Commentators have been predicting the disruption of core banking for many years now, but the scale of incumbents’ distribution and the strength of their engagement with customers have acted as high barriers of defence, limiting any assault on the lending and deposits core.

But now challengers are building on their central role within the digital money-flow as a trojan horse into core banking as they create deposit and lending products for their customers. And the move to cashless, branchless banking may actually be fundamentally weakening banks’ levels of engagement with their customers. But the example of Zelle in the U.S. shows how the banks can fight back, building on the strength of their own digital assets.

Banks should absolutely be scared sh*tless of fintechs. I expect to see very, very tough, brutal competition in the next 10 years.


The Historic Barriers to Entry

The barriers to entry that have historically enabled big banks to protect a lion’s share of the market in most economies are coming crashing down.

Incumbent banks were historically protected by five significant barriers that meant a huge capital requirement for challengers to even enter the market, never mind scale up.

The technological burden of building and running financial services at scale meant that the table stakes for building a new product was millions of pounds of IT spend, coupled with significant compliance and operations organisations. But now Banking-As-A-Service platforms and cloud computing are enabling scores of new competitors.

Before changes in legislation, the regulatory burden to starting a bank was extremely time-consuming and expensive. For example, prior to Metro obtaining a license in 2010, the UK government (famously pro banking competition) had not issued a banking license in ten years. But since then, 30 new banking licenses have been issued in the UK alone.

The brand trust that incumbent banks have developed over decades at the heart of communities was previously a real barrier for new, technology-led challengers to overcome. The security concerns of customers wanting to protect their hard-earned deposits took a lot of marketing spend to beat. Remarkably, the brands of most banks have held up well since the Global Financial Crisis – but financials services brands are still less trusted than technology brands such as Apple and Google.

The engagement challenge of winning and serving customers at a national and global scale is a critical success factor for both incumbents and challengers. Although, as interactions shift from branches to digital properties, engagement now means having a front-screen app, rather than prominent high street locations.

And, the final defensive barrier for banks has been their share of money-flow. Banks have traditionally sat on both the money-in (merchant acquiring, deposits, salary) and money-out (card issuing, ATMs, payments, payroll) sides of the money-flow, which enabled them to offer services around this prime position.

But given the erosion of regulatory and technology hurdles, and the eclipsing of banks’ brand trust by Big Tech – what is happening to engagement and moneyflow, and how will that impact banks?

Covid as a Catalyst for Digital Disruption

The Covid-19 pandemic and resulting lockdown measures have catalysed the shifts we have seen over the last decade towards a cashless, branchless world, accelerating the pace of adoption of digital financial services and disruption to traditional financial services.

The transition from branch and relationship-based banking to mobile and online customer servicing has been accelerated as branches have shut, and advisors work from home. This has forced the last remaining customers that relied on face-to-face banking to adopt digital channels. Whilst undoubtedly positive in many ways, it may not be good for banks’ ability to engage their customers, as it forces them to compete on ground that is not necessarily familiar or comfortable, and where others certainly have more experience and capability.

Meanwhile, the banks’ share of the digital payments value chain, already eroded as many incumbents divested acquiring businesses, has reduced further as Covid has accelerated the no-touch economy and driven commerce away from physical point of sale (where at least banks had some presence) to online and commerce platforms (where banks are much weaker).

In the years following Covid-19, incumbent banks will therefore be forced to compete with digital alternatives that have been buoyed by a seismic shift in consumer behaviour.

Core Banking is Now Under Attack

As any banker will tell you, deposits and lending have long been the heartland of banking products.

Whilst there have been challenges to this core, from pure-play digital providers (Monzo, N26, NuBank) and alternative P2P methods (Ratesetter, Kabbage), incumbents still claim most of the deposit and lending markets for consumers and businesses. And whilst challengers may boast high customer numbers, they have yet to convince customers to ditch their old accounts.

Data from 2020 showed that the best performing challenger bank in terms of monthly unique app users was still less than a quarter of that of the best performing incumbent. So whilst customers seem happy to use challengers for features such as paying friends, budgeting and foreign currency they continue to trust their traditional bank with the bulk of their moneyflow (salaries and payments). This goes some way to explain why challengers have struggled to land on bank-like unit economics and make significant inroads into lending markets.

But in the digital economy, the ability to protect that core is eroding rapidly. The incumbency that led to the organic cross-selling of debt has been replaced with digital engagement. Consumers and businesses are likely to borrow from a service that they are familiar with, has prominence and achieves the most screen time. Services like Australia’s Tyro and Stone in Brazil offer a natural extension away from their core products (merchant payments) and into core account and lending provision.

And the share of money-flow that allowed incumbent banks to act as the first point of lending to their customers, has been replaced with digital-first services offering payments. Payment service providers grabbed a foothold into the money-flow by offering the ability for merchants to accept card payments, giving them access to the majority of a merchant’s revenue. It is a natural extension for providers within the payments value chain to offer lending solutions, using this transaction flow both as collateral and a valuable source of data and insight on the health of a business. Services like Square Cash and PayPal now offer lending to smooth out cash flow for SMBs, whilst services like Viva Wallet have provided merchants with the ability to spend their acquiring incomings on prepaid cards, without the need to settle funds to their bank. Likewise, installment lenders at the point of sale, like Klarna and AfterPay, are offering consumer micro-lending solutions as and when the need arises, initiating a new financial services relationship by taking control of consumer outgoings.

Payments and commerce companies are grabbing hold of engagement and money-flow. If the 2010s were about incumbents weathering the direct threat of challenger alternatives to their deposit and lending products (whilst delivering on a significant regulatory change mandate), the 2020s will be defined by their response to the rising threat of payments and commerce companies.

