Once Upon a Time in the West
Much has been written in recent times about the way in which FinTech companies are disrupting the financial services market and how Challenger Banks are set to dislodge traditional global banking groups. In many respects the market is reminiscent of the rapid expansion across the American West in the 18th century. A mad dash by those with entrepreneurial spirit and a thirst for adventure to find unclaimed fertile land, to stake a claim, build a homestead and raise cattle. A tale of conquest, a battle for survival, the marking of trails for others to follow and the eventual establishment of law and order.
We are still in the very early stages of this expansion where FinTechs and the digital disruption of banks and financial services companies are concerned. We can already see however the way in which law and order is beginning to be established across this new frontier as regulators increase the amount of time and effort they are spending both encouraging and educating participants from outside the industry to embrace some of the key regulatory principles, particularly where conduct, consumer protection and market competition are concerned. Governments and European bodies also have a large part to play in levelling the playing field to open up markets through the use of legislative mechanisms to set boundaries and to layout the banking and payments equivalent of the Oregon Trail. The second Payment Services Directive (PSD2) is the most significant of these in the short term and the implications and impact of this legislation will shape the nature of banking in Europe for years to come.
A Fistful of Euros
Sergio Leone’s A Fistful of Dollars established the Spaghetti Western as a new cinematic subgenre in the mid-1960s, spawning a number of successful (and not so successful) films following a very similar formula. The more successful of
these combined European filming locations, film crews and extras with US headline stars and US financing. In this seminal example of the genre, the Mexican border town of San Miguel is ruled by two rival feuding gangs making it impossible for the poor downtrodden population of the town to go about its business. That is, until the arrival of a heroic gunslinger who decides it’s time to redress the balance.
As unlikely as it may seem, PSD2 replaces the unnamed stranger in our own story of European banking disruption. Following initial moves by the European Union to address the high costs associated with payments across the single market by imposing caps on interchange fees charged by the major payment card scheme providers, it was recognised that more fundamental changes were required. This initially led to the creation of the Single European Payments Area and the first Payment Services Directive. Emerging from the Global Financial Crisis of 2007/08 it was recognised that further steps were needed to address the issue of banks which were perceived to be ‘too big to fail’ and the need to stimulate competition in the payment services industry. It is with this backdrop that PSD2 was conceived and born.
How the West was won
At the heart of PSD2 is a fundamental principle which establishes the right for an individual or business to grant secure access to account and transaction information held by a bank as well as to grant permission for third parties to initiate banking transactions. This principle fundamentally shifts the balance of power from banks to the users of banking services in relation to access to basic account transaction data and payment services. It is this principle which opens up the market and leads to some profound implications for banks and other payment service providers as well as new entrants looking to provide financial services related customer propositions.
Alongside Account Service Providers (ASPs, typically traditional banks), PSD2 establishes two new types of entity:
- Account Information Service Provider (AISP): An organisation providing secure access to consolidated information on one or more payment accounts held by a customer. This means that the customer allows the AISP to obtain account transaction information from their bank account and the bank must provide this information to the AISP.
- Payment Initiation Service Provider (PISP): An organisation providing services to initiate a payment order at the request of the customer with respect to accounts held at a bank. This means that the customer allows the PISP to arrange payments directly out of their bank accounts and the bank must enable this externally enabled transaction to be undertaken.
These changes are quite profound and they begin to call into question the fundamental nature of retail banks and the relationship between banks, bank accounts, customers and third party service providers. As the banking industry across Europe begins to understand and adjust to the implications of this legislation, new propositions and business models will emerge. Banks who do not recognise the seismic shift will find themselves in a race to the bottom as they attempt to compete on price as providers of simple low cost account ledger services.
Open Banking APIs will rapidly commoditise the basic transactional services which banks provide via their underlying account structures.
Given the demands of PSD2 to open up access to basic banking services, all existing banks will ultimately need to comply with this shift. Banks who see PSD2 as simply another regulation in a long list which must be complied with are missing an opportunity to reposition themselves for the consequential changes in the industry. The European banking industry is entering an era where customer ownership and account ownership will be prised apart and the value chain of financial products and services will be reconstructed. New business models are likely to emerge which focus much more on the needs of customer sub- segments and the needs of individual customers. Gaining insight into a customer through accessing their banking transaction history and supporting a customer as their needs change over time will be the features which distinguish successful payment service providers going forwards.
PSD2 account aggregation services will not only help customers to better manage their money but will also proactively spot opportunities to shift funds to accounts with improved terms and conditions as well as to help avoid punitive fees. As an account aggregator with access to account history and the ability to initiate payments from an account, it will be possible to spot when a customer is likely to need an overdraft facility. At this point it would be possible to either automatically move funds between banks to avoid this or potentially to arrange a short term line of credit on more favourable terms to avoid the use of a higher cost overdraft facility with an existing bank. As customers in this scenario, we become much less concerned about where our bank accounts reside as the relationship that is important and that we value is the relationship with account aggregation service. In this scenario, the banks have lost the ability to make money from this customer through overdraft charges. The banking landscape is about to become very fragmented with new intermediaries offering a range of services and new propositions which will appeal to an increasingly segmented customer base.
