Out-Law News | 24 Jun 2014 | 9:56 am | 6 min. read
The Pinsent Masons financial services sector team bring you insight and analysis on what really matters in the world of financial services.
Recent discussions with our clients have had us talking a lot about two growing trends: the growing potential for technology businesses to offer financial products and services and the reality that all financial institutions must now become digital enterprises.
There is no doubt that technology companies could pose a serious threat to banks, but the banking industry still possesses some major barriers to entry that might yet slow down those traditionally fast—moving companies.
Tech businesses going financial
Recent research by Accenture suggests that a third of traditional bank revenues are at risk of being eroded by non-banks within 6 years. Technology businesses know this and are increasingly confident that they will be better placed than traditional financial institutions to deliver financial product and services digitally. For many in financial services it is these businesses, and not their traditional competitors, that they fear the most.
Over the years the moves of leading tech companies into financial services have been no more than tentative. Amazon has for some time offered loans, but only to small businesses, through Amazon Capital Inc. Google has been in the electronic wallet business since 2009. Google Wallet is a mobile payment system that allows users to make purchases in retail stores with near field chip (NFC)-enabled devices and make press buttons online to make purchases, instead of filling out the usual forms. But it has not rapidly sought to expand its use. It has also acquired more than one price comparison website but not gone on to provide online financial advice itself.
Recent reports say that Facebook has plans to deliver financial services. Last month it was reported that it has approached regulators to obtain licences to enable it to provide money transfer services across Europe. But it is yet to make any real incursions into core financial services.
The direction of travel, however, seems clear. Amazon has the resources available to it to expand beyond small business loans. Electronic wallets have the potential to be more than replacements for retail store vouchers and holders of credit card details. Tech disruptors have the potential to replace core functions of financial institutions: in the case of banks - deposit taking, loan making and payment services.
So should financial services firms, and in particular banks, fear a more aggressive approach in the coming months?
Barriers to entry: retail banking
Metro Bank claims to be Britain's first new high street bank in over 100 years. This claim is often cited in discussions about the barriers of entry to retail banking, and as a basis for the suggestion that they are prohibitively high. The prudential requirements and authorisation hurdles required to obtain authorisation to become a bank, as well as the ongoing liquidity requirements, are no doubt significant barriers.
But Metro Bank is not the only organisation independent of the existing retail banks to become 'a bank' in the UK over the last 100 years. There are 157 entities that have been incorporated in the UK that each qualify as 'banks', in the sense of what "businesses and the public would think of as banks", according to the Bank of England. Nor is it the only genuine 'challenger bank' in the UK, with Shawbrook, for example, recently reporting its first pre-tax profit, and Aldermore reportedly having ambitions to provide "the full suite of banking services". All of these entities, to varying degrees, have navigated the regulatory and prudential landscape.
Further, over the last 12 months, regulator the Financial Conduct Authority (FCA) has made changes to its rules and processes for the purpose of increasing competition in retail banking. Before a regulatory review last year 'start up banks' faced additional 'add-ons and scalars' that required start ups to meet initial capital thresholds that were higher than those expected of existing banks. Following the review these additional hurdles were removed and new banks have also been given concessions in relation to liquidity requirements and compliance with new capital thresholds under Basel III.
The authorisation process has also been simplified, to the point where the FCA and Bank of England are indicating that they can work together to ensure that an assessment of an application to become a bank and all decisions in respect of that application can take place within a period of six months. This approach seems to be tailored particularly to the circumstances of the leading tech companies, as they may already have the capital and infrastructure in place to set up a new bank quickly.
But while this may be the intention, almost everyone with whom I have spoken who works in the sector or who has otherwise been involved in the process contends that despite the rule changes, a six month turn around to become a bank is completely unrealistic. It may be a comparable to the bank switching service requirements. Though the regulation mandated swifter switching, the reality is that the process is being underused.
Better placed than the retailers?
Among the 157 entities listed by the Bank of England are the retailers' banks: Tesco Bank, Sainsbury's Bank and Marks and Spencer Financial Services, and these stand out as potential competitors to the established retail banks. Yet none of these has progressed to wholly compete with them. While Tesco Bank is now offering current account services, unlike Metro Bank it was not set up independently from the existing banks, and is not building a significant physical high street banking presence.
So why have they been slow to really compete? Ease of access to payment systems and the investment required to develop a trusted banking brand are factors. And so is the cost and complexity of banking IT. Tesco Bank's recent annual report revealed that it has 'work in progress' intangible assets of £124.1 million, mostly related to software development.
That sum might not seem huge in banking IT spending terms, but it does illustrate the gulf between the technological capability of retailers' banks compared to existing high street banks.
Software development costs are only part of the picture. IT resiliency and security are areas of significant investment for established retail banks. RBS, for instance, has committed to investing £750m over a three year period in improving the resiliency and security of its systems alone. Some of this will be legacy systems-related and so not relevant for new entrants, but over time new entrants will face similar long-term legacy costs to deal with resiliency and security issues.
Technology investment of this nature and development in the short term may be prohibitive for retailers, but could tech companies move more quickly?
Tech companies might be able to do more of the software development themselves and more cheaply than retailers could, but they should not underestimate the costs and complexity of developing and implementing banking systems.
Where tech companies are clearly at an advantage is in relation to the know-how and skills required to move quickly in response to digital innovation, whether that be building better banking applications or enabling convenient use of payment services such as Paym.
They may also be in a better position to genuinely innovate and incorporate new financial services that non-tech providers are ill-equipped to deal with, such as peer-to-peer lending services and digital payments mechanisms. They have the expertise required to deal with and respond quickly to technology resiliency and security risks.
There is therefore a case to suggest that tech companies can compete in the retail banking space. They have distinct advantages over the existing banks – no legacy IT issues to deal with. They also have distinct advantages over the retailers – the expertise to quickly become effective digital service providers.
But whether they can develop banking brands that consumers trust and bear the expense involved in starting and developing a bank remains to be seen. Current accounts are expensive to maintain and, for all the advantages that tech companies enjoy, they would still need to acquire the skills necessary to operate the main business of banking - taking money from depositors and lending it to borrowers. In this respect, tech companies are no better placed than any other type of business.
It has been reported that the FCA is currently considering at least a further 21 banking authorisation applications. If tech companies are among the applicants, it may indicate that they have to some extent considered these challenges and have the confidence that they can be overcome.
Of course it may just be that tech companies decide that the effort and cost of setting up a bank is not worth their while and instead continue to focus on innovating around the margins – developing key financial services driven by technology – payments, platforms and wallets.