What next for Australian banks?

Digital disruption and the Royal Commission

10 October 2018

What next fro Australian banks?

In my view now is not the time to ‘discount’ the impact of disruption.

Summary

A recent research trip to the US to meet with banks, fintech firm and other financial services companies has reinforced my beliefs about how the collision of digital disruption and the Banking Royal Commission could change the shape of the banking industry in Australia:

  • Successful disrupters often grow from a wedge – gaining rapidly in a narrow market before expanding further;
  • Risk aversion in Australian banks post the Royal Commission may create a space, or wedge, that will be filled by disruptors;
  • Incumbents do still have advantages and are fighting back in the US and other markets.

In the following paper, I discuss the US experience with digital disruption, and what the current environment means for Australia’s incumbent banks.

HIP TO BE SQUARE…

Recently, I walked into the San Francisco offices of payments firm Square. It’s a very different scene from your typical corporate office. There are chess boards in booths, internal platforms for meetings and headphone-wearing workers, fixed to screens full of code.

However, behind all these tech clichés, what has made Square a success is its singular focus on empowering the small business entrepreneur. Square now has the chance, with millions of users, to broaden its service offering and grow with them.

...or wedge shaped

Many successful disrupters create a wedge; they enter a niche of financial services with a unique mission and lowcost access to customers that allows them to scale. Then they extend the offering to something broader that could threaten the role of incumbents.

Looking across US fintech success stories so far, many have followed this path, and the emerging backdrop in Australia is creating similar conditions, making the ground more fertile for disruptors.

Many successful disrupters create a wedge; they enter a niche of financial services with a unique mission and lowcost access to customers that allows them to scale. Then they extend the offering to something broader that could threaten the role of incumbents.

Some key examples discussed with experts during my recent trip were:

  • the aforementioned Square, which started with painsaving payments terminals for small business that now extend to an ecosystem of credit, cash and software services;
  • a recent US IPO GreenSky which funds ~1.5 million home-renovation customers accessed via HomeDepot or the ‘contractor’ channel;
  • UK-based Revolut, which has acquired two million customers almost exclusively by word of mouth to a prepaid currency card that offers no foreign exchange spread or fees. It is now rapidly adding further products;
  • the original fintech pioneer PayPal, accessed customers via the unique channel of eBay before becoming the trusted vehicle for internet payments for 200 million+ accounts; it continues to promise twenty percent growth rates.

All of these companies started narrowly, whereas those that have failed have generally had issues with the cost of customer acquisition or gone head to head with major banks.

What will force Australia’s wedge?

In the US (and UK), ‘payments’ or ‘specialised lending’ have been key areas for disruption, but this hasn’t happened meaningfully in Australia yet.

Advancing technology and changing customer behaviour supports fintech disruption, but the challenges of earning trust and acquiring new customers loom large. Australian banks have defended well, and been innovative themselves, but they could now be exposed differently.

My historical view had been that a focus on business-to-business activities and partnering with the large players would be the path to success for both fintechs and incumbents in Australia, with large banks proving particularly resilient.

Similar reforms on ‘Open Banking’ to that in the UK, allowing customers to share banking data via application programming interfaces (APIs) to third parties; should open the door for a wider array of services. I discussed the concept of Open Banking in greater detail last November in Tales From The Road: Lessons From The UK For The Australian Financials Sector.

Aus banks 1

But given the fragmenting effect that the ongoing Banking and Financial Services Royal Commission is likely to have on the big incumbents, should we be more openminded to the little guys?

Filling the space left by risk aversion

The potential biggest takeaway from the Royal Commission hearings may be on governance.

The impact on the mindset of boards and management towards risk aversion creates scope for disruption to have a bigger impact than it otherwise would have.

The impact on the mindset of boards and management towards risk aversion creates scope for disruption to have a bigger impact than it otherwise would have.

An encounter during my US trip highlights this theme of risk aversion. A prominent litigation funder I met with in New York said we could see a situation where “Board members in Australia could be forced to dip into their own pockets to pay for class action settlements after shortfalls from insurance coverage”.

Whether he is right or not, this shines light on an idea that risk aversion is going to create a space, or wedge, in financial services that may potentially be filled by disruptive firms.

Incumbents may be too busy to defend

I see that risk aversion may create years of additional compliance spend and internal focus, leading to management actions that aren’t consistent with defending against disruption.

We are already seeing this backdrop driving Australian banks away from any business line that is ‘non-core’ or places reputation at undue risk. Wealth platforms, thirdparty originated lending, auto lending, insurance, overseas subsidiaries and high-risk lending are some of the examples.

Exiting a lot of these relationship-building products not only gives up the profit pools, but also the data insights that could unlock the types of platform- style services customers might want in the future.

This narrowness should make banks better at compliantly delivering core products but may create the space for new players to drive a wedge and disrupt them.