Insurance Firms are already used to this so called ‘new world’. Many of us buy our insurance through price comparison sites and/or through independent brokers. We are indifferent and in many cases unable to name who provides the underlying insurance. Our brokers switch provider for us automatically every year to ensure that we get the best terms, providing nothing more than a quick confirmation that we accept their recommendation. When it comes to banking services most of us are extremely loyal to a brand. This is however likely to change significantly over the next few years.
Given this direction, banks must begin to see themselves more as platform businesses who have the advantage of an existing customer base and an underpinning infrastructure which can deliver value beyond the extent of its original design. This is the position Amazon found itself in a number of years ago as it begin to extend its proposition from the retailing of books into an extended range of goods and services.
The Ecstasy of the Gold - Creating the Platform Bank:
Examining the evolution of the strategy that has powered organisations like, Google, Amazon and Apple will be important for big banks challenged by the implications of open banking and PSD2. The direct comparisons we make are far from perfect, but do each in their own way highlight possibilities for the banks.
# Universal connectors
PSD defines a set of technical standards for the creation of a common banking API. These have the potential to be the equivalent of the ultra-low cost contractual arrangements that exist within Apple and Amazon that creates the vast ecosystems of partners. The use of these APIs means there is no time wasted in building a trading environment. This is really low friction growth, a vital component of elastic enterprises. And it takes place through connectors like those defined within PSD2 (RSS, APIs, and universal terms). The universality of the technology channels and the business idea eliminates friction in a way we have never seen happen before in banking.
# The new business platform
The success of both Amazon and Apple has been driven by their ability to develop as platforms. In the case of Amazon the platform consists of the rules and facilities that organize and manage the commerce engine, its reviewer database and community, the apps community, the Amazon marketplace, the vendors who sell through Amazon, digital rights management, and the writing community that self-publishes to Amazon, as well as its reluctant publishing partners, as well, of course, as its Cloud capability.
In the case of both Amazon and Apple, the platforms used are closely linked to a device, and are tied into a system that manages digital rights management effectively. Given the open banking landscape that is emerging, banks have the opportunity to do the same. In their case the bank account is the equivalent of the device and the regulatory landscape that surrounds the account the equivalent of the digital rights management that Amazon uses to good effect. Under PSD2 the Bank remains responsible for the customer and their data, for compliance with Anti Financial Crime requirements, etc.
Within this emerging landscape this risk management and regulatory burden becomes an advantage enabling the Bank to retain their relationship with their customers, even when other partners within the ecosystem (the equivalent of the app developers in Apples case or the digital publishers in Amazon’s ecosystem) offer services directly to the consumer. Banks should become enablers for people who want to sell to their community.
A platform bank enables business. It doesn’t just sell at customers or lock them in. It enables entrepreneurship, reputation development, and personal and professional growth. Apple and Amazon have demonstrated that they can do this rapidly and at extraordinary scale. In short, as well as providing a new way to scale business they bring value to all parties - and that is the real meaning of shared value, a term that is still badly misunderstood. The opportunity is there for Banks to do the same. To the benefit of the innovative and rapidly evolving Fintech landscape that surrounds them.
# The ecosystem
Amazon, Apple and their like have created an ecosystem of mutually dependency. Their ability to manage this ecosystem is one of the core capabilities that they have developed. The Amazon ecosystem is made up of many thousands of companies whose futures rest on Amazon making the right calls. All these people need to develop their own capabilities in order to succeed on the Amazon platform. To participate you need to be capable of growing and adapting, and of course competing - all the while putting your trust in Amazon's ability to make the right strategic decisions. In order to create the Platform Bank, Banks need to develop a similar capability.
# The cloud
The fourth capability that powers these companies is the ability to scale infrastructure dynamically through the cloud. The ability to grow infrastructure instantaneously and to shrink it back if things don't work out. Agile management is important but elasticity in resource attraction and usage is what really gives these companies momentum on a vast new scale. The Banks need to cast off the shackles of their legacy infrastructure and embrace the cloud not just as a means of reducing costs but also as a fundamental driver of the new business platform.
These four capabilities allow Amazon and Apple to make radical adjacency moves and to bring vast ecosystems of small businesses and independent creatives along with them. Amazon allows people in the ecosystem to grow too. It enables their businesses and it enables them to change direction, to reframe their opportunity horizon. These peers are heavily invested in Amazon and in the decisions it takes. It's a very different form of management, requiring new skills.
PSD 2 and open banking are both a significant risk to established banks and an enormous opportunity.
Scenarios for the future range from a retail banking sector forced to deliver expensive infrastructure for little return whilst competitors build valuable relationships with the customer. Or alternatively strong businesses sitting at the heart of an ecosystem where all parties benefit. Whilst the above analogies are imperfect, we believe that there is insight to be gained from looking outside of the field of immediate competition to see how others have addressed themselves to similar challenges.
These analogies point to a number of key aspects of strategy that are of fundamental importance:
- Look to understand and build on core competencies even when these competencies are seen as a burden today. For example, banks managing risk and compliance might be seen as a core competence, one that is perhaps of little interest to others.
- Look to turn these core competencies into businesses that make money in their own right by providing value to the ecosystem, perhaps by offering as a service to partners.
- Find mechanisms to make customers stick and maintain control of distribution.
- Think laterally about your business, seek to move it into areas where there is value to be derived.
- Start to use this to develop a portfolio of strategic options that allow the management team to navigate the emerging competitive landscape.