Fintech is a hot subject today, including the question of whether it will take a big bite out of the traditional banking business. In a move that will give fintech companies more market access, two ground-breaking regulations in Europe will force banks to share customer information with third parties when customers request it. This may well revolutionize consumer finance in Europe and will be closely watched in the U.S. and around the world.
To understand the implications, Knowledge at Wharton asked Warwick Business School’s Markos Zachariadis, a professor of information systems and management, and Pinar Ozcan, a professor of strategy, to discuss their recent research on the topic. They are co-authors of papers sponsored by the SWIFT Institute. They offered their views on the Knowledge at Wharton show, which airs on SiriusXM channel 111. (Listen to the podcast using the player at the top of this page.)
An edited transcript of the conversation follows.
Knowledge at Wharton: Let’s start with what exactly is happening. The formal titles are the Open Banking Initiative in the U.K., and the Payment Systems Directive, which will affect all of Europe. It’s sometimes called PSD2 or the Payments Directive.
Pinar Ozcan: These are regulations that actually force banks to open up their customer data, of course upon customer’s consent, to third parties in order for those third parties to provide better services and better data analytics to the customers. If, as a customer, I decide that I want to go with a website or some apps that I’ve found that promise to help me to find a better mortgage, then upon my consent, that app is going to be able to connect to my bank and get my data and analyze it in a meaningful way, to see if they can give me a better deal than what my bank has been giving me.
This is obviously quite revolutionary, if it works. But it depends on whether the customers are going to adopt this new way of behaving and if they are going to trust these third parties with their data.
Knowledge at Wharton: Banks obviously don’t want new competition. But this rule is saying, “Sorry, you have no choice. You have to do it if the consumer wants it.” Are banks the losers?
“Companies that have the largest customer base — and in this particular setting, these will be the incumbent banks — are in the best position to turn their business around and make it a platform.”–Pinar Ozcan
Ozcan: No, in fact one of the things that we know already from research is that those companies that have the largest customer base — and in this particular setting, these will be the incumbent banks — are in the best position to turn their business around and make it a platform. So if banks were able to act fast and get these third parties, these fintechs, on board to provide a platform where maybe in the spirit of, let’s say, the application store that we see on different mobiles, like Android versus IOS, for example … and act quickly to build a platform in order to offer better services to the customers, the customers wouldn’t even have a need to go anywhere else.
Everything would already happen on the bank’s platform, anyway. So in a sense, the banks have the greatest leverage to change and to act quickly, to turn their business around, to make it rather than being in between their four walls and kind of concentrating on securing the data — which of course is quite important in this particular setting. If they are able to collaborate, they have a lot to gain from this — much more than a small bank that’s coming into the business or a fintech that’s going to, as you say, struggle to get the customers to themselves.
Knowledge at Wharton: A natural collaboration seems to exist. On the one hand, the banks are established. They have the big customer base. They have the trust of the customers. The fintech companies, on the other hand, have the ground-breaking ideas. And so the banks could collaborate with them, or I imagine in some cases they would be investing in the fintech companies or even buying them out.
Markos Zachariadis: What’s really interesting here is that there is the possibility for entire shifts in the architecture of the industry as a whole. Pinar nicely gave the example before that upon the customer’s consent, you will see customers would like to share data with others. What that does, essentially, is create an opportunity for the sector to move towards a more modular architecture, as we say — or towards its own architecture.
We’re used to banks as being vertically integrated, in a way, like manufacturing firms are now or used to be a couple of decades ago. And that meant that a bank basically does everything itself. It provides the infrastructure. It provides all the kinds of communications. It provides all the payments and processing. It provides pretty much most of the things we know, as customers and hiring the supply chain at the bank.
But opening up with certain customer data in a standardized way, that leads to collaboration. By itself, collaboration is useful, but it means that we’re moving to a new kind of format in the industry which is more modular. It’s kind of like a shift in mentality, of how business is being done in the banking sector.
Knowledge at Wharton: Europe is leading the way on this. And typically, you might expect that to happen in the U.S., just because it is so strong on high tech and the huge international banking system here. And yet, everyone will be watching what happens in Europe.
Zachariadis: I think that’s fair to say. I think that you take specifically London, being one of the financial centers, but also at the same time, a very important tech hub — so it’s one of the rare places in the world which is also a center of significance and a tech hub at the same time. And the two worlds kind of meet together.
It came naturally when, after the fiscal crisis, a lot of tech entrepreneurs saw this opportunity to move into the financial service sector because of the huge inefficiency. So the financial crisis was a wake up call. But these were more effective in the U.K. and London because of the reason I explained. It was where the two worlds meet of tech and finance. In the U.S., you have Silicon Valley, obviously, but then Wall Street is quite far apart. I’m not sure how much these two worlds are communicating. Well, at the moment a lot more than they used to, but I think there was a boundary between them.
