The history of financial services traced back to the 11th century in the Italy where money traders exchange currencies with customers on benches. Later in the 17th century, Goldsmiths become the ‘keeper of running cash’ for the Royal families. Soon in 1780s, merchant banks began to gain importance, supported by two families, the Rothschild and the Barrings. These are the early days of financial services. The modern finance started to develop since the first wave of economy globalization during 1870 – 1914. Until today, the modern financial services system has 100 years of history and financial institutions have developed their scale gigantically.
Despite that, over the last 100 years, financial institutions’ operation model barely changed. Yes there were system upgrades, new products, change in document formats, updated regulations. However, the customer experience, the cost scale, the operations, seem still lagging behind. FIs have an advantage to resist change because of their strong bargaining power. Consumers are weak to resist policies of FIs. I believe many people have experienced ridiculous services (long turnaround, high fees, etc) of some FIs but still stay with it, simply because there is no choice. It might not be healthy but the FIs do not feel the push or threat to change.
So why after these years, FIs suddenly have a wakening call? Why many of them now are calling for change, promoting change and even welcome disruption by working with Fintechs? Here are the major reasons:
- Demand driven by Millennials
- Less fee income from sophisticated products
- Prolonged low interest rate environment
- Higher compliance and regulatory costs
Let’s take a look at these factors:
1.Demand Driven by Millennials
We call this group ‘Generation Y’, often children of ‘Baby Boomers’. This group grew up during the digital transformation period. In general means, they are used to internet, mobile technology, and are closely associated with social media. They are used to digital form of life ranging from entertainment (music download), shopping (online mart) to networking (Facebook, Twitter). They want things at their fingertips at almost instant, because that is what they experience in most daily life aspects. They request friction-less, simple, intuitive and transparent customer experience. However, FIs are not used to it. FIs are good at building complex procedures and layered pricing, which is quite a contrary of what our Millennials require.
Millennials gradually become the productivity of the society and are gaining more wealth. They now become a target segment of the FIs. The FIs have to design product and services for this customer group and find themselves losing out as there is a huge gap what Millennials want vs. what the FIs are offering these days. Fintech startups (or even some ecosystem players of other industries) see the gap and developed niche solutions that intensified the competition.
2.Less fee income from sophisticated products
This factor, and the one under point 3. and 4., are by products of financial crisis occurred in 2008, the most sever depression after 1930s. I am not going to go into details of this as readers should find loads of resources easily (if you are interested, I would suggest reading the book “Too Big to Fail”, or for those who like it more dramatic, check out the film of the same name). It all started with the crisis of subprime mortgage in the US market, causing a chain effect to large FIs (including insurance companies and banks) which possibly lead to collapse of global finance system. People has lost their confidence in FIs and become much more risk averse when they come across sophisticated financial products. To be fair, some products were meant to be sold to layman on the street.
Since then, corporations and consumers avoid purchasing financial products of high risk. Especially for WMNCs and large corporations, which many of them now only allow hedging with vanilla products based on business need. FIs also do not proactively market complicated high risk products to avoid risking their reputation and being fined by regulatory bodies due to misrepresentation or insufficient risk disclosure.
Those products used to earn decent fee for the FIs. With FIs focusing again on bread and butter business, margin looks less exciting than it was.
3.Prolonged low interest rate environment
A majority of the FIs (or banks to be specific) business is lending. Banks give out its balance sheet to institutions and consumers and in return, charge an interest. To save the market from recession, the world’s central banks make interest rate cut. Despite this lower the funding cost of banks, the net margin was narrowed under extreme low interest rate environment. So bank makes less profit even from bread and butter business.
Both fee and interest income were squeezed since 2008. Banks are urged to find new income sources, as well as cutting costs. Financial technology seems the only way out for banks to identify new income source from new channels (while managing its risk level effectively), and lower the cost of maintaining the franchise (e.g. less human operation, more automated process).
4.Higher compliance and regulatory costs
Since the financial crisis, the regulatory requirements of banks have tightened. Most banks have expanded their compliance team. Expenses have grown significantly. Areas covered include Anti Money Laundering (AML), Know Your Customers (KYC), Foreign Tax Account Compliance Act, fraud detection, data for regulators’ stress test, etc. Banks have to figure how to fulfill the requirements, while keeping the cost low. Hiring more compliance staff should not be the answer in a long run. Adding up point 2,3, and 4, banks are experiencing a severe margin squeeze than ever.
All the above factors are driving the FIs to act fast in order to survive. Innovation and technology advancement seem to be the most possible way out. It is time the FIs rethink the way they conduct businesses and seek breakthrough.