Banks adapting to technological innovation - experiences of the past
By Freddy Van den Spiegel, Professor at Vlerick Business School
Since the start of the financial crisis in 2007, banks have been confronted with many challenges:
- The huge losses caused by exploding financial bubbles had to be digested, which for many European banks required governments to step in, directly or indirectly.
- Complying with the new regulatory framework required a complete rethinking of business models, and continues to put downward pressure on profitability.
- The continuing difficult economic environment in Europe, characterized by low growth and extremely low interest rates further undermines profitability.
- The political uncertainty in the Eurozone, were fundamental solutions for failing Member States still have to be found, undermines confidence even further, which increases risks and reduces profitability.
And as if all these problems were not enough, the speed at which the ICT revolution develops challenges the core activities and internal processes of traditional banks and creates a kind of “strategic” panic. New competitors are aggressively competing with the traditional banking activities. Crowd funding platforms could in theory replace the quasi oligopoly of banks’ lending to SME’s and private households; Google and other internet or communication providers are eager to take over part of the payments industry; internet investment platforms could replace banks as traditional providers of investment advice; and Bitcoin or more specifically its blockchain technology could push financial disintermediation further than anybody could have imagined a couple of years ago. Banks get nervous and feel compelled to act: missing the boat would be fatal for their future, but selecting the right boat is difficult, given the frequent unexpected twists of the unpredictable innovative process. The hype of “big data” is not over yet, but is increasingly replaced by the urgency to define a “fintech” strategy.
While the history and impact of every wave of technological innovation is different, it can nevertheless be interesting to have a look at how banks reacted in previous times of “disruptive” innovation, and which strategies were the most successful. Fortunately, we do not have to go back in time very far, to find a similar huge wave of technological innovation that was leading to a complete rethinking of banking strategies. An interesting comparable environment is the 1960’s, when modern retail banking was developed, based on the revolutionary introduction of computers, able to handle massive data.
Lessons from the 1960’s
It can hardly be imagined today what “retail banking” was in the early 1960’s. Indeed the average household at that time had essentially only two financial products at its disposal: savings books and mortgage loans. In most countries, both products where heavily regulated in order to protect poor households, and were essentially offered by public, cooperative or saving banks. Current accounts existed, but where only offered by commercial banks to corporate clients, professional clients and wealthy individuals. And even the functionalities of these current accounts where hardly comparable with what we today consider as the basic role of a demand deposit. Indeed, the technology to treat massive payments in real time was not available. Heavy regulated payment instruments such as cheques were only used for important transactions and only by a limited number of clients. Even within large banks with several offices, there was no central database of clients, which means that the client relationship was strictly limited to the office where the account was opened and managed. Almost all payments were done using banknotes. Sometimes, postal services offered a more advanced solution with a kind of cheques for “distant” payments. Other retail financial products, such as consumer credit did not exist and was not considered to be acceptable: the golden rule was that consumption follows saving, in other words, any luxury should only be afforded if savings were available. And investment services on a large scale did not exist because average households did not have sufficient savings capacity.
Two elements were at the origin of the retail banking revolution. First, as the economy recovered gradually from the Second World War, and entered the “golden sixties”, average households became richer, and were capable to save more and to afford all kinds of durable consumption goods. Second, computers were gradually introduced in business processes, and allowed treatment of massive data on an almost real time basis. The combination of these two elements was extremely powerful to push innovation: commercial banks were eager to have access to the savings of the wealthier households, and computers could take care of managing efficiently thousands of accounts in the back office, without expensive human intervention.
The impact on the retail banking sector was huge. From a commercial point of view, thousands of branches had to be opened to get access to the new mass consumer of financial services. Marketing for bank products suddenly became essential to attract clients, and that pushed product differentiation and innovation. The key to the heart of the client was his wallet, and every household was offered a demand deposit on which the salary could be paid, and from which all kinds of new payment instruments could be used. In one rush, clients became heavy users of cheques, also for retail payments. Already in the 1960’s, the first ATM’s appeared, allowing clients to withdraw money from their account without human intervention. The debit card became essential as a payment instrument when the EFTPOS technology was developed in the 1980’s. And this was not the end of the story as credit cards, smart cards, phone banking, home banking and e-banking still had to come. But focusing on the first period of retail banking innovation, a number of lessons can be learnt.