Knowledge at Wharton: What are some of the risks that you see for each group — and some of the biggest challenges?
Ozcan: Here we have talked about consumers, and I think you’re right. The upside for consumers is great, and of course the security issue is probably the biggest hurdle in their minds — whether it is psychological or whether there’s actually a heightened risk is another question. But for banks we see that this is actually quite challenging. And a lot of those challenges come from some of those organizational and cultural dimensions of their work. And in particular, as we know, banks have been largely monopolistic players in their industry for a long time. And this is a highly regulated industry, where the data is very sensitive, and there’s a high legal liability for handling it and for when something goes wrong.
Basically this is a situation where banks have been focusing on making sure that everything is as secure as possible, and their compliance departments are huge, and this has been their focus. And then suddenly there is a regulation that tells them, “OK, look, you have to collaborate now.” But first of all, this is a player that doesn’t know how to collaborate, because security has been the main issue so far.
“Speed versus security is one of the main issues that is difficult when a bank tries to collaborate with a fintech.”–Pinar Ozcan
For example, when a bank tries to collaborate with a fintech, a natural question is how are we going to brand this? Because the fintech, obviously, would like to get some visibility, but the bank is used to owning the customer, and in a sense every single service that they take to the customer in the bank’s branded service.
Branding is a huge challenge for them. Another interesting one, in terms of innovation, is when a fintech brings a service that actually exists within the bank, but the fintech because they’re more agile and because they have better technology — when the fintech is able to provide a better service than what exists in-house, in the bank — what is the right strategy for the bank? Do they adopt what they see outside, and kill off some of their own products? And what is the right balance? I think our interviews show that these are some of the issues that the banks really struggle with.
Knowledge at Wharton: Could you just give an example?
Zachariadis: One example is lending. There are quite a few platforms out there in the fintech world where they are doing that a bit more efficiently than banks are doing at the moment. And their statistics show that default ratios are much, much lower than traditionally the banks have been lending out to people. And there are names that are already becoming quite popular. I don’t really want to name any brands, but lending is kind of like the newest example. And another one might be payments, as well.
Knowledge at Wharton: Fintechs tend to make loans quicker but then there is the security issue.
Ozcan: Yes, in fact speed versus security is one of the main issues that is difficult when a bank tries to collaborate with a fintech. And also look at it from the fintech’s side. These are small companies that are struggling for cash, and the longer the bank takes in order to make sure that everything is attested to and all of the boxes are checked, the more the fintech is running out of money in the process. This issue of how fast the bank can go through the due diligence and bring a fintech on their platform to collaborate with them is a huge struggle for the fintechs.
Knowledge at Wharton: Banks have these huge compliance departments and reserves. Who knows how well some of the fintechs capitalized? Who knows how good their security systems are?
Zachariadis: Yes, so the security is a major concern. I’m not sure, though, how much we cannot blame banks for — you know, based on their track record because I think there are a lot of issues that have been emerging lately as banks are becoming the victims of cybersecurity breaches. The point is there may be a lot of them, maybe we don’t really get to find out because the banks have quite a big, deep pocket, and they can absorb damage in that sense. In the same way, I think a fintech would be much more challenged in the same scenario, where obviously they don’t have the balance sheets that the bank has to absorb these kinds of breaches.
“If [fintech companies] have issues with their security, and a lot of customer data has been stolen, or payments have been wrongly initiated, et cetera, will they be able to deal with that?”–Markos Zachariadis
We have seen a couple of charter banks in the U.K., for example, having issues around security. Tesco Bank was one. They dealt with it, because they were backed by Tesco — one of the largest retailers in the U.K., and they again had deep pockets. But we cannot really say the same with smaller fintechs. If they have issues with their security, and a lot of customer data has been stolen, or payments have been wrongly initiated, et cetera, will they be able to deal with that?
The solution really comes to be the change in mentality — the business model of big collaboration between the fintechs and the banks. That’s what’s going to make the difference.
Knowledge at Wharton: Would the banks backstop the fintechs with their deep pockets?
Zachariadis: That’s a good question. In a collaborative mode, let’s say, between a fintech and a bank, I think all of these kind of security issues need to be dealt with up front, obviously. And it’s like co-creating a value proposition for customers, obviously different with a nice experience and everything, but it’s also secure. If banks are becoming more and more like platforms … then as platform leaders they need to make sure that they work with fintechs that are well established. They have the latest technologies, but they also have the latest standards for security and interfacing with older systems that the banks have. And that’s part of the business of curating your platforms. You need to choose carefully how do you actually link up and collaborate with a particular fintech.
Having said that, in Europe, the process of curation is 50% with the regulator — because this is now regulated in Europe — but the other 50%, I think, goes to the bank. In other market stocks … open data in banking hasn’t been regulated. I think it’s easier, and you can strategize a bit more around it, but it’s easier to curate as a bank, your own platform, with fintech’s on top of it.
