"Banks who are able to navigate this expensive and difficult transition will be able to develop a modern, cost-effective platform, becoming part of the very fintech industry that threatens to make them obsolete."

CORE COMPETENCY OF INCUMBENT BANKS

Amidst this unbundling and reshuffling of the modules, what advantages do incumbent banks have? While offering an aggregated bundle of services is becoming less and less crucial, they still maintain a crucial comparative advantage: regulatory management and compliance. The financial services industry is one of the most heavily regulated industries in the global economy. Large banks have become increasingly adept at navigating this byzantine system of complex regulations with onerous requirements that smaller, upstart competitors have difficulty coping with. Even when developing new fintech services, there are a dizzying array of disclosure requirements such as Sarbanes Oxley and Know Your Customer laws that vary by regulatory jurisdiction.

One of the arguments in favor of fintech startups providing unique services is that existing regulations do not (yet) inhibit them. Conversely, investors attach substantial risk premiums to these companies due to the vast degree of regulatory uncertainty. Often a startup’s survival is predicated on the whims of regulatory discretion. Recently P2P lending startups suffered a major setback when the FDIC issued a dictum that restricted their ability to sell securitized products to banks, causing a plunge in their valuations and future prospects. Simultaneously, investment banks like Goldman Sachs intensified their interest in entering the industry since the ruling did not inhibit them.

Established firms (who possibly hold sway over policy makers), are much better positioned to weather, or even co-opt, regulatory turmoil.

The task of managing balance sheet risk for large pools of capital is extremely complex, highly sought after, and plagued by high fixed costs. Startups do not have the quantitative expertise to effectively maneuver through these regulations, but incumbent banks are used to doing this daily.

Despite changing industry fundamentals, incumbent banks appear well positioned to maintain their role as managers of large balance sheets, ensuring them a comfortable spot in the middle layer of the stack. They have all the pre-existing infrastructure to manage deposits, execute settlements, securitize assets, generate net interest margin and comply with regulations already built. Large, incumbent banks will not disappear. But their ability to adopt a new business model that exploits their core competency while managing the decline of other divisions will be tested.

FINTECH REGULATORY HURDLES

New banking startups can be split into two categories.

The latter category has faced significant regulatory challenges. In the UK, Atom Bank and Tandem were issued licenses in 2010, after an extensive and costly regulatory process, – the first licenses issued to a new bank in the UK in over 100 years! Comparatively, the FDIC has refused to approve “full-stack” digital banks. Without FDIC insurance, a new bank will be unable offer a deposit account acceptable to consumers. Meanwhile, Washington regulators have decided to put new fintech approvals on hold and focus energies on specific segments of the industry, stunting growth.

Capital requirements further restrict “full-stack” fintech banks, by forcing them to grow profitably, or in plain English, slowly. This conflicts with the expected growth trajectory of a startup: forego monetization early on to mature the product and scale. Consequently, holding deposits heavily constrains a startup’s ability to innovate, impinging growth.

These impediments add further credence to the thesis that incumbent banks will remain the managers of deposits and large balance sheets, allowing fintech companies to flourish further up the stack. Startups who decide to take deposits will grow far more slowly and be fewer in numbers. The recent acquisition of Fidor by BCPE aims to alleviate capital constraints by providing Fidor with a large, mature balance sheet while maintaining its operational independence.

FIDOR AND THE FINTECH BANKING PLATFORM

German banking startup Fidor perhaps represents the best example of the macro trend of unbundling and creating a broader platform for other players to build on. Fidor is seeking to build a banking platform company from first principles, modeling it off the iPhone. From the start, the founders’ core belief was that “if it is not coded, it does not have value.” Fidor had to be a digitally native product with an organization capable of fully extracting the benefits. The case for Fidor is that banks who have more money, engineers and experience are unable to build next generation financial services because they are weighed down by legacy baggage. Their incentives, culture and organization are predicated on serving existing products to existing consumers, through existing channels.

A clean start gives Fidor the advantage in building the currently nonexistent.

A software native banking infrastructure devoid of legacy costs allows Fidor to conduct business at a fraction of the expense of conventional banks while implementing the most modern and advanced protocols like Ripple. Their IT expenditures per account are less than 10% of a conventional branch bank, making their cost structure more similar to a Google or Facebook than a Citigroup or JP Morgan Chase. Additionally, their net interest margin, a critical factor that accounts for 50% of commercial banking profits, was 6% in 2015, more than 2x the industry average in the United States. Superior net interest margin performance will only increase in importance as the other half of revenue generated by fees heads to zero. Even more surprisingly, their net interest margin has been growing rapidly in an environment with increasingly lower real and nominal interest rates and falling industry averages.

The goal of FidorOS was to build a platform that made “innovation happen in a compliant way” by acting as a bridge between core banking and customer interfaces, removing complexity. One of the key achievements of Fidor’s software is that it is built to be interchangeable with various core banking systems found across countries. This abstracts away the core banking stack, making FidorOS the target development platform that banking products are built on top of instead of the CBS. In effect, their aim is to create “a global industry standard for modern, online banking” that is lucratively dependent on them to function and impossible to transition off of.

FidorOS allows clients to focus on the last mile of delivering the consumer-facing services, allowing non-traditional players to provide financial services. Telecom providers like O2 and Telefonica are taking advantage of this opportunity by leveraging their strong distribution channels and go-to-market ability through their mature retail and mobile presence as network operators. O2 and Telefonica are just 2 examples of the bevy of potential non-traditional entrants willing to introduce new, disruptive business models and products that are enabled by Fidor.

The vertically integrated banking stack is effective at offering branch-based retail services. It makes it difficult for a new entrant to compete against highly efficient incumbents who have spent decades gathering expertise and economies of scale. Yet, these conventional banks are predicated on a world without mobile, sophisticated telecom and cloud computing. These factors shift the axis of optimization, leading to an unbundling of the banking stack.

In the search for new customers, forward-looking banks like BBVA and Citi have started thinking of themselves as platforms.

In retrospect, this may be seen as a retreat to core competencies that are still relevant in an evolving market, letting other firms handle consumer interactions. The fundamental question banks face is determining who and what form will they serve customers in a world where traditional services are becoming unbundled.

Amazon Web Services and the smartphone are most responsible for the last decade’s boom in startup activity in Silicon Valley, ushering in an IT renaissance. AWS gave any programmer with a laptop the ability to inexpensively scale to millions of people without paying millions of dollars or committing months of engineering. This dramatically lowered the barrier to entry and experimentation, creating an environment of ‘permissionless innovation.’ A few dozens of engineers can now create sophisticated services that scale to hundreds of millions of users. Banking as a Platform will have the same impact on financial services as AWS, providing cutting-edge banking infrastructure while foregoing the need for regulatory approval and a host of licenses. This will be the impetus for an explosion of new fintech startups fielding new ideas, products, and services.