The banking scenario has turned in favour of legacy banks. The rise in interest rates is a big factor. Higher rates make banks more profitable and help them grow. Terence Tse, Mark Esposito, and Danny Goh write that despite the favourable winds, traditional banks must push past legacy solutions and come up with initiatives fast to fend off new entrants.
For the past decade, the future of finance has seemed to belong to fintechs and fintechs alone. Traditional banks are seen as obsolete and having no role to play in an everything-tech economy. It is understandable why many have subscribed to this view. Start-up banks could run at a lower cost and offer more customer-friendly services, gaining more and more market share. Low interest rates in the last eight years made funding cheap for these new entrants, an essential condition that enabled them to pay for costly new customer acquisition and hence growth. It is no coincidence that the British Bank Awards have gone to challenger banks in the past years.
Challenger banks are not the only new rivals. Other technology companies have been upping their financial services offering. In the US, Apple recently launched its own “buy-now-pay-later” (BNPL) product by lending out the cash on its own balance sheet. This is a new addition to the range of financial services offered by the company, which also markets its own branded credit cards by partnering with the retailing banking arm of Goldman Sachs. Regulations have also made life hard for traditional banks. Incumbent banks are often subjected to far more regulatory scrutiny than newcomers.
Traditional banks’ legacy IT infrastructure often holds them back and affects their ability to catch up with new technology-driven competitors. It is not for the lack of trying: traditional banks have been updating and expanding IT capacities. Yet, decades-old IT stacks have made it difficult for traditional banks to compete with new entrants in terms of personalisation, customer experience, and innovation. This prompted some of them to try to build completely new challenger banks as side bets. Not all of these initiatives were met with success: UK’s Royal Bank of Scotland created Bó, which lasted only seven months before it was shut down for good.
Where the old is now the new
Lately, the wheel of fortune is turning in favour of traditional banks. To start with, interest rates are most likely to be on a continuous rise, making banks more profitable. This in turn helps them to expand and invest in their lending businesses and to build a strong defence against fintech companies. To keep growing, many fintechs have resorted to offering an ever-widening, yet expensive, range of products – from access to airport lounges to cryptocurrency and stock trading, and sizeable referral fees. At the same time, as funding dries up for fintech companies, investors care much less about their revenues and are interested in seeing them finding a pathway to profitability.
In contrast, traditional banks have all got large customer bases, making it cheaper for them to cross-sell and easier to move these to digital banking platforms. With high interest rates and high inflation, decreased customer spending will impact those challenger banks that rely on transaction fees. It is therefore likely that incumbent banks will generate far more revenue on a per customer basis than challenger ones.
Indeed, the rise and rise of fintech in the past years has often left us over-estimating their market power. For instance, in spite of their enthusiasm towards challenger banks, a majority of retail fintech customers (still) do not use them as their primary account to, say, receive their salary or savings. In 2020, the average monthly customer deposit was only £396 for Revolut and, in 2021, £793 for Monzo. Even for Starling, which has been marketing itself as a proper banking institution, it was only £2,180 in 2021.
The regulatory environment is also likely to change. Currently, fintech companies are less constrained by regulations, whereas incumbent banks often have their hands tied. As the economic situations worsen, regulatory crackdowns such as “stronger credit checks” on BNPL are now on the horizon. Crackdowns or not, as fintech companies mature, they will in all likelihood come under the regulatory spotlight. The changing market horizon is now seemingly handing advantages to the traditional banks.
Now on a more equal footing
Even though the general environment is turning in favour of the incumbent banks, they must still come up with initiatives fast to fend off new entrants. This means they have to up their game on the most basic services (one of us recently wanted to contact a high street bank for a business loan and discovered that the phone number on its webpage was disconnected, with no further help provided!). At the same time, legacy banks must push past legacy solutions. Since banks are organisationally large and complex, it makes good economic sense to focus on improving processes. Undoubtedly, this will require a great deal of time, effort and resources. However, with a more favourable competitive setting, traditional banks will probably find it rewarding. The great comeback is about to get started.
- This blog post represents the views of its author(s), not the position of LSE Business Review or the London School of Economics.
- Featured image by Nathan Dumlao on Unsplash
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