Why banks probably shouldn't be afraid of fintech firms, but depositors should

Jeremy Kahn and Charlie Devereaux wrote an interesting article in Bloomberg Business last week, on how banks are fighting back against fintech firms:

Scrappy online financial startups have spent the past few years building buzz, backing and the beginnings of a customer base.

For a while, the world’s banking giants largely ignored them. Now they’re starting to feel the heat—and fighting back with the most formidable weapon in their arsenals: cash.

Spain’s Banco Santander SA announced a few weeks ago that it will funnel 20 billion euros ($22 billion) into digital transformation and information technology in the next four years.

On an annual basis, that works out to one-and-half times all of the venture capital Europe’s fintech startups received in 2018—a disparity highlighting that, despite all their rhetoric about burying existing banks, fintech firms and neo-banks are still monetary pipsqueaks facing an uphill battle against entrenched competition.

There's been a lot of rhetoric over the last several years about disruption in the banking sector, and how small fintech firms will eventually crush the banks (for example, see here or here). However, how at risk are the conventional banks really? I'd argue that they're probably not at risk (at least, not yet), and not just because they have financial backing that the fintech firms can only dream about.

This is a story about trust. To see why, let's rewind to a time when banks were still very new. Depositors (or savers) couldn't necessarily be sure that their money was safe in a bank. They might worry that their bank was a crook, and honest bankers had a challenge to convince depositors that they weren't crooks. Essentially, there was a problem of adverse selection in the banking market.

Adverse selection may arise when there is information asymmetry - that is, when there is some private information about characteristics or attributes that are relevant to an agreement, and that information is known to one party (the informed party) to an agreement but not to others (the uninformed parties). The informed party then uses their access to that information to their own advantage (and to the disadvantage of the uninformed party).

In the case of banking, the 'agreement' is between the depositor (who has money) and the bank (who offers to store the money for the depositor). In the early days of banking, the problem was that information about whether the banker was honest, and wouldn't run off with the depositors' money and leaving them broke and angry, was private information. Each banker knew whether they were an honest banker, but the depositors didn't know who was an honest banker. You might think I am joking, but in the early days of banking, crooked bankers were a very real problem.

So, in the early days of banking, the real problem was a lack of trust. Depositors couldn't trust that any old banker would keep their money safe. It wasn't easy to tell the honest bankers and the crooks apart. So, how could an honest banker convince depositors that they were an honest banker?

Honest bankers engaged in signalling. Signalling is when the informed party (in this case, the banker) tries to reveal the private information (that they are honest) to the uninformed party (the depositor). There are two important conditions for a signal to be effective: (1) it needs to be costly; and (2) it needs to be more costly in a way that makes it unattractive for those with the low quality attributes (the crooks) to attempt. One way that signals could meet the second condition is if they are more costly to the crooks. These conditions are important, because if they are not fulfilled, then those with low quality attributes could signal themselves as having high quality attributes - the crooks could easily pretend to be honest bankers.

In the early days of banking, a banker signalled that they were honest by engaging in a costly building exercise. Have you ever wondered why old banks are often huge stone buildings with big classical columns and suchlike? A big stone building is more difficult for bank robbers to break into, sure. But it is also very costly to build. And, if you're intending to build a building for your bank and keep it for a long time (which is what an honest banker would do), it's much less costly than building the bank and leaving it behind when you move onto the next town full of suckers (which is what a crook would do). Depositors could trust the bankers who had big expensive buildings, because having a big expensive building was only something that an honest banker would have.

Anyway, back to fintech firms and modern banks. Fintech firms are new. They haven't had time to develop trust with depositors, or a reputation for being safe, to the extent that conventional banks have. Depositors couldn't know which fintech firms are honest, and which are crooks.

How can fintech firms signal to depositors (or savers) that they are honest? Fintech firms don't have big stone buildings. And basically, anything that an honest fintech firm does to try and differentiate itself from a crook can be easily copied by the crooks. Maybe it's not the banks who should be worried about the fintech firms - it's the depositors who should be worried!

However, maybe there is one way for a fintech firm to signal they are honest, and it is fairly ironic. Being owned by a bank is costly for a fintech firm, as Kahn and Devereaux note:

And while most fintechs are turning losses, they have one big thing going for them: they don’t have outmoded technology weighing them down. Many major banks would need to spend billions of dollars just to bring their IT systems into the 21st century. Even Santander’s Parthenon back-end software platform is increasingly antiquated even though it is newer than what a lot of the other European banks use.

“While they can copy our features, they cannot copy our cost base,” Starling Bank said in a statement. “They have to contend with legacy technology, not to mention the massive costs of maintaining a branch network and the slowness to action that is inevitable with large bureaucracies.”

Only an honest fintech firm would be willing to face the costs of having a bank on board. And, banks would only want to associate with honest fintech firms (or at least, we can hope that's the case!). A crooked fintech firm isn't going to want to face the costs of associating with a bank. So, maybe being owned by a bank is an effective signal to depositors that they can trust a fintech firm? This key point is missing from the conclusion to Kahn and Devereaux's article:

For now, though, [conventional banks'] giant budgets will loom large over the fintech industry—especially if digital banks fail to win over deposits in the next few years.

Fintechs will need to build “a truly different customer journey” to capture significant market share, said James Lloyd, the Asia Pacific financial technology lead for consulting firm Ernst & Young LLP. “I don’t think it will be sufficient to just have another bank product in a digital format, offering a slightly better customer experience.”

Part of the customer experience is finding some way to signal to customers that they can trust you. In an era where Bernie Madoff and the Global Financial Crisis are still casting a long shadow, trust in finance firms is more important than ever.

[HT: New Zealand Herald]