Digital technology has introduced a new era of innovation that will change consumers’ relationships with banks. What many people both inside and outside the banking industry do not realize is that these changes could, in fact, bring the end of banks as they have existed for centuries.
Alex Lipton, David Shrier and Alex Pentland of the Massachusetts Institute of Technology’s Connection Science & Engineering recently authored a paper titled, “Digital Banking Manifesto: The End of Banks?”
The paper begins with an overview of what purpose banks serve, followed by a summary of digital technology’s impact on banking to date, and an overview of what future changes are to be expected, including the possible disappearance of banks.
What Is Banking?
Banking is the skillful record keeping in a double-entry general ledger. Banks can be seen as dividend producing machines that seek deposits and issue loans at the micro level. At the macro level, they create credit money.
Successful bankers are able to attract a large pool of reliable borrowers. They also have to attract long-term depositors who they must serve well retain the deposits. Otherwise, the bank exhausts its liquid reserves and defaults.
Digitization Suits Banking
Because banking activity is mathematical and technological, it is suited to digitization. Nonetheless, legacy systems inhibit banks from embracing innovation to survive in the digital economy.
While other industries such as communications, mass media, retail and travel have changed their business models in the last 30 years, banks are static. As a result, customers are generally dissatisfied with banks’ customer service.
Negative or zero deposit rates have made keeping money in the bank risky and unprofitable.
There is also a large group of people in undeveloped countries who are unbanked or underbanked since traditional banking systems are not flexible enough to address know your customer (KYC) needs or assess credit worthiness.
‘Digital Bank Of The Future’
Developments in mobile telecommunication adoption and data technology portend a third wave of banking innovation, the “Digital Bank of the Future (DBF).”
The first wave of digital innovation in banking were the “incrementalists.” The mid-1970s brought the ATM. The concept was to deploy machines to process transactions. Banks had historically had limited business hours. The ATM addressed the needs of two-income households.
Online banking came in the 1980s and gathered momentum in the 1990s with the Internet. Browser-based tools gave consumers access to banking transactions, including bank statements, money transfers and electronic bill payments.
Internet banking gave rise to the dedicated Internet bank such as NetBank.
Digital hybrids like NetBank brought the second wave of digital innovation. These hybrids took advantage of front-end systems to connect with consumers, but they were hindered by legacy back-end infrastructure, labor models and risk modeling systems.
Other hybrid banks used purpose-built IT that was less costly than legacy banks. But these “digital hybrids” still used centralized databases, primitive user data protocols and cloud-based storage. They marked a bridge between the legacy bank and the fully-digital bank.
New Technology Arrives
A new set of technologies has emerged allowing banks closer integration with consumers’ lives, access to the 2.5 million underbanked or overbanked, and more financial flexibility for the 45 million small and medium-sized enterprises (SMEs).
DBF will use the new technology to address the 50-year -old and under generation that grew up with computers. A mobile-first strategy will deliver ease of access and fast adoption. DBF will dispense with a central data depository that can be easily attacked. Instead, it will use an encrypted distributed system.
What Role For Banks?
The question arises: what role do banks have in the new economy? Is fractional banking facing its end with the introduction of government-issued digital cash that can be stored in digital wallets outside of the banking system?
On the retail side, DBF must provide the following:
• A holistic, intuitive, interactive overview of the customers’ money, encompassing their financial life, including information on their current account and deposit balances, recurring payments, pension contributions, transactions, outstanding loans and securities accounts.
• A holistic digital experience for customers, including paperless application and passing the KYC process. This includes an intuitive, interactive financial planner to organize financial life and optimize resources. It will provide immediate cash flow needs, tools for automatic savings, education, retirement, medical expenses, robo-advisory services, and tools for trading securities. This digital experience will empower customers to electronically apply for a mortgage and access competitive insurance contracts.
• Mobile e-payment solutions, such as domestic and international payments and remittances, peer-to-peer payments and automatic bill payments.
• Seamless and inexpensive foreign exchange services, such as protection against exchange rate fluctuations by offering multi-currency accounts. A full range of instruments will allow for hedging against foreign exchange risks, such as spot contracts, forward contracts, swaps, and exchange-traded options.
• Biometric technology like face and voice biometrics.
• A bank e-credit card based on customer preferences with pre-set limits and permitted transactions. This will include an electronic ID for secure online purchases, and tools to view, pay, analyze, organize and archive e-bills, and generate tax documents.
• Access to “crowd-everything” including P2P lending and payment opportunities.
Digital Banks’ Advantages
Digital banks have no real estate overhead or the need to spend on legacy IT systems. They expect to grow multibillion-dollar balance sheets with a fraction of staff compared to traditional banks.
The U.K.’s Atom Bank plans to grow into a £5 billion balance sheet business in five years with 340 full-time staff, compared to legacy bank Metro, which has the same size balance sheet with 2,200 people.
