How COVID-19 Fast-Tracked Digital Transformation in Financial Services Market
Although the financial services industry has become increasingly digitized with the emergence of new technologies, Bhavik Pathak argues that we have yet to see disruption in financial services parallel to what we have seen with Netflix, Uber, and Airbnb to the entertainment, transportation, and lodgings industry, respectively. The contrast is primarily due to restrictive regulations and infrastructure that favor the incumbents and limit the potential of emerging fintechs to niche product/service offerings. Pathak discusses how COVID-19 has disrupted this constraint by forcing governments to relax certain regulations. He goes on to suggest what this could mean for the digitalization of financial services in the years ahead.
Financial services (FS) firms have been integrating computing technologies into their operational processes for more than six decades,1 while the digital transformation technologies of cloud computing, the Internet of Things (IoT), and business analytics/artificial intelligence (AI) have been in place for around a decade. Although a new generation of online-first or exclusively online (“pure play”) startups has leveraged these technologies to challenge the incumbents, digital disruption on the scale of Netflix, Uber, or Airbnb has not yet occurred in world finance.
Digital disruption, as described by Clayton Christensen, is a transformation that occurs when both technologies and business models affect the value proposition of the incumbent’s existing goods and services.2 While FS pure plays are agile and creative in adopting and utilizing the technology, their fundamental business models have generally remained very similar to FS incumbents, primarily due to high regulatory barriers and the prevailing infrastructure. Digital payment fintech firms, such as PayPal, Revolut, and Stripe, still require conventional banking or credit card information for consumers to open accounts and conduct transactions. For most practical purposes, consumers cannot use digital payments as a replacement for their traditional FS accounts. This is fundamentally different than the digital disruptions in entertainment, transportation, and lodging industries, where Netflix, Uber, and Airbnb have created transformative business models to replace those of the incumbents.
Digitization in the FS sector has followed two main trends. First, the incumbent “too big to fail” firms have been building digital capabilities to enable frictionless transactions, allowing them to maintain a stronghold in the market, although strict regulations and inherent product/market factors have slowed these firms’ digital transformations.3 Second, pure-play fintech startups have unbundled established firms’ service portfolios and used transformative technology to challenge the incumbents in niche product/market segments. But fintech firms are a novice in the heavily regulated FS sector, and while they have been proliferating both in terms of number and volume of transactions, their impact (beyond a few subsectors such as payments) on the digital capacity of established financial conglomerates has remained minimal.4
The COVID-19 pandemic has further disrupted the slow digital transformation process of the FS industry. In this article, we begin by reviewing the digital transformation across the information-centric industries and summarize the pre-pandemic status of digitization in FS firms. Next, we explore the regulatory and product/market factors that have slowed down the pace of digital transformation in the FS industry and inhibited the emergence of a fintech-led disruptive business model. Then, we discuss how swiftly governments relaxed regulations, FS firms changed their business processes, and customers adopted digital technologies in the face of the pandemic. Finally, we explore how, post-COVID-19, incumbent firms may continue to lead FS by partnering with fintech pure plays and capitalizing on their size, knowledge, and regulatory compliance experience. Consequently, there will be a massive upsurge in large-scale strategic digitization projects and fintech mergers and acquisitions (M&As). And Big Tech firms — Amazon, Apple, Facebook, and Google — will likely play a significant role in the digital transformation of the FS industry.
Digital Transformation of Information-Centric Industries
Technology-led frictionless commerce has substantially improved efficiencies in various information-centric industries over the last few decades. In just 20 years since its emergence, almost 70% of the US population shops online.5 In the case of digital goods, the total number of US subscribers of leading streaming service providers (Netflix, Amazon Prime, Hulu, Disney+, and Apple TV+) is around 485 million.6 The efficiencies in these markets are also found in the nearly instantaneous distribution of digital goods and significant progress — from same-day to same-hour delivery of physical products. The extent of digitization in some information-centric sectors, including entertainment, communications, and retail, is nearly complete, comprehensive, and transformational.
