The threats from challenger banks and fintechs to the incumbents

Birendra Agarwal

It’s crucial for banks to have a mature understanding of the fintech and challenger landscape, as well as the emerging industry trends like customer-centricity, hyper-personalisation and the use of emerging technologies in the space. Here we’ll explore the main threats the challengers and fintechs pose to incumbent banks, how they can tackle them, and also the scope for opportunity.

Threat One: Open Banking

Incumbents need a mindset shift – to understand both the nature of the threats, and the possible opportunities. For example, incumbent banks need to be aware of what fintechs are out there that stand to disintermediate them through Open Banking, but also understand the potential of Open Banking to build connections to existing fintech solutions, and meet new customer demands a lot quicker, rather than having to build solutions themselves. An example strategy would be platformisation.

Open banking in the larger institutions is still about PSD2 and regulation, so all the time, effort and resource on the banks’ side is being spent complying with the regulation – but Open Banking is much more than just a regulation.

The promise of Open Banking is the flexibility, brought about by the use of APIs, that the banks can do a lot more. To some extent, it also allows the incumbents to look at what the challengers are doing, and almost ward off the threat from the challengers, in the sense that they can be a lot more flexible through the use of open banking and APIs and actually connect to fintechs.

The danger is that the incumbents don’t move to own the interface with the customer, to build the solution the customer sees, and instead are simply saddled with providing the plumbing, and therefore become disintermediated from this emerging market.

Threat two: fintechs are quicker to market and to onboard new customers

If we take the example of lending, incumbent banks take a long time to onboard new customers, so the time-to-loan is very long, and the bank’s criteria for lending may be very strict, or based on traditional methods. In this case the fintech could have a product offering where they are still fully compliant, but the onboarding can be much smoother and have a superior credit algorithm. They might even feel they are superior in their AML/KYC fraud checks than the traditional providers.

Fintechs have the new technology and don’t have the legacy of the incumbent banks’ infrastructure – both in terms of systems and people. In this way they can be more efficient, and in some cases may have a better systems using machine learning to bring in information on the customer from various sources. This isn’t to say that an incumbent bank can’t build it, but if a fintech already has, and the fintech really feels like they have an edge they can seek investment from PE or VC firms and go to straight to market on their own, knowing they’ll be in competition with the existing offerings.

Threat three: fintechs grow large enough to become banks

The British startup OakNorth recently raised a $440 million funding round from SoftBank’s Vision Fund as well as private equity from Clermont Capital. The role of private equity firms in fintech funding is significant, as PE firms see the capacity for fintechs to grow quickly and sell up, rather than seek a more elusive exit.

OakNorth is creating a digital bank and focuses on loans for small and medium enterprises and the technology behind those loans. They started life as a fintech serving a narrow segment, but have grown out of the SME lending sector, and now by going it on their own and raising investment (rather than working with a bank) they can build out other solutions that banks offer, and move to directly compete with the mainstream banks. They became so strong in SME lending that they have now the tools, i.e. the power and the money, to compete in other aspects of FS.

To understand how this can happen, banks need to think about the long tail. There are lots of cases where incumbent providers wouldn’t have wanted to lend and it’s these customer segments that fintechs can jump in to serve. These challenger lenders can tackle segments that the banks are ignoring or turning away, for example below a certain credit score. Initially it would seem that the fintechs are taking a bit more risk, but if they have superior CX, credit checking and AML/KYC technology, they can service what seemed on the surface to be the more risky end of the market and grow rapidly under the incumbents’ noses.

Now that OakNorth have the investment from SoftBank, they can move to lend to the customers who are more traditionally credit-worthy anyway with the help of their superior CX. The customers who may have previously gone to the banks for lending can opt for OakNorth instead.

If a fintech can find a narrow segment of the market that’s not well serviced by the incumbent providers, and goes deep enough, and is successful, then can progress to becoming a bank.

And if not? Well if the tech is good enough, they can develop a product that they can sell to the banks for example by pivoting to a whitelabel offering. In this way, it’s understandable for fintechs to try to initially directly compete with the banks. Ultimately the customer will dictate who which strategy and which provider wins.

Threat four: The money is moving to the millennials

Banks traditionally worked hard to be competitive on price for customers, but this is no longer the most important metric in FS.

Millennials are not as price-conscious as the generations before them. They are willing to pay for a superior experience (including convenience) and quickly become reliant on the new customer experience they enjoy. We can look to the example of Uber, which started off by offering very cheap rides, but now that customers have got used to the convenience and have come to rely on the service, they will book an Uber even when the surge pricing is in effect.

