Cutting Through The Noise Around Fintechs

Banking has historically been one of the business sectors most resistant to disruption by technology. Since the first mortgage was issued in England in the 11th century, banks have built robust businesses with multiple moats: ubiquitous distribution through branches; unique expertise such as credit underwriting underpinned by both data and judgment; even the special status of being regulated institutions that supply credit, the lifeblood of economic growth, and have sovereign insurance for their liabilities (deposits). Moreover, consumer inertia in financial services is high. Consumers have generally been slow to change financial-services providers. Particularly in developed markets, consumers have historically gravitated toward the established and enduring brands in banking and insurance that were seen as bulwarks of stability even in times of turbulence.

The result has been a banking industry with defensible economics and a resilient business model. In recent decades, banks were also helped by the twin tailwinds of deregulation (in a period ushered in by the Depository Institutions Deregulation Act of 1980) and demographics (for example, the baby-boom generation came of age and entered its peak earning years). In the period between 1984 and 2007, US banks posted average returns on equity (ROE) of 13 percent. The last period of significant technological disruption, which was driven by the advent of commercial Internet and the dot-com boom, provided further evidence of the resilience of incumbent banks. In the eight-year period between the Netscape IPO and the acquisition of PayPal by eBay, more than 450 attackers—new digital currencies, wallets, networks, and so on—attempted to challenge incumbents. Fewer than 5 of these challengers survive as stand-alone entities today. In many ways, PayPal is the exception that proves the rule: it is tough to disrupt banks.

The fintechs moment

This may now be changing. Our research into financial-technology (fintechs) companies has found the number of start-ups is today greater than 2,000, compared with 800 in April 2015.1 Fintech companies are undoubtedly having a moment (Exhibit 1).

Exhibit 1

Cutting Through The Noise Around Fintechs

Globally, nearly $23 billion of venture capital and growth equity has been deployed to fintechs over the past five years, and this number is growing quickly: $12.2 billion was deployed in 2014 alone (Exhibit 2).

Exhibit 2


So we now ask the same question we asked during the height of the dot-com boom: is this time different? In many ways, the answer is no. But in some fundamental ways, the answer is yes. History is not repeating itself, but it is rhyming.

The moats historically surrounding banks are not different. Banks remain uniquely and systemically important to the economy; they are highly regulated institutions; they largely hold a monopoly on credit issuance and risk taking; they are the major repository for deposits, which customers largely identify with their primary financial relationship; they continue to be the gateways to the world’s largest payment systems; and they still attract the bulk of requests for credit.

Some things have changed, however. First, the financial crisis had a negative impact on trust in the banking system. Second, the ubiquity of mobile devices has begun to undercut the advantages of physical distribution that banks previously enjoyed. Smartphones enable a new payment paradigm as well as fully personalized customer services. In addition, there has been a massive increase in the availability of widely accessible, globally transparent data, coupled with a significant decrease in the cost of computing power. Two iPhone 6s handsets have more memory capacity than the International Space Station. As one fintech entrepreneur said, “In 1998, the first thing I did when I started up a fintech business was to buy servers. I don’t need to do that today—I can scale a business on the public cloud.” There has also been a significant demographic shift. Today, in the United States alone, 85 million millennials, all digital natives, are coming of age, and they are considerably more open than the 40 million Gen Xers who came of age during the dot-com boom were to considering a new financial-services provider that is not their parents’ bank. But perhaps most significantly for banks, consumers are more open to relationships that are focused on origination and sales (for example, Airbnb,, and Uber), are personalized, and emphasize seamless or on-demand access to an added layer of service separate from the underlying provision of the service or product. Fintech players have an opportunity for customer disintermediation that could be significant: McKinsey’s 2015 Global Banking Annual Review estimates that banks earn an attractive 22 percent ROE from origination and sales, much higher than the bare-bones provision of credit, which generates only a 6 percent ROE (Exhibit 3).2

Exhibit 3


Fintech attackers: Six markers of success

While the current situation differs from the dot-com boom, the failure rate for fintech businesses is still likely to be high. However, in a minority of cases, fintechs that focus on the retail market will break through and build sustainable businesses, and they are likely to profoundly reshape certain areas of financial services—ultimately becoming far more successful than the scattered and largely subscale fintech winners of the dot-com boom. Absent any mitigating actions by banks, in five major retail-banking businesses—consumer finance, mortgages, lending to small and medium-size enterprises, retail payments, and wealth management—from 10 to 40 percent of bank revenues (depending on the business) could be at risk by 2025. Attackers are likely to force prices lower and cause margin compression.

We believe the attackers best positioned to create this kind of impact will be distinguished by the following six markers:

Advantaged modes of customer acquisition

Fintech start-ups must still build the most important asset of any business from scratch: customers. Banks already have them, and attackers will find it difficult to acquire them cost-effectively in most cases. Fintech attackers are subject to the same rules that apply to any e-commerce businesses. Over time, a key test of scalability is that gross margins increase while customer-acquisition costs decrease. During the dot-com boom, eBay, a commerce ecosystem with plenty of customers, was able to reduce PayPal’s cost of customer acquisition by more than 80 percent. Fintech attackers this time around will need to find ways to attract customers cost-effectively. In the payments point-of-sale (POS) space, several fintech attackers, such as Poynt and Revel, are seeking to capitalize on an industry disruption—the rollout of EMV (Europay, MasterCard, and Visa—the global standard for chip-based debit- and credit-card transactions) in the United States and the resulting acceleration of POS replacement cycles. They are attempting to leverage distribution from merchant processors and others with existing merchant relationships to acquire merchants as customers more quickly and less expensively than would otherwise be possible.

Step-function reduction in the cost to serve

The erosion of the advantages of physical distribution makes this a distinctive marker for the most disruptive fintech attackers. For example, many fintech lenders have up to a 400-basis-point cost advantage over banks because they have no physical-distribution costs. While this puts a premium on the importance of the first marker, it also enables fintech businesses to pass on

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