Digital transformation has also been witnessed in industries where information technologies traditionally have not been crucial to success and have not played a role beyond simple transactional processing systems. The transportation industry, for example, has been transformed by the digitally disruptive business models of Uber and Lyft; eBay has digitally disrupted fragmented used goods market transactions across the US; and Airbnb and Priceline have revolutionized the lodging and travel industries, respectively. Such successful disruptive models in retail, transportation, entertainment, and secondary marketplaces have all been prompted by challenger firms providing frictionless, efficient, and cost-effective alternatives to incumbent firms’ products and services.
Traditionally, the FS sector is more information-centric than the retail industry, more technology-driven than the transportation and lodging firms, and more vital to people’s lives than the entertainment services. The FS sector’s central element is money. With only 10% of the global money supply existing in its physical form, the financial institutions’ principal transactional resource is primarily digitized.7 The storage, organization, access, retrieval, and transfer of money are simply database operations in most financial transactions worldwide. With the emergence of online accounts, mobile technology, and cloud computing, most financial transactions do not require the physical movement of goods (i.e., money and documents). In stark contrast to the transportation and hotel industries, where principal assets and transactions are still physical, it is intriguing that Airbnb- and Uber-type digital disruptions have not yet materialized even after decades of technology integration in the FS industry.
Status of FS Digitization
The information-dominant FS industry has witnessed fractional, fragmented, and transactional digitization. Everything that can be digitized is indeed getting digitized, but at different scales, rates, and levels. “Financial technology,” a phrase from which the abbreviated term “fintech” is derived, was coined in the early 1990s when Citicorp established the Financial Services Technology Consortium, but the FS firms had adopted computing technology decades before the term became popular. Since the 1960s, computing technology has played a vital role in facilitating financial transactions by removing spatial and temporal barriers. Some prominent examples include ATMs (1960s), credit cards (1970s), online brokerage (1980s), Internet banking (2000s), and mobile banking (2010s). Customers now can submit applications, open accounts, view statements, dispute transactions, pay bills, submit claims, book appointments, deposit checks, and transfer money using online or mobile channels. The integration of technology in the operational processes has helped financial institutions minimize transaction costs and continue growing organically by enabling product-market innovations. This organic growth, along with the M&A-led expansion strategies of the 1990s, has allowed incumbent firms to maintain their stronghold in the FS industry.8
The adoption of technology in the FS industry, however, has occurred on a piecemeal basis, without a strategic or transformative perspective. Firms have continued building digital capabilities but have not entirely harnessed digital technologies’ power to improvise efficiencies. The inefficiencies in the banking, insurance, investment, and real estate sectors of the FS industry are striking. After all, it can take 42 days to close a home loan and two business days to clear checks.9 Even in the post-Internet era of information transparency and disintermediation, the financial intermediation costs in real estate and insurance have shrunk very little. Indeed, the 6% real estate commission is still the reality, resulting in the US home sellers paying an estimated $100 billion to agents annually.10 By and large, the traditional FS firms have remained ineffective in addressing much of the broader society’s FS needs. Today, 6.5% of US households (around 8.5 million people) don’t have bank accounts, while as many as 25% remain unbanked or underbanked, approximately 8.5% of the US population is uninsured, and 30% don’t have credit cards.11
While digitization among the big incumbent FS firms is slow to develop, the fintech pure plays that have emerged over the last decade have focused on narrow product/market segments and have used new technology platforms to increase the financial sector’s efficiencies and effectiveness. Some noteworthy examples include the mobile-first Robinhood for a zero-commission stock trade, Stripe for cost-effective integrated payment processing and payment gateway solutions, Zendrive as an insurtech data intermediary, Xoom for instantaneous global money transfer, Root Insurance as behavior-driven personalized car insurance, and Opendoor for real estate property transactions.
Compared to entertainment, transportation, travel, lodging, and retail, the FS industry is heavily regulated, consolidated, and has already-built digital capabilities. The fintech pure plays have shown efficiency, but many are built on the same business models as the traditional FS businesses. Thus, a genuinely disruptive model challenging the prominent incumbents of the FS industry has not yet emerged.
