The Big 4's biggest battle

For other articles in this series, see:

1. The building blocks of banking

2. Regulation shapes bank returns

3. Home truths for the big banks

5. Twilight of a banking era

‘Software is eating the world' said venture capitalist Marc Andreessen. New competitors using new technology are replacing incumbents across broad swathes of industry. Netflix and Youtube have hammered free to air and pay TV; online news, social media, and blogs have decimated newspapers; and 3D printers are threatening traditional manufacturing. The list goes on.

Despite many attempts, though, banking is one area where the forces of disruption have yet to upset the status quo.

Before building electric cars and reusable rockets, entrepreneur Elon Musk tried to develop a digital bank in the late 1990s. It didn't work, but it did lead to PayPal, the online payment processor. Such (seemingly) peripheral banking activities are where disruption has been most successful. Attempts to disrupt core banking activities such as lending and saving have been more mixed.  

Would-be disruptors have faced hurdles in the form of incumbents' economies of scale and huge distribution reach. Heavy regulation is also a barrier, as is customer inertia. In any case, banks have provided satisfactory products for the most part, while using technology to improve their offerings.

But the door to disruption has been opening. Technological developments have enabled new business models, which are beginning to shake up the financial landscape.

New era

Take, for example, Ant Financial, which is 33%-owned by Chinese technology giant Alibaba. Ant provides payments technology in the form of Alipay and is deeply embedded across Alibaba's network. That's allowed for additional financial products, including a savings product, Yu'E Bao, so customers can earn interest on unused balances in their Alipay accounts. Yu'E Bao is now the largest such product in the world, at over US$200bn.

Alipay collects vast amounts of data that allows it to assess risk better than many banks. The data feeds into Sesame Credit, Ant's credit-scoring business, and has allowed it to provide billions of dollars in loans to consumers and businesses.

So, Ant Financial offers core banking services of payments, savings, and lending. Alibaba is trusted by customers and has the scale and a wide distribution reach. It also owns a separate digital bank.

This is one model for bank disruption; and a lucrative one with Ant being valued at around US$150bn despite Alipay being founded only 14 years ago.

Increasing reach

Alibaba's Chinese peers are no less ambitious or capable. The leading social media platform, WeChat, owned by Tencent Holdings, is widely used for payments and connects to WeBank (a digital bank owned by Tencent). Baidu (China's equivalent of Google) and JD.com (its answer to Amazon) also offer a range of financial services.

And it's not just happening in China. Amazon offers many of the same services as Ant Financial, including loan originations above US$1bn, and has an increasingly global presence. Facebook, through its Whatsapp messaging platform, is in the early stages of allowing payments. Apple and Google have a history of entering a range of industries and already enable mobile payments in Australia through Apple Pay and Google Pay respectively.

None of these tech giants started in financial services, but their ability to use technology to increase customer engagement has enabled them to expand their activities. Convenient payments appear to be a precursor to offering broader financial services.

Technology companies could build successful financial services businesses without even underwriting a financial product. They could be the organisers and distributors, for example, while a bank provides the actual product. Known as white-labeling, it is common practice in financial services and it can help a product provider build scale – often at the expense of lower margins.

This general approach has been successful for technology companies over the past 10 or so years. Uber is among the largest transportation companies but owns no vehicles. Airbnb is a dominant property renter but owns no houses. Technology and consumer capitvity is allowing this model to prosper.

Platforms step up

These companies are often described as ‘platform businesses'. Characterised by low incremental costs to grow and distribute products, platforms benefit from a weak form of network effect. That is, their popularity among customers attracts product providers, which in turn draws in more users (a pure network would link all users as peers).

Consumer engagement is critical to the success of platform companies entering Australian banking. Where the Big 4 banks have had a patchy record with reputation, engagement and cross-selling products and services, technology companies could be more successful.

This could enable them to overcome the big banks' distribution and scale advantages, paving the way for lower margins as bank products become commoditised. And with the ability to shift deposits easily, major banks' funding and liquidity would face increased volatility.

All this could improve convenience for consumers. Bank A might provide the cheapest mortgage; Bank B the highest deposit rates; and Bank C the best credit card, but they could all be managed under the one umbrella with a large technology company – particularly with the advent of open banking.

The economics of the banking industry can be changed from a few taps and swipes of a mobile phone.

Not so fast

Most likely, though, this kind of thing will take some years to develop; industry transitions tend to start slow then accelerate, but considering potential outcomes is crucial for investors. It's also likely to look different to what we imagine today.

So far, we've discussed the potential for widescale disruption, but the reality is likely to be more mixed.

The adoption of new technology can vary significantly between different markets. Australia's experience will likely differ from that of China, and perhaps the US and Europe. Australia's major banks have a large customer base, providing for a range of customer segments with differing needs. New providers may not have a similar capability.  

