By Ryan Battles, Principal, Financial Services, Ernst & Young LLP and Matt Cox, Principal, Financial Services, Ernst & Young LLP
As FinTech companies disrupt the financial services industry with marketplace lending and blockchain-based supply chains, wholesale banks are meeting the challenge by reprioritizing IT spending and improving their innovation capacity.
Throughout the digital economy, consumers perform key transactions seamlessly from any electronic channel, and these digital experiences are beginning to influence their expectations in wholesale banking. Banking clients expect their commercial technology platforms to operate like consumer-facing technology, and yet new FinTech companies are taking the lead in fulfilling that vision for the financial ervices marketplace.
In areas of innovation, FinTech companies make formidable competitors, as they possess strength in areas where banks are most vulnerable. Where FinTech talent is trained in the newest technologies and agile development methodologies, bank information technology (IT) departments still struggle with old mainframe systems, outdated waterfall development methodologies and monolithic technology systems that are difficult or delicate to change. By using the latest technology architectures and approaches, FinTech firms are building attractive solutions using highly scalable cloud-based infrastructure, intelligent analytics and intuitive user interfaces.
Drawing upon these advantages, FinTech companies are capturing market share in numerous lines of business, despite having started without the credibility and trust associated with long-standing client relationships.
Also, with their narrow focus on single-product markets, FinTech startups sidestep many of the more complex regulatory requirements that apply to traditional banks, conferring an additional (if temporary) advantage. FinTech regulation is an evolving concept, and although regulations are emerging on the state level, what happens next depends on whether federal and state governments begin regulating FinTech companies more like banks, or whether they try to foster further FinTech innovation by reining in compliance efforts.
In this article, we explore two areas that have attracted significant interest by FinTech innovators:
Marketplace lenders (MPLs) that are disrupting traditional credit-underwriting models with lower overhead, higher transparency, faster loan approval and higher returns on capital.
Blockchain-based supply chains with the potential to disrupt entrenched payments and credit processes by managing the physical and financial flows associated with commerce. In addition, we discuss approaches to IT spending and innovation that banks can take in response.
Although these innovations are operating on different time scales — MPLs are an immediate consideration, and blockchain-based supply chains could take a few years to mature — wholesale bankers need to get up to speed on each, at an equal degree of urgency.
Considering these and other innovations, business leaders will need to figure out how to redirect IT spending and innovation capacity to meet the competitive threat.
MPLs match lenders and borrowers using peer-to-peer business models. In the past, small businesses have been underserved by traditional lenders. Due to the variety and complexity of small businesses, it has been cost-prohibitive for banks to conduct traditional origination and underwriting processes.
MPLs automate origination and underwriting using technology-driven methods for data aggregation and analytics, typically using one of these two MPL operating models:
Direct lenders (or balance sheet lenders) originate loans directly to borrowers, and then maintain those loans in their own portfolios. Other sources of capital may include credit facilities, loan sales and securitizations. Direct lenders acquire licenses in each state where they originate loans and are not currently subject to federal banking regulators’ supervisory authority.
Platform lenders originate loans through a nationally chartered depository institution. Those loans are then resold or held in a portfolio that compensates investors based on the performance of the underlying loans — either way, the platform lender offloads credit risk to investors. The platform lender uses the national charter of its financial institution partner, and so does not need individual state licenses. However, the lender is subject to regulation and examination authority of the federal banking agency of its principal investor, per the Bank Service Company Act.
Although these business models have been effective, the continued growth of the MPL marketplace faces challenges in scarcity and volatility of funding, the uncertain regulatory environment, a normalizing interest-rate environment, and open questions about the business model and credit scoring methodologies.
Because of these challenges, we expect the market to consolidate into a smaller number of MPL providers. The marketplace also requires a stronger secondary market for securitization, which in turn will call for uniform loan data standards, trusted methodologies for risk rating and greater regulatory clarity.
Blockchain-based supply chains
Blockchain is a low-cost, near-instantaneous method for settling transactions without the need for a central authority. By establishing a trusted ledger, participants in the financial supply chain can theoretically reduce the time and expense required to manage payments and shipments. In addition, a single source of trusted information would simplify documentation processes, while eliminating opportunities for fraud and corrupt business practices.
Potential applications include:
- Recording the ownership of goods and services
- Providing an unalterable record of the delivery and payment terms of a trade
- Listing the identity of trading partners as needed for regulatory and tax compliance
- Authenticating and validating contracts
- Providing documentation for fraud investigations
For blockchain-based supply chains to take hold, participants will need to resolve the questions of how to deal with anonymous transactions, how to manage growing pains of the technology, and how to institute the required suite of standards, risk management frameworks and applications needed in financial services. A wide variety of stakeholders, including buyers, sellers, shippers, banks and governments, will need to comply with burdensome regulatory requirements for know your customer (KYC), anti-money laundering (AML) and customer due diligence (CDD). Accordingly, considerable uncertainty remains about how, when and whether the technology will be adopted.
Redirecting IT spending and innovation capacity
In response to the competitive threat posed by FinTech firms in MPL, blockchain and other areas, banks have increased IT spending and worked to develop improved capabilities for fostering innovation.
IT spending priorities for US banks have been focused on three areas:
Operational efficiency. Initiatives to simplify document management, workflow and business processes contribute to higher operational efficiency, and improved data management facilitates faster and more flexible regulatory compliance and reporting.
Client experiences. Seamless unification across channels delivers an “omnichannel” client experience, with a “single view of the client” that assists employees with serving and selling. Successful integration of digital channels promises to reduce costs and increase return on equity.
Banks have had to respond to challenging new cybersecurity threats by improving privacy and data protection measures.
Banks in the US and around the world have pursued a combination of four strategies to bolster innovation in competition with FinTech firms:
Custom build: Banks have leaned toward internal innovation projects for areas largely under their control, such as digital transformation and process automation.
Acquisition/partnership: Banks have purchased FinTech innovation outright with deals such as BBVA’s acquisition of Simple, Santander’s acquisition of Kredyt Bank (Poland) and Funding Circle, and Citibank’s acquisition of money-transfer service PayQuik.com.
Venture capital (VC): Banks’ VC units are providing capital to startups through strategic investment funds in areas ranging from digital delivery and online lending to online investment and big-data analytics.
Incubator: Beyond providing capital, banks can search for disruptive solutions and innovations by offering mentoring, workshops, networking events and interim office space to innovators.
Although FinTech startups and nonbank players may have sparked the present wave of innovation, traditional wholesale banks still have immense opportunities. By building services for existing clients while drawing upon their unmatched industry knowledge, regulatory expertise and market presence, today’s traditional banks have the capability to reshape the industry.
Marketplace lending and blockchain applications remain key focus areas, but there are numerous other areas of interest, including applications for artificial intelligence. Yet before diving into these technologies, wholesale banks should take a step back to evaluate their readiness for innovation.
As outlined above, IT spending needs to support improved operations, omnichannel client experiences and cybersecurity improvements. Then, banks need to evaluate whether they are best positioned to build their own solutions, acquire technology, or invest as VC partners or through incubator funding. Finally, banks should evaluate their own current and future business and operating models to determine which innovations should be given priority toward the transformation of the industry.
By establishing a foundation for continual innovation, wholesale banks can not only fend off the competitive threat posed by FinTech startups and nonbank players — they can set the pace for ongoing success.