Factors Affecting FS Digital Transformation
Two primary factors have slowed the pace of digital transformation in the FS industry. First, its strong regulatory nature means that, in many instances, firms require regulatory approval before they adopt new technology to build digital capabilities.12 For example, the first digital scanners to deposit electronic checks were made possible only after the electronic Check Clearing for the 21st Century Act (Check 21 Act) took effect in the US in 2004.13 Likewise, there has been an enormous opportunity to develop innovative products and services based on the insight into consumer behavior using data analytics and IoT. However, before the recent implementation of Europe’s open banking regulations, such innovations were not practically feasible. The second factor slowing FS digital transformation relates to product and market factors. Customers are highly sensitive to the way financial institutes manage their money. Hence, factors including operational processes, security, and culture all influence the pace of digital transformation in the FS industry.
The FS industry directly impacts people’s lives and nations’ economies. These firms are among the most regulated, in an effort to maintain financial stability, protect consumers, and maintain market confidence. Regulations and guidelines exist for maintaining record-keeping, processing, auditing, securing transactions, and safeguarding customer information. Consequently, the technology enabling today’s digital disruption models — cloud computing, IoT, and data analytics/AI — cannot be efficiently and speedily applied in the industry due to myriad security, privacy, audit, and control-related compliance requirements.
Many regulations that do exist are outdated or not updated with the times, creating loopholes or inhibiting innovations, and some pre-Internet era regulations lack specific requirements for online banking. For example, in these days of instantaneous money transfer, current US federal laws allow banks to hold at least some amount from a deposited check for up to three days. Regulations further mandate notarized documentation and appraisal in mortgage closings and “know your customer” and anti-money-laundering guidelines in banking. While technological developments provide considerable opportunities, the heavily regulated FS sector cannot fully exploit these opportunities in the absence of a fostering regulatory climate.
Traditional financial firms have a long experience with regulatory standards, and their business model and processes have evolved accordingly, but the fintech pure plays are relatively new in the business and have less experience with these regulatory frameworks. Typically, fintech companies are online businesses or technology-oriented companies. Apple Pay, Ant Group (formerly Ant Financial and Alipay), and PayPal are affiliated with Apple, Alibaba, and eBay, respectively. Stripe, Robinhood, and Square, on the other hand, were started by technology entrepreneurs. Neither of these two groups of companies have the breadth and depth of regulatory experience of the traditional FS firms. The comply-or-perish reality of the FS sector also slows down the pace of digitization. In many instances, fintech startups must partner with traditional FS firms to capitalize on their regulatory expertise.
The FS firms are custodians of people’s financial assets, making trust, risk mitigation, and security critical requirements for success in the industry. As most financial investments and corresponding transactions now take electronic form, technological adoptions must pass through stringent scrutiny. In addition to their financial assets, FS firms are also responsible for protecting their customers’ personally identifiable information (PII). Today’s digitally disruptive models like Airbnb, Uber, and Netflix use the public cloud infrastructure of Amazon Web Services (AWS). However, most FS firms are reluctant or slow in moving data and core applications into the cloud due to regulatory guidelines as well as security-related concerns. Security compliance requires adequate supervision and oversight, geographic restrictions, and control over data management before adopting the public cloud infrastructure.14
The large volume of customer information that financial institutions hold creates significant opportunities for developing personalized products and maximizing the customer experience. However, these firms must maintain adequate security to highly sensitive data and balance data analytics opportunities with privacy- and security-related compliance requirements. The Payment Card Industry Data Security Standard (PCI DSS)15 for securing credit and debit card transactions against fraud, for example, and the recent California Consumer Privacy Act (CCPA)16 for regulating how global businesses can use California residents’ personal information apply to both established FS firms and fintech pure plays.
Compliance, risk mitigation, security, and trust are built into the traditional FS firms’ legacy business processes. The typical credit card transaction process does not allow direct data exchange between merchants and a customer’s bank accounts. These protections result in multiple parties’ involvement, including the cardholder, merchant, card association (e.g., Visa, Mastercard), merchant’s bank, cardholder’s bank, and payment processor, and require a 2%-3% processing fee for each credit card transaction.
