Banking in the USA at an inflection point
Andy Grove, the famous co-founder of Intel, once described the concept of an 'inflection point' as "an event that changes the way we think and act." I believe that the US banking market is fast approaching such an inflection point, driven by the confluence of three significant trends, combined with the Covid-19 pandemic's advent:
The rise of 'Challenger Banks' (also known as 'neo-banks'), and with them, digital banking more broadly;
The adoption of 'Open Banking' regulatory frameworks; and
The emergence of 'Banking-as-a-Service.'
These three trends have accelerated over the past 5-7 years - but mostly in countries and financial services markets outside of the United States. They matter to US banks now because they have laid the groundwork for rapid change in the industry here by proving out the technologies and business models that work.
These developments have taken place in advanced markets, with significant banks. They cannot be dismissed as 'not invented here' by US banks. (Ironically, many of the underlying technologies come from Silicon Valley - it is just that they have been adopted and refined in real market conditions by non-US banks). The US banks that do not take notice will discover the famous quote attributed to Ernest Hemingway: "How did I go broke? At first gradually, then suddenly".
The rest of this article will review how these three trends (Challenger Banks, Open Banking, and Banking-as-a-Service) developed in many markets outside the US. For each trend, it will also outline how they have played out so far in the US itself. It will conclude with some ideas on how US banks, especially community banks and credit unions, can not only respond but actively benefit from these trends.
Challenger Banks & Digital Banking
The UK banking market has seen a sharp rise in the number of new digitally-enabled banks (also known as ‘Challenger Banks’) since 2016, enabled by the UK financial sector regulator's desire to promote competition in the banking market. It found that up to 2010, no new bank was launched in the UK for over 100 years! The UK regulator worked actively to make it easier to start a bank, with the required safeguards, and this led to the launch of at least eight new banks since 2015, including Atom Bank, Monzo, and Starling Bank.
Similar paths were followed in other major markets, including in Europe, with the launch of N26 (Germany) and Klarna (Sweden). More recently, challenger banks have emerged in countries as diverse as Volt Bank (Australia), Pepper Bank (Israel), and others.
These new banks actively adopted new technologies ("fintech') to deliver the essential services of banking - payments, lending, and also risk management (e.g., account opening and customer authentication). In doing so, they gave a massive push to digital banking overall (the provision of banking services via online and mobile channels). This spurred the biggest banks in many markets to invest heavily in building digital channels to compete with the challengers. Banking customers, both retail and business/SMBs, benefited enormously from these changes.
There were some notable early attempts at challenger banking (a.k.a. neo-banks) in the US, including Ally Bank in 2009; Simple, launched in 2012 (and acquired by the Spanish banking giant BBVA in 2014); and Chime, established in 2013. For a full list, see this Fintech Futures article. They pioneered digital banking in the US and tried hard to change the banking landscape, but struggled to make a dent in the vast US market despite early successes.
That changed sharply in 2020, as the pandemic helped accelerate digital banking adoption in the US. New research released in July 2020 showed that "6% of US adults with a checking account ... now consider a digital bank to be their primary bank" (see this excellent article by Ron Shevlin). The same report shows that Chime is now among the top 10 consumer banks in the US by the number of primary bank customers, with over 4.3 million individuals.
Open Banking
The UK Competition and Markets Authority (CMA) passed regulations back in 2016 to promote banking competition. Specifically, it called for 'Open Banking,' which the CMA defined as "enabling customers and small and medium-sized businesses to share their current account information securely with other third-party providers." It required UK banks to make this possible from January 2018 onwards (see the Open Banking site).
Separately, the European financial service regulators passed the Payment Services Directive II (PSD2) in 2018. This required banks to share customer data with authorized 3rd party firms - see Deloitte article for more background. PSD2 spurred the further development of Open 'Application Programming Interface' (Open API) technologies. Open APIs are essentially the tools that make it possible for banks and 3rd party firms to share data efficiently and securely.
The initial focus of Open Banking outside of the USA has thus been mostly about access to data - making it possible for customers to give access to their banking data to third parties, enabling them to provide new services. This spurred the rapid growth of financial technology ("fintech") firms worldwide, many of whom raised large amounts of venture capital funding. Fintech firms typically focus on solving a well-defined problem area or 'pain point' for customers. This can range from customer onboarding and loan origination (e.g., nCino); to client identity management (e.g., IDmission); to forex trading (e.g., Currency Cloud). Outside of the US, these firms could leverage open banking legislation to acquire customers in their chosen market niches.
The US has mostly lacked a regulatory framework for Open Banking (although there were attempts by the OCC to create a 'Fintech Charter' in 2016). Open Banking in the US has to date been somewhat fragmented and resulted in a piecemeal approach that hasn't significantly changed the market landscape - yet.
The potential remains for any organization with a large customer base and a robust technology capability to use Open API technology to offer financial services. This is the 'banker's boogeyman' - the idea of firms like Amazon, Apple, or even Walmart, launching a bank. This hasn't happened for various reasons, including these giants' assessment that the hassle of becoming a regulated bank is probably too great, especially compared to their own existing highly profitable businesses.
