Uneven progress in the digitalization of banks

Digitalization remains a challenge for traditional banks and few of them are able to achieve success that translates into financial profits. Meanwhile, an entire class of digitally-native entities has entered the market.

Over the past three years banks across the world have spent the huge amount of money, like a trillion dollars, in an attempt to transform their activities in the area of digital technologies. According to the report prepared by Accenture, the results have not been particularly impressive. The survey covered 160 largest banks in 21 countries and focused on identifying the relationship between the level of digital maturity and the financial results of banks. Only 12 per cent of the surveyed entities (the so-called “digital focused” banks) are putting digitalization in the center of their strategy, 38 per cent (“digital active” banks) are pursuing the digital transformation of certain operations, while the remaining half have not made any clear progress in this area. The banks undergoing a digital transformation have higher profitability and return on equity, but their revenues increases weren’t significant. However, these entities enjoy greater confidence among investors, which is reflected in higher price-to-book ratios. Digital focused banks were the only group with a price-to-book ratio above 1, which means that the gap between that group and the rest of the industry is widening.

The authors of the report admit that despite a clear correlation between the level of digital maturity and efficiency, the results of “digital focused” and “digital active” banks may also be influenced by other factors. These factors include geography, as the profitability of banks operating in North America or in Australia has for many years been almost twofold higher than that of European banks (reaching an average of approximately 16 per cent). The higher GDP growth rate and the greater intensity of competition, particularly from technology companies, may play a role.

Over the past several years the banking market has seen the emergence of a new class of digitally-native entities, which have virtually no physical branches and no material infrastructure. A comprehensive analysis of these new entities has been prepared by Citi Research. They are often referred to as “challenger banks” or “neobanks”. These are not only FinTech companies that have entered the banking sector, but also entities introduced to the market by traditional banks and technology companies. The report lists nearly a hundred of such institutions. Their expansion is the result of growing digital needs of customers, the availability of new and increasingly affordable technologies, the emergence of digital platforms, the liberalization of regulatory requirements (especially in the United Kingdom), as well as increased competition. Another important factor is the financial support from venture capital funds, which provided the amount of USD700m to the owners of challenger banks in the Q1’19 alone.

Fintech entities are designed around the digital customer experience and utilize data in order to personalize their offer. They quickly implement new products and processes provided by external suppliers, while having few products and processes developed in-house. They are mainly focused on younger, unbanked or underbanked customers, offering them solutions cheaper than those provided by traditional banks. Their advantage lies in simple technological solutions, without the burden of outdated IT systems. These fintechs include British entities such as Atom, Tandem and Monzo, which hold a banking license, as well as Revolut and Loot, which hold a payment-processing license or base their business on the license of another entity. One of them is also Starling Bank, which conducts a banking-as-a-service (BaaS) business activity. Thanks to the provided application programming interfaces (APIs), external companies — fintechs, banks, electronic money institutions and e-commerce entities — can use the bank’s platform to build financial offers for their customers. These services generate revenue based on a subscription model or a commission per transaction. They are used, among others, by the company Raisin, which offers savings and investment products. The company acquires customer data, while Starling Bank carries out the regulatory obligations relating to customer verification. Some fintech banks have global ambitions — Revolut currently operates in over a dozen European countries. Monzo and the German N26, which has 3.5 million users and operates in the Eurozone — both banks employ only 180 and 250 workers, respectively — have already announced expansion into the United States market.

On the one hand, the process of digitization gives traditional banks a chance to reduce personnel costs (by up to 30-50 per cent). On the other hand, it creates the risk of losing revenue (10-30 per cent) in favor of the new entrants. At the same time, it also enables the incumbents to gain customers in places where brick-and-mortar branches would be unprofitable. However, a complete digital transformation often proves to be too costly both in terms of finance and organizational effort. Some banks are thinking about establishing digital subsidiaries, which would not be burdened by the legacy IT systems. One of the largest digital banks controlled by global banks is Di-Ba, which belongs to ING. It has almost 9 million customers and operates in Germany, Austria, France, Italy and Spain (it also has physical branches in the latter two countries). In turn, Hello Bank is a digital bank owned by BNP Paribas, with 2.5 million customers across five countries. Meanwhile, in 2016 the Singapore-based DBS bank established a fully-mobile bank in India and Indonesia, attracting 2 million and 1 million customers, respectively. Similar steps have been taken by the Thai UOB and the Malaysian CIMB banks, which are planning to conquer Asian markets thanks to digital banking operations. The banking supervision authorities in Singapore, Hong Kong and Malaysia have adopted a favorable approach towards the creation of challenger banks and have even announced the issuance of simplified virtual licenses with lower capital requirements for such companies. However, for the time being they will only be applied in relation to domestic entities.

Virtual solutions are also increasingly being embraced by American banks. The activity of the Marcus digital consumer brand belonging to Goldman Sachs can be seen as a success. It has attracted nearly 2 million customers, more than USD35bn in deposits, and in 2019 it entered the British market. The Greenhouse digital bank created by Wells Fargo is also doing well. Meanwhile, the digital creation of JPMorgan Chase, known as Finn, was shut down after one year of operation. It only acquired 50 thousand customers despite offering a USD100 bonus for setting up an account. Finn did not have a distinctive product offer or a marketing strategy that would set it apart from the competitors. The attempt to acquire and service customers in locations without access to brick-and-mortar branches proved ineffective, and the executives at JPMC feared that the new digital entity could cannibalize the existing customer base. This example shows that digitalization as a strategy in and of itself does not work anymore. Meanwhile, some community banks in the United States have developed their own interesting digital strategies. They are focusing on local communities, including freelancers, as well as small and medium-sized businesses, while continuing to put emphasis on building customer relationships. One of such community banks, the Blue Ridge Bank, established a digital subsidiary under the brand Carolina State Bank. Apart from digital mobile solutions, it enables customers to contact a local advisor through interactive ATMs, which are supposed to replace branch visits.

Challenger banks owned by technology companies are primarily found in Asia. In China, the digital banks MYBank and WeBank, established in 2015 and controlled by the technology giants Alibaba and Tencent, have obtained huge customer bases. WeBank, which operates in more than 500 cities, has 60 million customers. Its main products are cash loans. Meanwhile, MYbank uses the customer base of Alibaba, which also includes 6 million small and micro enterprises, for the sale of loan products. Spectacular success was achieved by the Korean Kakao Bank, which was developed on the basis of a messaging platform of the same name (Kakao Talk). It acquired 2 million customers within the first two weeks after the application was launched in 2017. At present it has six million users, accounting for 15 per cent of South Korea’s adult population.

Banks backed by technology companies seem to have the most comfortable financial situation and the most promising prospects for the future — they have access to a huge customer base, they can be subsidized with funds derived from their owners’ other activities, and they have the ability to cross-sell additional products. The remaining challenger banks cannot even dream of such advantages and many of them, formed on the basis of fintech startups, face risks resulting from low profitability due to the high cost of customer acquisition and insufficiently fast rates of revenue growth. They are also struggling with the regulatory burden of capital adequacy requirements. The Fitch rating agency points out that British challenger banks are particularly exposed to the effects of a possible recession which could be caused by Brexit. Their operating risk may be underestimated, as their customer base includes many borrowers with relatively low credit scores, some of whom have also been granted mortgage loans. As a result these banks may not have sufficient capital reserves to face such a situation. The British Prudential Regulation Authority (PRA) is aware of these risks. Already last year it reduced the number of approved banking licenses for digital challengers to just four.

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