Disrupted Banking – the advent of the zombie banks?

 

Disruptive technology, antique banking regulations and poor customer loyalty means traditional banking is going one way

iDisrupted Commentary

If banks faced a perfect storm in 2008, then they are now set to face the next thing up– call it a potential banking apocalypse.

You could even say banks face the financial equivalent of a zombie apocalypse, after all bailouts have had the effect of propping up banks which had previously applied practices that should have led to their demise, instead the world’s army of undead banks are ill-equipped to a face multitude of threats that are set to transform global banking permanently. Only regulators who choose to support the devil they know and enact policies designed to protect existing banks, or a very agile new business models and un-bank like approach to business can save them.

Although, regulators may well seek to protect the existing banking systems from various disruptive threats it faces, it does appear that in many respects their regulations are having the opposite effect, and ceding even greater opportunity to the ‘disrupters’. iDisrupted has interviewed David Krischer, Partner and Head of the Americas Allen & Overy LLP, a top legal firm with expertise in this area. Mr Krischer comments appear to support the view.

The only possible hope for banks looking to survive lies with adopting lean and agile management practises. Banks need to throw out the traditional analogue business way, involving hierarchal structure, minimal experimentation, and a slow cumbersome response to a rapidly changing market place, and adopt a more digital type strategy with a more agile flat management structure. This involves empowering staff to make more decisions, and take more non-systemic risk. By that is meat risks in experimenting with new ways of operating and is quite different from the risk taking in financial transactions that nearly brought down the global banking system in 2008.

Although it is far from certain that existing banks can apply such a digital approach, some banks, such as Barclays, are at least applying some of the digital techniques referred to here.

Central banks and government need to wake up to the threats posed by new technologies. Many of the new technology led services will represent a positive step, and if the demise of many of the world’s existing banks follows, many might say good riddance.

But regulators need to somehow manage the change-over. There is a risk of that a collapse in the current banking system to be replaced by a technological led system, could lead to a banking crisis even more serious than the one faced in 2008. The solution to this does not lie in trying to hold technology back, that is as fruitless of as trying to stop the tide, but it does require facing up to these new realities.

The danger that virtual currencies may evolve and remove from government and central banks the ability to control the money supply at a time when technology threaten to disrupt the way the economy has operated for the last two centuries also needs to be faced, or else the dream of plenty that technological revolution can bring, may be replaced by the nightmare of mass unemployment, and unprecedented levels of inequality.

The threat of challenger banks
New challenger banks pose a threat to existing banks in two key ways:

  • The need to radically overhaul their technology while encumbered by an IT legacy. New banks are at an advantage because it is often easier to build a new IT system from scratch, then change an existing system.
  • Diminishing barriers to entry. Banks used to be supported by their branch network, even by their imposing entrances designed to convey a sense of strength and permanence. New banks used to face a near insurmountable task climbing over such barriers. However, in the age of online banking these barriers have almost entirely collapsed.

The twin threats of IT legacy and diminishing barriers to entry, combined with a sense of mistrust of banks, have afforded challenger banks a unique opportunity

The technological disruption

However, there are further threats to the entire edifice of the banking industry, even challenger banks will be under threat.

  • According to the Millennial Disruption Index, [1]73 per cent of the millennial generation [2] would be more excited about a new offering in in financial services from Google, Amazon, Apple, PayPal or Square than from their own national bank. This shows that many of the more well-known technology companies appear to face an open door when attempting to offer banking services to younger members of the global-work-force.
  • Peer to Peer payments, such as a service now available from Facebook, currently work in conjunction with the traditional banking, with customers able to make payments via social media using their existing debit card. In this way they can, for example, pay family members, or a baby sitter, but peer to peer payments represent three other disruptive threats to existing banks.
  • Firstly, they could bypass existing banks altogether if technology companies put the appropriate infrastructure in place. For example, Facebook has sought approval from the Bank of Ireland to become an e-money institution, this provides it with a near open goal in trying to score victory over existing banks. Companies such as Facebook also have the advantage that they do not need to generate money directly from offering banking services, rather they use the provision of such services to act as a ‘Trojan Horse’, reeling in more users, cementing their user base, and in turn generating revenue from advertising.
  • Secondly, peer to peer payments also have relevance to people who don’t have bank accounts, a problem especially prevalent in Africa. Many economists agree that within a few decades, Africa will be the fastest growing economic region in the world, and with its growth the need for a means to make electronic money transfers will rise. Technology companies are benefit from first mover advantage.
  • Peer to peer payments and other similar technologies may remove the need for cash altogether, again removing one of the core purposes of existing banks, namely the distribution of cash. In the process as money transfer’s becomes solely a digital process, technology companies whose speciality is after all digital technology, will have the edge.