It's also unlikely all bank activities will be impacted equally. Major banks offer a wide range of products that have different requirements; retail deposits are very different to corporate loans.

To date, fintechs and large technology players have focused on payments, loans and (to a lesser extent) deposits for retail customers and small businesses. There's been less traction with large business lending and associated products and also with home loans – which provide such a large part of the major banks' earnings.

So there's likely to be more segmentation: with players gaining market share in some areas and losing it in others. That's already been occurring with the major banks, other than Westpac, largely exiting wealth management operations. More change could be ahead. 

Up for the fight

The big banks, though, have not been asleep at the wheel. As former Commonwealth Bank chief executive Ian Narev has put it, banks must ‘adapt or die', and the major banks have been investing heavily in technology. While not often recognised as technology companies, the banking industry is among the biggest spenders on IT.

Assessing the technological capabilities of the different banks can, however, be difficult. As consumers, we're exposed to the ‘client-facing' technology such as mobile banking apps. But the true competitive positioning of a bank may depend more on what goes on behind the scenes in their ‘core banking systems'.

The major banks have systems that reach back decades. Keeping them up to date is a complex and expensive process and a distraction from new innovation –  making it hard to compete with new players unencumbered by legacy systems.

CBA has a lead over its peers having begun the process of comprehensively updating its core banking system over a decade ago at a cost of over $1bn and 1500 full-time staff. The bank's technology prowess is one reason for its premium valuation.

Partner up

There have also been some interesting developments in the banks' approach to investment. Major banks have always innovated, but they're increasingly willing to enter partnerships and buy capabilities. In all likelihood, competitive threats have forced their hand.   

NAB, for example, partners with Xero, an accounting software provider that has access to much client data that can be used for loan purposes. Westpac has set up a venture capital subsidiary, ReInventure, and provided it with $100m to take stakes in nascent technology businesses.

Partnerships and investments can provide cost efficiencies, while speeding the adoption of new ideas, giving better access to data and allowing greater customer engagement. This approach is still in its infancy and it'll be a while before we can fully judge how well it's working.

Partnerships do have limits. While ANZ has adopted Apple Pay, its peers have been reluctant to adhere to Apple's terms. Instead, CBA developed a (clunky) card that attaches to a customer's phone as a work-around. Many CBA customers are not amused, further highlighting the market power that technology companies have.  

Internal change

Competition and consumer adoption of technology are also forcing major banks to change their culture and operations. The banks have to meet increased customer expectations for ease of use, capability, and convenience. ANZ and NAB are perhaps the most vocal in this area, though all banks are undergoing material change.

ANZ, for example, has promoted its ‘agile' working methods, where employees join ‘squads and tribes' to improve productivity. It's easy to dismiss it as a gimmick, but ANZ has provided evidence that it's led to quicker product development.

More importantly, it shows that ANZ recognises the need to adapt; it needs to get from idea to implementation more quickly, as typically happens in technology companies. Employees will look the part as well, with the bank encouraging them to channel Apple and Google with more casual attire. 

NAB is also undergoing some significant staffing changes with around 6,000 staff being made redundant. A fraction of those jobs will be replaced with staff with technology expertise. NAB's chief executive, Andrew Thorburn, talks of the need to ‘disrupt ourselves from within' and ‘become simpler, faster and easier to deal with.'

The major banks are also working to reduce costs, which is another requirement to remain competitive. While the Big 4's cost structure appears lean relative to foreign banks, greater adoption of technology will allow for greater efficiencies. In time, that will also include fewer branches and reduced staffing levels. New technologies allowing greater productivity are available to all players, so the Big 4's cost advantages involving scale are potentially less durable.

All these internal changes involve execution risk and, for better or worse, will no doubt affect staff morale.

Murky predictions

How all this is likely to end up, the banks themselves don't know. Maile Carnegie, ANZ's digital banking head and former Google Australia boss, says ‘it's going to look like whatever customers want it to be'.

Australia's major banks are in a good position. They're aware of the challenges and have the capital and profitability to invest in the necessary areas. They're protected by regulation, to at least some degree, and they have established customer relationships, scale, and cost advantages.

Overcoming these advantages will be no easy task for challengers. The regional banks have struggled to match the majors, and to date, fintechs have not been able to take material market share. There's no guarantee that large technology companies will have greater success.

One thing is certain, though: competition is increasing and at least some elements of the banks' business models are being threatened. And all this is coinciding with weak growth prospects, which will be the focus of the final article in this series.

For other articles in this series, see:

1. The building blocks of banking

2. Regulation shapes bank returns

3. Home truths for the big banks

5. Twilight of a banking era

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