The Covid-19 pandemic has forced the financial services sector to accelerate its digital transformation. But there is another reason why banks are under pressure to digitise quickly: Big Tech companies are looking beyond payments to capture other profitable areas of banking, using vast databases and sleek digital interfaces to lure customers away.
This is not the first time the threat of digital disruption by alternative providers has loomed over the sector. Until recently, fintechs were heralded as an existential threat to the established banks. But it has since become clear that fintech startups are often an effective complement to established banking providers, expanding their reach in underserved areas of the market and improving digital services.
By comparison, Big Tech has all the advantages that fintechs lack when it comes to mainstream banking: a wealth of data and a large, sticky existing customer base. This makes them well-placed to challenge legacy banks, says Martin Sommer, principal in Oliver Wyman’s corporate and institutional banking practice.
“If you’re an international bank, you have a business in many countries, [then] you’re sitting on a customer network that very few fintechs could feasibly replicate in the medium-term even,” he says. “Whereas some of the Big Techs have more than a billion users.”
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Big Tech moves into lending
Many Big Techs have already made in-roads into the payments space, as it is a natural complement to their existing offerings. Apple, Google, Facebook, Alibaba and Amazon all offer customers their own version of a mobile wallet. Increasingly, however, they are also looking to another banking segment: credit.
The appeal of consumer and SME lending is clear: it is one of the more profitable areas of banking and allows Big Tech companies to draw on their existing strengths, says Jorge Padilla, senior managing director and European head at economic consultancy Compass Lexecon.
“These are the most profitable activities of commercial banks, where they make their return on capital employed, [while] many other activities are loss making,” he says. “This is a big issue for legacy banks – one that threatens their stability.”
In Europe, open-banking legislation has removed one of the largest barriers to entry for external players, levelling the playing field for Big Tech. The digital giants have the added advantage of having plenty of ‘soft’ information about their customers that help to inform credit decisions, adds Padilla.
“The main barrier to entry is information about your customers,” he says. “Big Tech has tonnes of information and now, thanks to Open Banking in the UK and Payment Services Directive 2 in Europe, they also can get some of the financial information from the banks themselves – and so, they are at a clear-cut competitive advantage vis-a-vis banks.”
This partially explains why Big Tech companies pose more of a threat to banks than fintechs, which have long struggled with profitability. Both types of alternative lender have been hit hard by the pandemic, but Big Tech has retained an edge when it comes to net profit margins in financial activities. There is some evidence that the use of alternative data and machine learning has driven lower default rates than conventional models, according to a working paper from the Bank for International Settlements – although it remains to be seen what the fallout from the Covid-19 crisis will be.
In Western markets, Big Tech’s foray into credit is still in its infancy. Apple, for example, debuted a joint credit card with international banking giant Goldman Sachs last year. It is Asia that has seen the most penetration. According to a report by Citi, Alibaba has issued almost $100bn in loans over the five years to 2018, while Ant Financial’s MYbank had already extended around $17bn in loans with an average size of $2,500 in the two years after launching.
It will not be long before Western markets catch up, Padilla believes, especially in light of the Covid-19 pandemic. “Everyone expected that what was observed in China would happen here pretty soon,” he says. “Things seem to be going a little bit slower, but Big Tech is making significant in-roads – especially in payment systems but also in consumer lending.”
Rapid progress in Asian markets can be explained by disparities in financial infrastructure. Two-thirds of Chinese citizens lack traditional credit histories, according to research by the Institute of International Finance, creating a much larger untapped consumer base for Big Tech to exploit using the wealth of data it has access to.
The draw of an underserved market is augmented by a less mature financial ecosystem, says Padilla. “In China, commercial banks don’t really have very close ties to consumer or businesses,” he says. “The banking system was weak, and it was much more arm’s length.”
Greater ease of doing business, lower bank credit-to-deposit ratios and less stringent banking regulation enable alternative credit providers to thrive, according to research by the Bank for International Settlement. In fact, easing regulation and allowing greater banking sector concentration has a more pronounced positive impact on credit volumes for Big Tech than fintech – a stark warning to regulators who have only just got their heads around policing fintech and are concerned about the potentially destabilising impact of Big Tech.
Indeed, if Big Tech companies become intermediaries for banks, this poses a significant threat to financial stability akin to the situation before the crisis in 2008, says Padilla. This is because having separate bodies issue and fund loans creates a misalignment of incentives.
“We need regulators to keep an eye out to make sure that the originators [of loans] behave and that the banks don’t completely delegate their role of screening, scoring, monitoring,” he says. “Otherwise we may end up in the same trouble that we got in 2008.”
The banks’ response
It is too early to tell how regulators will respond. Whether Big Techs become banks in their own right or financial intermediaries for the existing market is largely in the hands of the legacy players.
Padilla argues that the big banks will attempt to strike out on their own, leveraging the fact they have large, loyal customer bases, and potentially forming coalitions between themselves. Smaller banks will have to collaborate and become intermediated by the Big Techs.
Sommer, in contrast, says that it is the interests of banks and tech companies to collaborate. “I personally believe more in the partnership model than a winner-takes-all approach,” he says. “It seems to be more complementary and opening up new sources of demand, but definitely banks are, and they should be worried.”
According to a survey by PwC, banks in the US and Europe predominately still see non-traditional players like the Big Tech giants as a threat to their business models. But in regions where these non-traditional players are more established, like Asia, almost half of banks see them as an opportunity to access untapped areas of the market and update their digital systems, hinting that attitudes in Western markets may shift over time.
A catalyst for digital transformation
Despite the potentially destabilising impact, disruption from Big Tech will be welcomed by many as a catalyst for digital transformation in an industry that has long resisted the necessary overhaul of legacy infrastructure. According to a 2019 study by consultancy Cornerstone, almost 70% of respondents said that their institution’s current technology infrastructure was a barrier to digital transformation and a staggering 55% of banks stated they lacked digital maturity, with only 12% rating themselves as digital leaders earlier in 2020.
What’s clear is that to compete with the Apples and Googles of the world, banks need to overhaul their digital strategies, says Sommer.
“It’s not enough to put up a glossy front end… it really requires them to embark on an end-to-end transformation journey and I think many see that opportunity more clearly,” he says. “The extremely rapid changes that the Covid crisis has mandated has surfaced weaknesses in processes and capabilities for some banks.”
What’s more, adds Sommer, the digital maturity of Big Tech means it can offer an entirely new value proposition, something that legacy players will struggle to compete with. “They provide that integrated solution that really goes to the heart of addressing the customers’ needs,” he says.
Although it has proved resilient so far, the finance sector – which deals in electronic transactions – is ripe for digitisation, and therefore exposed to competition from Big Tech. But as the internet of things expands the data collection capabilities of the internet to the physical world, any industry could find itself in the same position, warns Padilla.
“As the Internet of Things takes over, data is going to be the essential asset,” he says. “Say you want to make sure that that you’re successful selling cars. Well, you need data about the individual because what he or she is going to buy is a basically a computer.”
(Main photo by Koshiro K / Shutterstock)
