and, of course, there’s always the threat they do all this stuff themselves. They’ve got the networks, they’ve got the customer base to do it."
You only need look to China, where tech companies Alibaba and Tencent dominate payments and are becoming increasingly important in other financial services. It’s hardly implausible that the Chinese could start operating here themselves. Earlier this year, Alibaba’s fintech sibling, Ant Financial, bought UK-based payments company WorldFirst for a reported $700m (£549m) as it looked to grow its international presence.
Outside of payments, where Facebook is now making a major play, the tech giants have so far only danced around the edges of financial services and it remains to be seen whether one or more of them takes the plunge. Herrling is unconvinced that this is something they really want to do.
"I remember a few years ago, people were talking about a Google bank or an Amazon bank – we haven’t seen it," she says. "There are a few reasons why this might be the case. One is that managing a balance sheet through a credit cycle is a damn difficult thing, and it’s quite risky and distracting to their core business. Another is that they’ve realised how many regulatory issues are involved with handling people’s money. These businesses are agile, they like flying under the radar. All that compliance and oversight must be incredibly unappetising."
Rather than jumping into financial services feet first, the tech giants are more likely to become a platform on which conventional and challenger banks offer their own services – a solution that gets around most of these problems. But if customers access fintech services via Facebook, facilitated by algorithms rather than people in suits, then what’s the point of basing any of it in London?
Don’t be too hasty to rule out the major financial institutions, says Kingsbury. The big banks still have considerable advantages, not least their resources and their keen awareness of the threat. Not only are they partnering fintechs, setting up accelerators for them (Barclays’ Rise programme, for example, is home to 250 start-ups) and investing in them (corporate VC investment was $23bn in 2018, according to KPMG), they’re also creating their own (Esme from RBS is essentially an alternative finance start-up that exists outside its parent’s firewalls) and eyeing up fintechs as potential acquisitions.
"I fully expect one of the challenger banks to be acquired by one of the incumbents, and that may result in a feeding frenzy. It’s very hard to build a digital bank completely inside the big beast of an RBS or a Barclays, so I’d bet my bottom dollar those are active conversations in their corporate development teams," says Kingsbury.
As a result, it is unlikely that the pantheon of major banks will desert the capital any time soon. There is a risk of disruption, as with any industry, if they do not address the threat, but that’s precisely what the big banks are doing. What’s more likely, sooner rather than later, is that differences between banks, fintechs and tech companies blur as technology and innovation increase the levels of competition in the sector.
That won’t be such a bad thing. What might seem like a nightmare to those bankers who have grown too comfortable will be a dream for customers, both retail and business. As long as the safety of the financial system is not compromised in a fail-fast rush to win customers, we could all benefit from better and cheaper access to finance.
Main Image: Getty Images
Body Image: TransferWise