What next for Australian banks?

10 October 2018

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

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.

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.

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.

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.

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.

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”.

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.

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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