Digital banks can generate value in the following ways:
• Digital payments include mobile, online and P2P interactions. They allow banks to raise fees and interest income and connect with a broader set of customers with more diverse services.
• A digital wallet is essential for digital ecosystems built on value-added services. It optimizes funding costs for banking operations and transaction costs for customers.
• Artificial intelligence (AI) assisted sales of banking products include loans, mortgages and deposits that are conducted through direct channels, such social media.
• A seamless multi-channel approach to sales improves the bank’s share of customers’ wallet, strengthening customer loyalty.
• An AI-based digital financial planner manages monthly income, savings and investments, and recurring payments, increasing interaction between the bank and its customers. The bank serves as a trusted source defining financial needs.
• Robo-advisory services optimize investment portfolios based on individual goals and preferences.
• Advanced analytics enables the bank to transform its data into more personalized client services aimed at data monetization.
• AI- and Big-Data based credit models allow risk-managed provisioning of credit access to SMEs, banking the underbanked SMEs. By 2018, banks in Western Europe are forecast to have half or more of new inflow revenue from digital-related activities in most products.
What The Future Holds
A digital bank will be a cross between a fintech company and a bank. A digital bank can be organized into five divisions: retail banking, private and business banking, analytics and IT, finance management and operations, and risk management. The relationship between the divisions is different in legacy and digital banking, with IT and analytics being the cornerstone of digital banking. Success is measured by technologies and analytical methods rather than the product line.
Digital banks will include the following:
• Novel IT infrastructure. Building a digital bank from scratch allows the creation of a flexible IT infrastructure, providing state-of-the-art risk management. This can optimize the balance sheet to achieve a return on capital higher than the return of the incumbents, guaranteeing compliance with changing banking regulations in real time.
• Database design. Database technology based on a distributed ledger framework can cope with the growth in data, new Internet technologies and analysis methods.
• Advanced data analytics. The bank can consolidate data across deposits, consumer finance and other accounts for a unified view of customer activities. Customers’ in-store payments are more accurate than conventional profile data in predicting their future financial activities and credit worthiness.
• Artificial intelligence. Autonomous selection of best methodology when presented with arbitrary data lets banks build financial profiles of its customers, including debt capacity, credit worthiness, and risk appetite for financial planning. AI can present the best offers at the right time, changing as the customer evolves.
• Security and discretion. Security and protection is a competitive advantage for digital banks compared to other financial service providers.
Digital Bank Constituencies
Digital banks have natural constituencies. These include consumers with at least an undergraduate college education and digitally educated consumers who will form the foundation of the customer base for the digital bank.
Central and private banks are actively pursuing the creation of digital currencies. Considerations for this dimension are:
• Non-bank digital currencies. Bitcoin is not suited for high volume transactions due to its low transactions per second capacity. Other digital currencies based on consensus achievable by means other than proof-of-work will be used in digital banking.
• Central bank digital currencies. Several central banks are exploring whether a state-backed digital currency can reduce capital outflow, tax evasion and money laundering, making economic activity more transparent and efficient. The free or inexpensive deposits commercial banks have benefited from will disappear.
• Private bank digital currencies. Advances in digitization have made private bank currencies a viable idea. Bank of Tokyo Mitsubishi UFJ (MUFJ) is developing its own digital currency and a smartphone application to authenticate digital tokens on a P2P platform.
• Distributed ledger. Distributed ledger reduces transaction costs, improves the resilience of the system and mitigates operational risks. Distributed ledger will be part of operational procedures of a digital bank and its interactions with other digital banks.
Future Financial Ecosystem
A well-designed digital bank will be the cornerstone of a much larger financial ecosystem. Insurers, wealth managers, brokers, credit card issuers, robo-advisors, cross-border payment providers, P2P lenders and currency exchanges will all be part of the ecosystem.
The ability to satisfy the financial needs will be enhanced by access to a wider financial system through the digital bank. At the same, the bank will benefit by gaining additional information about customers’ habits and needs, thus closing the information feedback loop.
Digital cash issued by a bank can provide a lubricant allowing the wheels of commerce to spin faster and more efficiently. In addition to financial businesses, a digital bank can incorporate into its ecosystem various non-financial actors.
All such developments will enhance the social utility of the bank and its appreciation by the public while improving its profitability.
Banks Have Competition
Banks have to realize competition for their customers’ digital wallet is coming from current digital champions, such as Google, Amazon, Facebook and Alibaba.
The key is to have customer-centric data across all areas of life, held in a standard format with standard APIs working across all the digital ecosystem and not just its financial services. Given the rather uncertain and limited capacity of P2P networks to provide credit, digital banks have to come to the rescue.
The legacy banking model will need to disappear over time. But in the transition, digital banks will have a role in daily life as transaction lubricants and enablers.