[Dave Birch] McKInsey’s 2011 report on the state of the global banking industry makes the point (as far as I can see) that if banks don’t embrace disruptive technologies themselves then someone else will. This is the “standard” Clayton Christensen “Innovator’s Dilemma” view of the world, and I have to say that I subscribe to it too.

Banks have overcome previous crises by finding innovative ways to increase the top line. Although opportunities may seem to be limited, we see huge scope to improve pricing, to adapt products to the needs of customers, and to find new pockets of growth (taking advantage of the better risk-management processes many have introduced in the wake of the crisis). Opportunity lies in the potential for disruptive technology in both consumer and wholesale banking—yet many of banking’s digital strategies are still in their infancy.

[From In search of a sustainable model for global banking – McKinsey Quarterly – Financial Services – Banking]

But what were those “innovative ways to increase the top line”? Did they involve technology? In 2010, according to McKinsey’s figures, the US and European banking industries delivered an ROE of just 7 and 7.9 percent, respectively. They say that “At this level, the banks’ ROE is still some 1.5 percentage points below their cost of equity”. So have banks always been such bad investments? That’s not clear: these ROEs used to be considered normal for the banking sector.

In the period up until around 1970 ROE in banking was around 7 per cent with a low variance. In other words, returns to finance broadly mimicked those in the economy as a whole . . . But the 1970s mark a regime shift, with the ROE in banking roughly trebling to over 20 per cent

[From What do the banks’ target returns on equity tell us? | Martin Wolf’s Exchange | Economic commentary from the Financial Times – FT.com]

We all understand the big changes in bank balance sheets that led to these incredible returns: leveraging, and a big increase in risk. But banks have a special place in the economy, and there are a couple of reasons why they can target much higher ROE this way.

One is that they can earn monopoly profits. The other is that they are subsidised, principally because taxpayers provide insurance against catastrophic risk, particularly for bank creditors. The two – monopoly and subsidy – are, of course, related. Without barriers to entry, subsidies would be arbitraged away.

[From What do the banks’ target returns on equity tell us? | Martin Wolf’s Exchange | Economic commentary from the Financial Times – FT.com]

This is, as all observers anticipate, what will happen in the payments sector in Europe as the new regulatory environment begins to reshape the payments value networks. The Commission is so keen to see new entrants create new competition that they are right now considering further legal action to accelerate the process.

The EC has opened an antitrust investigation into whether the European Payments Council (EPC) is blocking new, non-bank, players from entering the online payments market.

[From Finextra: EC launches antitrust investigation into EPC and e-payments market]

You can see why this is a problem for European retail banks. There is going to be more competition than ever before. They are faced with competitors such as Google Wallet who appear to play nicely in the short term (by using bank payment instruments) but who could be utterly disruptive in the medium term by obtaining PSD and ELMI licences just as the mobile operators have started to. These are nimble and flexible competitors. This is not a criticism of our bank clients, who are well aware of these trends, but a reflection on the problems that incumbent players face in general (cf Christensen, as mentioned at the start).

Google Wallet launched three months after it was announced. On the other hand Isis, first announced in November 2010, is only planning to launch a pilot run in Salt Lake City and Austin in early-mid 2012.

[From Google Wallet Rival, Isis, Will Support Android | News & Opinion | PCMag.com]

There’s a really serious point behind this, and I think it’s central to what many of our clients have to wrestle with as they turn strategy into a tactics. It’s very, very difficult for banks and mobile operators to work together (a topic for another day) and for both of them the process of bringing new products or services to the mass market is slower than they would like. The mobile operators have been wrestling with this for some time, struggling to avoid being “just a pipe”.

Telecommunications carriers, facing increased competition from companies taking advantage of the global Internet, cost pressures and consumer demands must restructure now, or resign themselves to being utility providers, says Gartner principal analyst Will Hahn.

[From ITWeb :Gartner tells telcos to adapt]

If we focus on banks, there are smart people who are developing strategies and understand the environment, but their organisational IT spending goes almost entirely on operations and compliance. Therefore banks have to focus their “skunk works” very tightly into areas where they might expect to have some sustainable competitive advantage. It’s not clear to me that this is in payments. Suppose that in payments terms the banks are “just a pipe”? Then it makes sense to become an operationally-efficient and profitable pipe and forget about putting value-adding services on top. They should just open up their APIs and let other players come in and build new products and services.

Putting everything into an Application Programming Interface (API) is how Facebook, Paypal and others are working today and, if they didn’t, they would be dead. This is Craig’s contention for banking. In other words, banks should throw their functionality out there for anyone with the gumption to plug and play with and integrate into their apps, websites, mobiles … anything.

[From The Financial Services Club’s Blog: Banks should build their business models as APIs]

I can think of a million reasons not to do this from the incumbents’ position, but they probably have no choice. Look at the innovation that PayPal unleashed by opening up its API.

One thing that struck me about PayPal’s “Innovate 2010” conference in San Francisco, in (I have to say) fairly stark contrast to many of the events I attend in the more traditional banking world is just how much innovation was actually going on.

[From Digital Money: Innovate and innovation]

So suppose my Google Wallet could have direct access to my Barclays account via an API, and Twitter could get my Barclaycard transactions via an API, and… Wow.

These are personal opinions and should not be misunderstood as representing the opinions of 
Consult Hyperion or any of its clients or suppliers

1 comment

  1. I agree about the potential of API for ROE. However, one begs to question whether there will be significant IT security issues if more companies decide to implement it.

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