The logo of Paypal is seen on a screen of a smartphone next to an illustration of money and stock … [+] market. (Photo illustration by Alexander Pohl/NurPhoto via Getty Images)
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Traditional banks are facing an existential threat from FinTech firms in every aspect of their business ranging from payment services to corporate lending. Technological innovations have reshaped financial markets for hundreds, if not thousands, of years. Advancement in metallurgical engineering led to the creation of metal coins; the invention of the printing press facilitated the widespread use of paper currency; the electronics and communication revolution led to the development of the ATM. The list is endless. But there is something unique about the recent disruption. Instead of financial firms using technology to create innovative products, tech firms are now directly entering the banking space with novel solutions for customers. Will banks become obsolete? What does this transition mean for the CFOs and corporate leaders?
A deeper look at the cost of the traditional finance sector makes it evident that it has been ripe for disruption for quite some time. Research has shown that the cost of financial services is surprisingly high at about 2% of the asset value on average. Moreover, this cost has remained remarkably similar for a century despite all the technological improvements during this period. So why didn’t banks pass on some of these benefits to their customers by lowering transaction costs and fees?
Imperfect competition in the banking market explains a big part of this behavior. Indeed, regulatory restrictions make it really hard for a new player to enter the financial services industry, providing the incumbent banks with a lot of market power. With higher market power came higher rents that the banks have enjoyed for decades. But imperfect competition doesn’t tell the complete story. Banks also enjoyed rents from having access to information that others could not have. Additionally, they benefitted from the explicit or implicit government guarantee, making them a trusted counterparty for financial transactions.
At its core, the banking business is all about solving information problems among borrowers, savers, and other market participants. For example, on the credit side of the business, banks need good information to assess who to lend, when to lend, and when to intervene in a troubled borrower’s business. On the payments side of the business, banks need fast and accurate information on the integrity of the receiver of the payments. Detecting credit or debit card fraud is similarly an information and trust problem. Historically, banks enjoyed an information monopoly over their clients because it was hard to process information accurately and securely without the involvement of an intermediary. However, the revolution in big data and computing power has disrupted this information monopoly in the past decade. For example, Square Inc. (SQ) has disrupted the way financial information is collected and processed for small businesses across America.
These disruptions coincided with the global financial crisis of 2008-09, which fundamentally impacted both the demand and supply side of the banking business. On the demand side, consumers lost trust in the financial system. As per the annual Gallup polls, Americans’ confidence in banks dipped to an all-time low after the financial crisis, and it has remained low ever since. At the same time, technological innovations began to replace institutional trust, giving the tech firms an unprecedented window of opportunity to enter the financial services. Companies like Paypal (PYPL) seized the opportunity to offer payment services at a lower price and faster speed. Banks struggled to compete as they were still navigating the post-crisis regulatory burden. As a result, the business of banking has changed forever.
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What can the traditional banks do to survive this challenge from FinTech? One strategy is to acquire FinTech firms to enhance the efficiency and speed of banking, a strategy that JPMorgan (JPM) seems to be deploying. Another strategy is to make investments in FinTech startups through VC investments. For example, Goldman Sachs, JPMorgan, Citi, Capital One, and others have acquired equity stakes in several startups in wealth management, capital markets, and cryptocurrency through VC funding rounds. Finally, the third strategy is to enter into a strategic partnership with a tech firm to leverage the expertise of both companies. Goldman Sachs’ partnership with Apple to issue a new credit card seems like a good template for such a model: Goldman brings in its financial and regulatory expertise, whereas Apple brings its technological prowess. They also seem to be working on a new product that would allow installment payments for consumers who use Apple pay. Synergy gains are likely to be very high for such deals.
Banks are unlikely to survive the FinTech challenge unless they embrace one or more of these strategies reasonably soon. Where does this change leave the CFOs and other corporate leaders? The ongoing fight between traditional banks and FinTech firms provides them with an unprecedented opportunity to diversify their funding sources, improve working capital management, and lower the cost of capital. A critical first step is to educate the CFO’s team on these opportunities and then develop a strategic plan to exploit them. FinTech has reshaped the financial services industry in the past decade; it will reshape the CFO’s business in the next one.