But what has happened is the provision of selected financial services that don't rise to the level of full banking by firms in other industries. This has been termed "embedded finance" and includes services like offering loans at point-of-sale to consumers (a.k.a. Buy Now Pay Later or BNPL). Companies like Affirm pioneered this concept, and it is expanding in the more challenging economic environment of 2020 (up 162% 2018 to 2019), followed by recent launches of similar offerings by Amazon and others.
The point is that Open Banking was the start of all this change, and it has led to the creation of new industries (esp. fintech) and to changes in the business model of many industries - not only retailing but also banking itself. The enabling technology behind Open Banking (APIs) has, in turn, made possible the emerging field of Banking-as-a-Service.
Banking-as-a-Service (BaaS)
This term was first coined by UK industry commentator Chris Skinner way back in 2008 and is a necessary but widely misunderstood concept. (See the excellent article on this by Chris Skinner). Banking-as-a-Service is a subset within the broader Open Banking context. BaaS is the provision of one or more of the traditional core banking services (payments, lending, risk management), enabled by the strategic combination of licensed banks and Open API technologies implemented by (generally smaller) fintech firms or (medium to large) banking software providers.
In markets outside the US, especially in Europe, there has been a rapid growth in organizations offering BaaS. It's a vibrant market with many players, who broadly fall into two categories:
Technology firms ('BaaS' enablers or BaaS platforms); and
Banks that have embraced BaaS as a separate service that they provide to third party organizations.
Examples of the first category are technology providers like RailsBank and Bankable in the UK, and Temenos in Switzerland.
Examples of the second category include Fidor Bank and solarisBank in Germany, Starling Bank in the UK, and BBVA Group from Spain, and their US-based BBVA Open Platform. All of these have banking licenses and can enable third parties to offer checking and other accounts. (BBVA Open Platform has published some good articles).
In the US, we have seen more of the second category, with fintech firms working with smaller existing chartered banks, leveraging their banking license to reach end customers in selected niches (e.g., SMB lending). This is the 'partner bank' model (similar to BaaS banks above). Notable examples include Green Dot Bank, Cross River Bank, and Evolve Bank, all of which work actively with fintech firms to enable them to offer specific services to chosen markets. These partner banks are using their relationship with other firms to grow their deposit bases. In doing so, they are arguably leading the banking industry along a strategic path in which they play to their historic strengths (trust & regulatory expertise) and gain new deposits - but not necessarily new customer relationships.
US Banking's Inflection Point
In the US banking market, up until the advent of Covid-19, the above three trends were developments in far-away markets but didn't seem to impact locally. While some of the bigger US banks had teams looking at Open API technologies, there was little focus on actually bringing new products and services enabled by them to market. For community banks and credit unions, Open APIs were something of a pipe-dream, given the dominant core banking players' proprietary nature. The major core banking providers have started to offer more open architectures, but very much under their control and cost.
The growth in digital banking uptake in the US has primarily been at the expense of smaller community banks and credit unions. These smaller players have historically relied on strong customer relationships within their geographic or industry-based niches and have generally been technology laggards (or followers at best). This was fine when local bank branches and paper-based processes were 'good enough' to get the job done. The pandemic turned bank branches from assets to liabilities and showed the actual costs and inefficiencies of paper-based processes.
All of the above trends have come to a head in 2020: the pandemic made the old ways of doing banking business unworkable and often unsafe. For the first time, robust external demand for digital banking has come directly from end customers and banking executives. It accelerated the uptake of both Banking-as-a-Service and the broader concept of Open Banking. Strategic and competitive moves have accelerated into action, including:
Varo Bank just received a full national banking license in the US (after previously working with a partner bank), and is now moving to use Swiss-based Temenos's full-function SaaS core banking model, which has extensive and robust Open APIs.
Significant acquisitions of fintech firms in the US by larger financial services players, including the purchase of Kabbage, an SMB-focused fintech company, by American Express in July 2020; and that of OnDeck by Enova International.
The expansion into consumer banking by investment/brokerage fintech firms like Betterment and Wealthfront, who launched checking accounts this year (through partner banks like Green Dot).
In the face of these developments, it is clear that banking in the US is reaching an inflection point - where smaller banks (community banks and credit unions) need to define their futures more clearly. While they have strengths in terms of customer relationships and trust, they need to understand how to compete with digital banks and new providers of financial services.
The good news is that they can do this by (1) learning about and understanding what has been done successfully in markets outside the US, and (2) deciding how to leverage the new Banking-as-a-Service providers. Doing this will allow them to refine and improve their business models, enhancing them with the vast array of proven BaaS tools.
Next Steps for US Banks
US banks, and especially community banks and credit unions, must act quickly to benefit from the current inflection point. These steps should include the following:
Strategic review to determine which parts of the business are most at risk, and which parts can be most strongly leveraged in the new reality.
Planning for partnership with challenger banks, BaaS providers, and fintech companies to modernize and enhance key products and services that will maintain and deepen customer relationships.
Exploring new opportunities to take advantage of increased demand for the convenience and immediacy of digital financial services.
Some banks will have the internal expertise and capacity to work on these actions right away. Others will need to employ experienced industry players to provide guidance and connect them to key potential partners. Either way, this investment is not just a "nice-to-have" - it is critical for long-term survival.