Another factor in the fintechs’ favour is the fact that a millennial audience lack the brand recognition the incumbents enjoy with an older audience. They won’t care for example, that Lloyds and their ilk have been trading for over two hundred years. If Monzo, Starling or Atom are giving customers the best customer experience, millennials will make the move and they may even be willing to pay a small premium for a superior service.

If Monzo, Starling or Atom are giving customers the best customer experience, millennials will make the move and they may even be willing to pay a small premium for a superior service.

Millennials will do their own research, and often opt for new tech over the old brands. Mainstream wealth management providers stand to lose out via the same metric threatening the other FS incumbents – customer experience. Increasingly millennials opt to explore the new technology offerings rather than the traditional wisdom connected to a fund from an investment bank like Morgan Stanley.

There is also an inherent distrust among millennials in incumbent providers – they just presume that the experience and offering isn’t going to be as good.

Finally, the money in the market is moving and banks need to move with it. Most of the banks historically have been thinking about the baby boomers and Gen X as that’s where the money has been, but now that money is moving as we speak, from that generation to the younger one. That’s on top of the fact that while at their core the banks’ original desire and aim is to serve their customers, but in reality, this has been compromised by other factors like the shareholders (both in long and short term) and the regulators.

Threat five: The banking talent exodus

To compound the mainstream banks’ misery, the disengagement of millennials extends to hiring and developing the human side of banks’ infrastructure. The brand recognition incumbents used to enjoy is lost on a millennial audience, and this goes for hiring the top technologists as well.

It’s becoming harder and harder to attract the top talent, and the incumbents’ strategies to reverse the trend are ineffective. The incumbents have in part reacted by building innovation labs, but these can become propaganda machines for the bank’s brand, rather than achieving their originally stated aims of experimentation and discovery that can then be brought back into the mothership.

The banks that will succeed in the future are the ones that will be able to take the best learnings from their innovation labs, and then implement that through the fabric of their organisations. As of now, the results of the innovation labs is decidedly mixed. So, if the labs have had limited take up on their experiments, and the incumbent banks rightly don’t want to damage the trust they have built up, why not build their own challengers?

Threat six: The culture gap between incumbents and fintechs

In startups it’s common to hear language like ‘fail fast’, and you might even hear the same kind of language used in the mainstream banks’ innovation labs. In the main however, the banks are (quite rightly) beholden to the regulators. After all, if you have millions sitting in a bank, would you want them to ‘fail fast’? You don’t want the bank to fail—ever. It’s anathema to how big banks must operate.

The banks are desperately trying to become agile and learn from the experiments they are doing in their labs, but how quickly that’s being adopted into the core fabric of the bank, i.e front to back of the bank – the jury is still out.

On top of that, the regulator, while outwardly saying they want to help the banks be competitive and so on, is increasing the pressure on the banks rather than relenting. A case in point is Open Banking, because of what it takes for the banks to comply with Open Banking – the time and resources – it just becomes another hurdle from the regulator they have to navigate.

What incumbent banks need to learn from the challengers

The best strategies employed by the challengers present the way forward for the incumbents, for example treating Open Banking as an opportunity and figuring out to leverage their infrastructure.

For example Starling Bank’s platform strategy, combining banking-as-a-marketplace and platform-as-a-service, is a great survival and growth strategy for the bigger incumbents. Starling’s strategy is to create an open platform, allow as many fintechs as possible to plug in creating a long tail offering, so the customer enjoys best-in-breed solutions across different product areas, and the platform owner can control access to the platform.

If we apply this scenario to SME lending as an example, the platform owner can look to service the better providers to their customers, and even exclude the other lending products that aren’t doing as well. For the sake of argument, if Funding Circle are struggling to service customer needs on the platform, the platform owner could instead plug in OnDeck to maintain a high level of customer experience for their customers. This is one way to maintain ownership of the customers – which is a challenge the banks find difficult to resolve.

Similarly, Monzo’s great strides in customer experience set a great example to the incumbent banks on how to continue to fight for increased market share.

Threats = opportunities

In conclusion, the incumbents should consider the challengers in the same way as emerging industry trends – as threats, opportunities for growth, and food for thought.

Every strategy is a long play and there are no simple answers. Every incumbent is working on their own digital strategies, and the ones who are really working hard to invest and experiment should be commended, because they stand the best chance of survival and are demonstrating their commitment to giving their customers the best experience.

Every bank has their own digital strategy: Everybody is poking at the elephant from different angles, but no one has figured out the whole beast.

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