Peer to peer lending and crowd sourced funding
Existing banks also face threat from another core part of their raison d’être, the attraction of savings and lending of money. Both peer to peer lending and crowd sourced funding offer new opportunities for both savers and would be borrowers. At a time when interest rates are near zero, and in some parts of the world even below zero, peer to peer lending offers savers an opportunity to enjoy a much higher return on their money. At the other end of the chain, borrowers may find they have access to funding that does not trvel via an apparently inhuman process in which lending decisions seem to be determined by algorithm, and make very little allowance for personal circumstances – “The computer says no,” syndrome. Even more pertinently, as bankers appear to prioritise lending to consumers over business, crowd sourced funding may well release the log-jam of would be entrepreneurial business held back by the apparent intransigence of their bank.

Furthermore, in the US especially, it appears non-banks have a key advantage in the field of peer to peer lending over existing banks, because they are not encumbered by the same degree of regulation. David Krischer explained: “Peer to peer lending is largely business to business, via the co-called shadow banks, which includes insurance companies and asset managers not subject to traditional bank regulation.

“Generally speaking if you do not hold yourself out as both accepting deposits and making loans, then you are technically not engaged in the business of banking for regulatory purposes.   So a company with lots of cash can lend money peer to peer outside the federal bank regulatory regime.”

“Peer to peer lending takes advantage of a market segment that is generally not regulated.”

Mr Krischer added: “Stricter regulation and supervisory standards imposed on banks have made it harder for them to do certain types of activities and it is harder for banks to invest in technology.”

“Regulators find certain types of loans—such as leveraged lending—to be of much higher risk. As a result, we are seeing more nonbanks enter this space.

Lending to technology companies
Non-financial organisations also have the advantage over funding more entrepreneurial technology type companies in certain key ways.

Mr Krischer explained: “Firstly, because of potential risk. There is starting to be regulatory crack down on certain types of loans—particularly those that are highly levered. The argument is essentially that if there is a real chance you won’t be paid back then this is not lending but rather speculation—an unsafe and unsound practice that banks aren’t permitted to do. Non-banks can do this, however.”

“Also, banks need to consider the impact of the capital rules on every kind of loan they make. Sometimes their application can lead to odd results. For example, under the first Basel Accord, loans to corporates required a 100 per cent capital backing while OECD debt required none. So a loan to Apple would be risk rated 100 per cent, but a loan to Greece in the form of sovereign debt would be 0 per cent rated. Non-banks don’t have artificial capital charges and may price their loans more competitively.”

“So enhanced regulation and technology are arguably converging to drive change, pushing traditional lending from the regulated banking sector to the shadow banking market.”

On the subject of crowd sourced funding Mr Krischner said: “Fifty years ago, to raise money you went to an underwriter to distribute your securities to their list of contacts.   Now you have the internet, which can theoretically distribute your issuance quicker and more efficiently.”

“The SEC is looking at this. Their role is to protect investors. Since 1933 they have imposed a statutory regime that placed obligation and exposed underwriters to liability for material misstatements and omissions for materials sent to investors. But if the internet becomes the medium for deals, many care asking what protections there are for individual investors.”

The threat of virtual currencies
Another threat to banks lies in the possibility that new virtual currencies such as bitcoins may evolve, totally disrupting the financial transaction process. Although some central banks, such as the Bank of England, and some financial ministers such as Greece’s Yanis Varoufakis, have looked into block chain type technology that lies behind the bitcoin to launch a government/central bank controlled virtual currency, the fact is the main impetus for virtual currencies comes from the libertarians. It is possible that governments and central banks may be powerless to stop the rise of independent currencies controlled solely by market operations. After all, a currency is simply an alternative to buying and selling using a barter exchange system. It is hard to regulate against barter, and almost as had to regulate against a new block chain means for acting as a proxy for barter.

If we see the evolution of independent virtual currencies, central banks may lose the ability to influence interest rates, or even to engage in exercises such as quantitative easing. While some, libertarians especially, may see this as a positive development, in an age, when new technologies may led to greater inequality and large scale job losses, the ability of central banks to be able to control the money supply and print money when required may be paramount.

David Krischer said “The dollar note is legal tender for all debts public or private. But was the dollar ever meant to be an exclusive currency used in the US? There are a number of interesting legal questions arising from the Bitcoin phenomenon.

“Is the Bitcoin really an investment product as opposed to a form of money? And, if so, what protections are there for investors and consumers?”

To the extent Bitcoin does represent an alternative money system, there are implications for financial stability and indeed on the continued ability central banks to drive monetary policy.”