- All banks were in a hurry, hoping to be recognized as “first movers”, but the reaction of the clients was very often far from enthusiastic. Most retail clients were not really interested in banking or in the new developments. And even fewer clients shifted from one bank to another because of technological reasons. Once the basic current account was opened, most clients remained reluctant to change.
- The development of all these innovations was costly, but the services were almost always offered for free. Not offering the service was not an option, and asking a reasonable price was considered impossible.
- Lots of failing innovations were tried out: from “drive-in banks” to the first “smart cards”, but failed to attract customers. Those who invested massively lost their money, while the competitors could learn from the experience, as free riders.
- Successful innovations were quickly copied, as intellectual property in the financial sector is not easy to claim. Clients seemed to be aware that changing to another bank all the time because of a temporarily slight advantage just did not make sense and they became even more inert: all banks were considered to be more or less the same”.
- Some of the “fintech” companies of that time (debit card and credit card companies, consultants, hardware and software providers) indeed did very well and became big companies. However their ambition to sell their winning competence to as many banks as possible reduced their appetite to compete directly with banks. The number of “partnerships” on the other hand grew rapidly.
- A lot of money was spent in competing network initiatives, such as EFTPOS networks. Even a small country like Belgium had two initiatives of different groups of banks: Bancontact and Mister Cash. It took ten years before both networks merged, as the involved banks understood by then that the network was essentially a commodity that required continuous investments but on which it was not possible to build a competitive advantage.
Is it different this time?
It would of course be irresponsible to rely fully on the experiences of the 1960’s to decide that fintech is not a priority for banks today. There are a lot of differences between the situation 50 years ago and today. But many similarities also occur.
Banking clients today are far more mobile than 50 years ago. They have access to more information, and very often they are already client of more than one bank. The risk to lose clients if a bank is too late in the rush towards complete digitalization is real. But on the other hand, it are not necessarily the most profitable clients who are ready to leave. Since the crisis we have seen that banking clients in general remain extremely loyal to their bank. Market shares shifted somewhat, but not dramatically. Despite the fact that mobility of clients has increased, also thanks to new regulations, it is remarkable to see that in Belgium, there are huge differences in the offered interest rates on savings accounts between some of the big banks in comparison with “challenging” banks. Despite the fact that all deposit holders profit from the same deposit guarantee protection, and that savings accounts are a well-known and very liquid product, clients are only moving very slowly. And even if clients would become more mobile and move faster, one could consider that it is not a problem to lose a client, as it is easy to win him/her back in the future.
Today, as in the 1960’s, it is an open question in how far the client is willing to pay for the additional services that fintech could provide. The speed at which “apps” go and come, could be an indicator that the client is more volatile than ever, and less inclined to pay for services.
The free riders problem is not resolved. A more mobile client even increases the advantage of free riders as the client becomes extremely opportunistic. And technical problems to protect intellectual property on financial services are still as important today as 50 years ago.
A fundamental difference between now and 50 years ago is that the actual challengers like Internet companies or mobile phone companies have a clear ambition to be the “owner” of the client for selected services, essentially in the field of payments. But very few seem to have the ambition to become “full banks”. The fact that these companies try to avoid the intrusive banking regulation could well be one of the most powerful instruments of protection for the traditional banks. While “payments” are an important part of banking services today, it remains an open question if the customer of tomorrow will shift only a part of his/her payment activity to the internet or mobile operators, or if he/she leaves the traditional bank completely. Many surprises can be expected, such as joint ventures between big mobile operators and banks. As long as each one of the partners agrees with a clear separation of functions and a clear way to split the benefits, a combination of two major players could be an interesting business model.
Finally, one of the most important differences with the 1960’s is the economic climate. The 1960’s were a period of fast growth and huge opportunities. All the investments of banks in new technology opened the door to huge numbers of new clients, to whom they could sell huge numbers of new financial services. Today, certainly in the Western world, the banking market is saturated, and potential new profitable products are difficult to identify. Moreover, most banks are still recovering from the crisis, and their financial situation is not splendid. In such environment, strategic mistakes can rapidly grow out of control. Banks have already tried in the recent decades to extend their activities despite the saturation of the traditional markets, and this by looking at other regions, or other products like insurance and by becoming more complex. None of these roads seems to be easy, sustainable or possible given the experience of the crisis.