The scope for financial concierge-type services (cashflow management; digital wallets; AI-driven wealth advice) as possible future product ranges for digital banking is yet to be fully explored; however, if banks give up many of their peripheral services and associated data it seems likely they would be less ready to enable future digital platforms. It could be argued Australian banks have been living in a constrained oligopoly, where protecting margins and market share has been easy. Going forward, we could see the banks fight over a narrower set of products and this arguably means a weakening in the market structure. The recent breakaway by NAB on mortgage re-pricing may prove to be an early example.

This narrowness should make banks better at compliantly delivering core products but may create the space for new players to drive a wedge and disrupt them. Throw in the ongoing litigation and a major adjustment from responsible lending scrutiny and the backdrop could see incumbent banks relinquish their natural advantages.

But big can be an advantage

The perceived backwardness of the large incumbent US banks has been altered in the post-GFC rebuild toward digitisation. This has influenced how they are handling disruption, with many banks using the reinvestment period to improve data extraction or launch new apps.

Aus banks 3

For example, this year alone Bank of America launched digital initiatives including: Erica (digital AI), digital shopping, digital wallet (a store of users’ payment details on a digital device), mobile client onboarding, digital rewards dashboard, and digital wealth management.

Efforts to be all things to all people, to have ‘top of digital wallet’ status (i.e. be the first app to be reached for) and to cross sell wealth products – a form of vertical integration – are all still key tenets of the US banks’ proposition. This is a contrast to the prevailing trend in Australia.

I was told by one US fintech they “view their main threats as GoldmanSachs’ digital bank called Marcus, and Amazon. This tells you incumbents and the connections they have still drive some natural advantages. US banks are outspending the smaller players on financial apps and customer experience development. Bank of America now has 36 million active digital accounts, the toprated app, and spends US$10 billion p.a. on technology. This shows how digital banking has become as much about an arms race as a marketing race.

Large US banks also appear to have a growth mindset to digital banking; viewing it as an opportunity to win share and grow the wallet. For example, Zelle, which is part owned by a number of key banks, is now a larger peer-topeer (P2P) platform than the PayPal-owned Venmo.

Additionally, many of the fintech players have really struggled to scale their direct-to-consumer businesses with customer acquisition costs or underwriting issues; only those with tied access to customers are showing success at present. Businesses like the original P2P lender, LendingClub, have found regulatory compliance a big hurdle, despite scaling to a level of 12 million loan applications.

HIGH TECH, HIGH TOUCH

The US experience is showing that the traditional virtues of banking, staff engagement and customer satisfaction, will still be relevant, with many players talking about being “high tech and high touch”.

The Net Promoter Score (NPS), which is used to gauge the loyalty of a firm's customer relationships, is typically quite poor for the big-4 Australian banks, around -10 to -202. In the US there are examples of banks where this score is more positive and they are placing greater importance on relationships.

Aus banks 2

For instance, during my trip I met a bank called First Republic that generated an NPS of +75 in 20173. This was driven by a relentless focus on a single point of contact for the customer, staff tenure and delivery of a combined wealth and private banking proposition.

On the theme of bank customer loyalty, I also heard of another bank, City National, which apparently still retains many Hollywood stars as banking clients because it is claimed that in 1963 the bank manager gave Frank Sinatra cash in the middle of the night to pay a ransom over his son.

2Source: Statista, February 2017.
3Source: First Republic Form 8K; filed July 13, 2018.

Donn't discount disruption for Australian banks

The large US banks are showing leadership on digital investment by chasing new customers outside of their usual markets and continuing to push holistic customer strategies.

If Australian banks narrow their focus to just core products, they will have a real challenge turning this disruption, or perhaps more aptly the ‘creative destruction’, of their business models into a positive story for earnings growth.

It leads to the question of whether Australian banks can find a digital ‘cost out’ story to drive growth? The path to much lower digitised cost bases appears long and distant. Some US groups like Bank of America and American Express have managed to reduce nominal costs, though this was typically through traditional ‘lowhanging fruit’ cost-cutting. Most US banks, in fact, are not seeing anything better than flat costs, and view the tech spending arms race as ongoing.

Australian bank share prices currently reflect expectations of low growth, returns on equity remaining below historical levels and little benefit given to the banks for the healthy state of Australian corporates. The Royal Commission has seen investors overreact on some factors, and if the banks can mount the perceived comeback that has been evident in some of the US banks, they might even be considered cheap at the moment.

If Australian banks narrow their focus to just core products, they will have a real challenge turning this disruption, or perhaps more aptly the ‘creative destruction’, of their business models into a positive story for earnings growth.

However, the bad news is that expectations of a return to the banking glory days (once the dust has settled on the Royal Commission) are likely to be disappointed by actual meaningful disruption by non-bank players. This is in part due to the risk- averse regulatory and management response.

In my view now is not the time to ‘discount’ the impact of disruption. We see this creating a long, slow burn to subdued aggregate earnings and relatively static share prices for the banks.



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