Will banks survive the age of digital disruption?

Digital transformation and disruption are changing the dynamics in several industries. They threaten to render incumbents irrelevant. For example, in large cities like New York, ride-hailing apps such as Uber and Lyft generate more passenger journeys than taxis. Last year, Amazon surpassed Walmart as the world’s largest retailer as measured by a composite score of revenues, profits, assets and market value. The ongoing coronavirus pandemic has also catalysed the adoption of digital financial services and customers are getting more comfortable with fintech firms handling their financial transactions.

Are banks immune to the ongoing disruption revolution?

Globally, banking is a tightly regulated industry. It underpins the economic systems in which we live and operate. Governments seek to protect customers and their assets, and the rules may have favoured traditional banks for decades.

However, it can be argued that an imminent changing of the guards is afoot, with the rise of large, innovative fintech firms that are challenging the status quo. Earlier this year, PayPal surpassed Bank of America, the second-most valuable bank in the US, in market capitalisation. In September, the market capitalisation of Square, a fintech firm focused on payments, exceeded that of Goldman Sachs, a 151-year-old investment bank.

These fintech firms are processing record volumes, as the pandemic accelerates the use of digital payments, and they are also reporting larger profits. PayPal processed a historic $247-billion of transactions in quarter three of 2020 with a 25% year-on-year increase in revenues and delivered $1.02-billion of net income, beating analyst estimates. At the same time, financial institutions are encumbered by loan portfolios currently facing distress in an economic downturn. According to a report by Accenture, banks in the US will make provisions of up to $320-billion to cover potential credit losses in 2020 brought on by the financial strain of the pandemic.

To be sure, while fintech firms and challenger banks are rising in customer base and valuation, the extent to which they can dominate the banking space fully remains to be seen. Governments play a critical role in ensuring economic stability and they need to err on the side of conservatism.

For example, when Jack Ma, founder of Ant Financial, a very successful Chinese fintech firm, accused traditional banks of having a pawnshop mentality, preferring to hold on to collateral rather than rely on artificial intelligence and big data when making lending decisions, the company’s highly anticipated IPO on the Shanghai and Hong Kong stock exchanges was suspended by regulators. The role of governments in shaping the financial services landscape cannot be underestimated.

Non-bank players enter Africa

In Africa, over the past few years, there has been a surge in non-bank players providing financial services. Mobile money adoption is much higher than in other regions with 469-million subscribers completing 24-billion transactions worth $456-billion in 2019.

With a growing, youthful population and increasing smartphone penetration, payments have become a very hot category for African fintech firms.

Last month, global payments company Stripe acquired a five year-old Nigerian fintech, Paystack, for $200-million. The long-term opportunity Stripe seeks to capture is driven by the larger role Africa is expected to play in the global economy, with the potential to provide payments to a population of 1.3-billion consumers with favourable demographics, under a common trade pact, the African Continental Free Trade Agreement (AfCFTA).

Indeed, hundreds of fintech firms across the continent are building solutions to solve customer problems. For example, a decade ago, a flower shop owner in Lagos who wanted to be able to accept payments online would have struggled to find a functional and affordable way to do so. Today, there are several fintech firms offering that service, conveniently and at a price that meets both the company and client’s cost preferences.

The market to be served is vast and each player has its own capabilities. Banks specialise in financial intermediation and regulatory compliance. Mobile network operators excel at achieving scale in distribution and customer insights. Fintech firms are extremely innovative and deliver amazing user experiences. These three parties need each other to serve consumers in Africa effectively.

While digital challenger banks in Africa offer attractive rates on deposits at a time when returns on treasury bills and other government-backed securities are falling rapidly, it is unclear how sustainable this model is. Even where these fintech firms have leaner cost structures than traditional banks and lend at higher interest rates, they often run into liquidity challenges.

A middle manager in Accra with a family wants a good return on her savings. However, she fears that a neo-bank might disappear overnight, and is more likely to trust a traditional bank with brick and mortar branches as well as visible staff with her hard-earned funds.

Fintech players are thriving nonetheless and meeting customer needs and use cases previously ignored by banks, in a more agile manner. For example, PiggyVest, a Nigerian fintech firm, helps its largely millennial customers develop the discipline of saving, and Wealth.ng has enabled easier access to investments in stocks and other securities. In Nigeria, fintech accounted for just 1.25% of retail banking revenues, however, these firms are growing quickly, fuelled by foreign investments, advancing technology and an entrepreneurial spirit.

Unlike fintech startups backed by venture capitalists and private equity funds with a keen eye on valuation, traditional banks are under pressure to return profits to shareholders each quarter and must remain focused on delivering returns while staying within regulatory boundaries.

In the US, the challenger bank business model largely depends on card interchange fees which at 1.2% are high enough to cover the costs of their technology platform. European neo-banks have much lower debit card interchange fees, capped at 0.2% and also depend on digital lending to bolster revenues.

African fintech firms seeking to play in the banking space are more likely to mirror the European model as interchange fees are also quite low in the region.

However, digital lending is not without its challenges. For example both Monzo and Starling commenced lending last year and provisioned more for bad loans than they earned in interest income. A pioneer of digital lending at scale on the continent is Kenya’s Safaricom, disbursing $4-billion in M-Swhari microloans since inception in 2012. The product historically reported nonperforming loan (NPL) ratios as low as 1.8%, however this has deteriorated to about 8% as a result of the ongoing pandemic.

Banks and fintech firms venturing into digital lending in the same market have not been as efficient, with NPL ratios over 20% prior to the pandemic. Digital lending firms have also been accused of charging exorbitant interest rates and using unscrupulous methods to recover their loans.

The banks that are likely to weather the disruption storm will be those who learn to partner effectively, applying the UN’s sustainable development goal number 17 to advance financial inclusion. This will come through an alliance with fintech firms, mobile network operators and other entities with large customer bases and distribution networks. Big Tech, fast moving consumer goods companies and retail chains are obvious parties to these alliances. Customers benefit from improved options when synergies lead to lower costs and improved quality of services and this is critical in the face of declining interest rates and commodification of banking services.

As financial services ecosystem players in sub-Saharan Africa reimagine their strategies to survive the ongoing pandemic, they have a choice to make – try to do it all alone or find the right partners to go on the journey with. The former course is most comfortable. The latter would be a great adventure in discovery and growth.