The recently revised EU Payment Services Directive (PSD2) aims to protect customers, facilitate innovations, and secure transactions in the online payment sectors.17 The open banking feature under this directive provides the possibility of direct data transfer between a customer’s bank and a merchant, enabling extraordinary efficiency opportunities.18
Legacy processes in other FS sectors are complex as well. For instance, as noted earlier, an average mortgage loan closing process takes 42 days and involves many entities, including lenders, borrowers, real estate agents, title companies, insurance companies, home inspectors, notaries, and home appraisers. Most mainstream financial institutes provide a front-end online interface for mortgage applicants to submit various forms. But although it reduces the bank visits and paperwork, such digitization does not improve the process significantly. Likewise, while credit card application and approval can happen in minutes using online or mobile applications, it can take 7-10 business days to get a new card. This is in stark contrast with Apple Card, which one can start using immediately upon approval.
Moreover, many FS business processes are supported by a legacy technology infrastructure.19 And, in many instances, digital transformation requires replacing this legacy infrastructure, which can have a widespread impact on firms’ operations. In the absence of business process reengineering and changes in the technology infrastructure, even in these days of instantaneous real-time possibilities, the incumbent FS firms have continued using the benchmark of days, weeks, and months for many operational transactions.
Thus, the financial institutes’ digital transformation requires a significant change in the organizational culture and a fundamental change in mindset. While employees are relatively younger and well in-tune with the technologies, many traditional FS firms still run on the legacy technology infrastructure based on COBOL and mainframes. It is estimated that 60-year-old COBOL systems run $3 trillion worth of daily commerce in FS.20 COBOL supports checking and savings accounts, debit card networks, ATMs, and mortgage services. The mobile apps and other advanced features are written in new languages, but they need to work seamlessly with legacy COBOL systems. The digital transformation of the FS industry will require a large-scale technological transformative project.
Over the last few decades, primarily through M&As, the legacy IT infrastructure has become increasingly complicated and expensive to replace. The IT infrastructure conversion project for Commonwealth Bank of Australia, for example, took five years and cost more than 1 billion Australian dollars.21 The risk of such projects’ failure is high, resulting in nightmare scenarios like failed transactions and customer information loss. These risks have resulted in procrastination and a risk-averse culture across the industry.22 The FS firms’ culture is to focus on short-term profits and delay risky long-term projects. The cultural change from “if it isn’t broke, don’t fix it” to “let us fix it before it breaks” requires a fundamental shift in mindset from top management and the board of directors, and a cultural change must occur on the market side as well. A recent survey finds that 73% of the US population does not use the new-generation online-only bank, popularly known as “neobank” due to satisfaction with the conventional brick-and-mortar bank.23 There is an inherent inertia among the FS customers to switch to alternative options.24
The Response to Pandemic Disruptions
On 13 March 2020, the World Health Organization (WHO) declared the spread of the novel coronavirus, COVID-19, a pandemic, and the US announced a state of emergency. Subsequently, many US states announced shelter-in-place orders causing widespread disruptions in the nation’s economy. The unemployment and income instability caused by COVID-19 has resulted in many people having difficulty meeting their credit obligations and many industries struggling to run their operations. Worldwide, governments and businesses have taken steps with exceptional speed to match this pandemic’s unprecedented nature.