Knowledge at Wharton: As part of this research, you’ve done extensive interviews with professionals.
Ozcan: We have been looking at this issue for over a year and a half. It’s an ongoing project. The regulation just changed in January, which means that this is the time to observe some of the interesting strategic moves that the different players are making. But as part of our research, we’ve talked to over 50 individuals who are key stakeholders in incumbent banks, and fintechs, as well as challenger banks — these new online banks that are trying to provide competition to the incumbent banks — and also some regulators and industry experts.
Our research basically shows that there are different types of business models that are emerging. For sure, the incumbent banks are working on providing their own platforms. At the same time, there are all these issues that are organizational, as well as technology- and regulations-related. And the platforms provided by the incumbent banks have been rather slow.
This creates an opportunity for new players to come in and take some of that space that is not being filled by incumbent banks. For that, we see these new challenger banks coming into the space, offering these platforms, basically, where you have, as a consumer, once you go to the app or website of this challenger bank, it’s very easy for you to just move on to a fintech, and then get advice from them for a specific issue. There are even models where the platform that you connect to as a consumer is even connected to your utility company. So they can analyze your data and say, “Look, you’re spending too much. If you move here or there, it’s going to be easier.”
These platforms are getting richer and richer, but at the same time, of course, it’s difficult — since this is such a sensitive industry, and security is very important — how many people are going to use these challenger banks and these new models is an issue. As more millennials are using banking services, this is becoming less of an issue. However, it’s still true that most people are not going to switch away from banks. This means it’s going to depend a lot on what the banks are able to do in terms of collaborating.
Knowledge at Wharton: You recommend in the paper that banks shouldn’t take a short-term view — they shouldn’t be looking at getting short-term profits.
Zachariadis: That goes to what we said before, about the shifts in the entire industry, and the shifts that the banks need to make in terms of, how do they think that the profits are getting into the bank from?
The new rules are not just about checking the boxes for the regulator. It should be seen more as a strategic move, where banks would need to reconsider the revenues from the different places that they’re earning money from — from overdrafts, for example, or from lending activity or from payments, et cetera. There are some economic benefits from actually building platforms, and one of them we have seen examined in the paper a bit more closely is network effect.
“It’s almost unavoidable that this movement will come to the U.S., and maybe it’s an opportunity for the U.S. markets to learn more of the new strategy.”— Markos Zachariadis
The fact that if you have lots more fintechs on your platform, you’ll be much more attractive to customers, in the same fashion as iPhone, for example, which is a platform. You have all these developers developing applications on top of the phone, and that’s what made iPhone in the first place attractive to people. So that shift in mentality in how business is earned and how you profit from this business — that’s the new logic that the banks really need to pay attention to. We have seen the understanding of the new logic kind of vary among players. Older players that have legacy technologies, but also legacy thinking, tend to push PSD2 and open banking back, whereas newer firms, charter banks and things like themselves are very excited, because they see this as a strategic opportunity to provide new technologies and new quality services to customers.
We did get a lot of the banks’ thoughts: OK, so let’s use the new regulation to charge fintechs money, so they can actually tap into customer data in one way or another. We think that this is maybe the wrong way to go. If you want to create a platform and become a platform leader, you need to think of ways to incentivize fintechs coming to you to create that kind of reach. As we use the word “ecosystem” quite often, I think that’s what it implies — a lot of outside developers, a lot of players from outside of your own kind of organizational boundaries, that bring this extra value to your clients…. You can see that the more apps you attract in phone manufacturing, the better off you are, because people want to buy their own phone, their own kind of ecosystem and value proposition, et cetera.
The banks will need to think along these lines, not have short-term thinking about “Let’s … earn as much money as we can in this short-term.” But instead they need to think in the longer term of ways of competing on platforms, competing on new value propositions that external developers can bring to your own ecosystem.
Ozcan: When we talk to banks, lot of times these regulations — PSD2 and open banking — are being handled by compliance departments, and in a sense that limits it to [asking] what is the legal minimum that we need to do? We think that this is a strategy issue and it has to be at the core of the strategic thinking for a bank for the future.
Knowledge at Wharton: Will these ideas be moving to the U.S. any time soon? Are they going to sit back and say “Europe’s doing a great experiment. Let’s see how it falls out.”
Zachariadis: The U.K. and Europe are the planners in a sense. The U.K. is doing a great job, because also there’s a huge amount of things like concentration and investment. There are thoughts in other places around the world, including Australia and Asia. It’s almost unavoidable that this movement will come to the U.S., and maybe it’s an opportunity for the U.S. markets to learn more of the new strategy, then also learn from their mistakes with other countries, and see how they can leverage new technology, adopt the latest standards around security. They can think over a bit more the strategic implications, as we’ve been doing in the paper, about how we can shift to this common mentality of ecosystems and modular architecture in the industry of financial services.