The Threat from Tech, Social, Payments and Commerce

This threat is coming from four angles: global technology companies, social payment apps, payment providers and commerce platforms.

Many of the largest technology firms in the world appear to have placed financial services at the heart of their product strategies. They plan to leverage their wide and engaging product ecosystems to naturally extend into financial services.

As an example, Google announced the launch of Plex, its checking account. Adding core account functionality to its Google Pay app, the service incorporates social payments and enhanced transaction data, as well as integrations to its own marketplace of businesses and knowledge, and access to its Android payments operating system. The service is aimed at a “mobile-first” audience, so only available as an app.

There has been an explosion of social payments globally over the last decade, as peer-to-peer payments providers have broadened functionality to become full digital wallets.

Venmo, Zelle and Square Cash are battling it out in the US. Although P2P payments has grown every month for the last four years, the pandemic has accelerated this dramatically, with some estimating 19% monthly user growth in the US market through the first few months of lockdown in 2020. The appeal of the digital wallet and P2P payments market is the breadth of commercialisation opportunities once you have a large user base. As well as foundational use-cases like splitting bills and transferring funds, providers like PayPal and Square have offered the ability to spend stored value.

Square have been perhaps the most aggressive in using social payments as a stepping stone to digital wallets and on to core deposit banking. Thirty million customers now use Square’s Cash App, seven million of whom have been issued with a Visa debit card with which to spend stored value, including in virtual currency. At an aggregate, this represents a deposit value of around $1.7bn, which is small versus challengers, but is a good start as it takes its first steps with a full banking license.

Payment challengers around the world are also using their access to the transaction flow between SMBs and consumers to enter core banking.

For businesses that depend on card payments for revenue, of which there are many, payment providers can act as the primary financial service, so it is a logical extension for customers to bank with their payment provider. With cashflow consistently topping SME priority lists, speed of access is a critical factor. Payment providers conceptually have the ability to accelerate access for merchants (and to slow it to other banks), which may prove to be a real advantage.

Stone, the NASDAQ-listed Brazilian payments challenger, extended their product range from the core payments functionality that led them to win ~70,000 merchants per quarter, to offer lending as part of a complete SME toolkit. Launched in early 2019, the service had issued BRL185 million of loans to 13,400 merchants. The first step in delivering its “hub strategy”, this was followed up by the launch of its Digital Account later in 2019.

And commerce platforms, responsible for an ever-increasing share of global transactions, are also making a play for embedded financial services.

As social platforms like Facebook, Instagram and TikTok build more tools empowering their content creators and influencers to sell directly to users, platforms like Shopify have boomed, both in terms of customer numbers and the value of the transactions that they process.

Shopify is well placed to capture much of that value as the seller’s backend infrastructure, which as an internet business is proving a great place to be. Amazon processed more than $200bn in marketplace sales in 2019 but Shopify is catching up. This is proven by the U.S. Black Friday weekend figures in 2020, which saw Shopify generate $5.1bn in sales vs Amazon’s third-party sellers posting $4.8bn. Not content with its share of internet spend, Shopify is also making a play for other financial services. In 2020, it launched Shopify Balance – powered by Stripe Treasury – which lets merchants hold money, pay bills and spend money from Shopify funds, before they are funded out to core bank accounts.

Zelle: A Model for the Incumbent Fightback?

In all of the above scenarios, technology-enabled challengers are leveraging their role within moneyflow and highly engaging digital products to wrestle a share of deposits and lending. The good news for banks is that the digital channels they operate are as high in engagement, and as critical to customers’ financial behaviour, as the challengers’ alternatives.

Whilst the shift to cashless and branchless banking has placed slow-moving products like deposits and lending under new pressure, incumbents have all of the infrastructure, permission and trust – not to mention engagement and moneyflow – to fight back and defend their deposit and lending cores successfully. Many boast daily interactions in their mobile banking channels from the vast majority of their customers, across all demographics. The scale and engagement within these channels are enviable, even for the most aggressive of challengers. If incumbents are to successfully defend their core products, these channels can play a key role in doing so.

As an example, Zelle, the service launched by Early Warning Systems (a company owned by a collection of the largest banks, including Bank of America, Capital One, JPMorgan Chase, Wells Fargo and others), is a great example how banks can overcome the threat of disruption. Zelle took on the threat of Square and PayPal head-on, and seems to be winning the battle.

The reason for this traction was that it leveraged the existing native banking apps of the incumbent banks, without the need to download another app, providing distribution to tens of millions of customers, quickly gaining the market share necessary within peer-to-peer models. Zelle was also able to leverage the permission and trust of the incumbents’ brands, which led it to be trusted for bigger transaction sizes than Venmo and Square’s alternative products. In the first half of 2020, it processed payment volumes of $133 billion, around double that of Venmo.

What Zelle should prove to all incumbents fearing the threat of disruption (and even more so, those that are not) is that the same shift to digital can in fact prove to be profound advantage over challengers, which (whilst growing) do not have anywhere near the volume of customers in their digital channels.

As the competitive landscape appears to shift in favour of challengers, incumbents still have the vital assets to defend their market position. Though their branch real estate and ubiquitous share of the cash economy may have waned, they have some of the most used digital channels and are trusted by most customers to provide the services that matter. These are the banks’ last defences as well as the basis of their counterattack as Zelle proves.

By Jonathan Hughes, Co-Founder, Pollinate & Nick Parminter, Founding Partner, Class35