The information-dominant financial services (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.
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. 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. 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.
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. 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. 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.
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) for securing credit and debit card transactions against fraud, for example, and the recent California Consumer Privacy Act (CCPA) 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. 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.
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. 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. 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. 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. 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. There is an inherent inertia among the FS customers to switch to alternative options.
[For more from the author on this topic, see “How COVID-19 Fast-Tracked Digital Transformation in Financial Services Market.”]