In the US, the government eased certain regulations specific to the FS industry, and firms, both incumbent and fintech pure plays, moved fast to enable digitization. The Federal Housing Finance Agency (FHFA), for example, adjusted mortgage closing guidelines to allow remote online notarizations (RONs) to replace the requirement of a physical attendance of a notary and paper/stamp notarizations, resulting in a 200% increase in RON usage.25 Fintech startup Notarize created a secured and encrypted multimedia conferencing and document exchange application to conduct online notary transactions.26 The FHFA also allowed drive-by appraisals for refinancing and desktop appraisals for home purchase transactions. Moreover, the real estate industry started using 3D room-scanning videos and pictures enabled by fraud-deterring geo-stamping technologies provided by mobile property inspection–based fintech startups like Verisite. About a third of mortgage borrowers closing on properties with low loan-to-value ratio and no red flags were approved for appraisal waiver altogether, improving the overall process both in terms of cost and time.27
The need for expanded and inclusive digitization in the banking industry became apparent when, as a part of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), the US government sent out stimulus payments to the population. While those who had filed taxes and had bank accounts received those payments faster through direct bank deposits, 14% of Americans making less than $40,000 without bank accounts waited for months before receiving the money.28 Because of the financial, digital, and banking divide, millions of Americans still have not claimed the much-needed stimulus money after six months of passage of the CARES Act. With 260 million US mobile subscribers, the fintech option is more inclusive than direct deposit to bank accounts.29 Venmo and Cash, fintech payment pure plays, were allowed to distribute stimulus money through direct deposits, and the US Small Business Administration (SBA) approved fintech companies PayPal and Square to distribute Paycheck Protection Program (PPP) loans. Such regulatory relaxations were vital when more than 25 million of the 30 million small businesses are less likely to have a traditional banking relationship, as they are one-person operations with an average revenue below $50,000.30 Square reported providing 80,000 PPP loans totaling around $873 million to such small businesses.31 Fintech pure play Kabbage,32 with zero prior experience in processing an SBA loan, approved nearly 300,000 small businesses to become the second-largest lender by application volume.
The evidence of fintech pure plays’ financial inclusiveness and efficiency over traditional banking processes became evident during the pandemic. Overall, the fintech pure plays arranged 15% of the total PPP loans but handled 75% of the loans that the US Department of Justice (DOJ) has connected to fraud.33 In its desire to speed the process, the US government allowed applicants to self-certify in attesting their eligibility for the loans, contributing to this financial fraud. The situation exemplifies the necessity of regulations and the significance of regulatory compliance.
As a response to the pandemic, regulatory relaxations were also introduced in the highly regulated healthcare insurance industry. In March, an emergency funding bill was signed to allow all Medicare beneficiaries to access telehealth coverage regardless of location restrictions. It also allowed out-of-state physicians to virtually treat patients without any licensing requirements. Private health insurance companies were allowed to change their policy midyear to include coverage through telehealth services. In the auto and home insurance sectors, the direct impact of the COVID-19 pandemic on the digital transformation was minimal, as many of them already had full digital capabilities to open and manage accounts and in the processing of claims. AllState insurance company, for example, estimated that 90% of its auto claims would be submitted through virtual tools.34 However, the pandemic has prompted fast-paced regulatory changes, highlighting the need for secured transactions and changing legacy processes. And the evolving digital consumer culture has sped up these insurance sectors’ digital transformations.
The COVID-19 pandemic also has shown how swiftly governments can change compliance requirements, FS firms can reengineer their processes, fintechs can expand into unchartered territories, and customers can adopt digital channels. The digital transformation of the FS industry has been inevitable. Due to the pandemic, key stakeholders have realized the immediate need and have figured out how to address the inhibiting regulatory and product/market factors to speed up the transformation.
The Road Ahead
The COVID-19 pandemic has clearly shown that the debate and procrastination over digital transformation should be over, be it in higher education, healthcare, or the FS sector. The FS industry has successfully transitioned following the major relevant events in the last two decades, including Y2K, 9/11, and the global financial crisis. It has accomplished that by changing its processes, adopting new technologies, enhancing security, and complying with additional regulations.
FS firms have been integrating computing technologies in their operations for decades and have built up digital capabilities. The slow pace of digitization in the FS industry is partially attributed to the inherent product/market characteristics and strict regulatory climate. Some emerging fintech models are exciting and innovative but not challenging to replicate because they are primarily based on the old FS models with the new technologies. But COVID-19 has revealed the urgency for government regulatory changes. It has highlighted the rapid changes in the digital culture as well as the need for changes in financial institutes’ business processes and enhancements in security and risk mitigation practices.
Amid this changing environment, major incumbent FS firms will significantly enhance their digital capabilities by initiating massive IT infrastructure migration projects, merging with or acquiring financial institutions with low digital capabilities, or acquiring or partnering with the fintech pure plays, which are here to stay. The nature of regulatory development is still to be seen and may lead to a different set of outcomes. And Big Tech, with the interest it has already shown in the FS sector, will play a significant disruptive role with its unparalleled digital capabilities and resources.
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