FINANCIAL technology, or fintech, is changing the world of finance.
In the US and Europe, we are at a tipping point, especially in consumer banking.
The banks have clients and scale but the new fintech entrants usually have the innovation edge, especially at the "client experience" interface. To remain competitive, banks need to get innovation before the fintech companies get scale.
In China, by contrast, we are past the tipping point: fintech companies have both scale and innovation. India is the next biggest opportunity.
In this report we identify where fintech investments are being made by financial product and client segment. We assess where we are in the disruption cycle by segment and geography.
We take a deeper look at innovation in each of the key product segments - payments, lending and savings; and assess what banks can do to improve the efficiency of their businesses, both in terms of current headcount and distribution as well as long-dated options such as blockchain.
Follow the money
From California to China, the banking industry is increasingly being challenged by digital disruption. As Jamie Dimon, CEO of JPMorgan has noted: "Silicon Valley is coming. There are hundreds of startups with a lot of brains and money working on various alternatives to traditional banking."
Fintech investments have grown exponentially in recent years: US$19 billion of investment in 2015 was up two-thirds from US$12 billion in 2014 and from low single-digit billions of dollars per year earlier in the decade.
Given the recent shakeout in public equity markets, especially for marketplace lenders but also financial and technology companies in general, we may have a spill-over chill in private markets in 2016. This is not least from incumbent banking-funded ventures units (see for example the February 2016 announcement by Spanish bank BBVA that it will increase its original US$100 million fintech fund to US$250 million, now invested via Propel Venture Partners).
Fintech targets consumers and SMEs
Fintech new entrants are targeting some of the most attractive and valuable profit pools in banking today.
Citi Research analysts estimate that personal and small and medium enterprise (SME) banking account for about half of the banking industry's profit pool and a higher proportion of the sector's equity value. Sifting through over a hundred fintech private investments, we calculate that over 70 per cent of the fintech investments to date have been in the personal/SME business segments.
Why does business-to-consumer (B2C) dominate? Firstly, consumer client behaviour has changed. Smartphones have revolutionised information and content delivery in general and are now becoming important in financial services transactions across multiple continents.
B2C solutions can "win" new clients with a better experience whereas Business-to-Business (B2B) solutions need to jump several more hurdles, including corporate clients' greater product/service customisation and corporate procurement department's focus on safety and supplier risk, all of which increase switching costs.
The West at a tipping point
In the US and Europe, only a very small fraction of the current consumer banking wallet has been disrupted by fintech so far.
However, this is likely to rise. Greg Baxter, Citi's global head of digital strategy, notes that we are not even at "the end of the beginning" of the consumer disruption cycle in Western Europe and the US.
Greg's team estimates that currently only about 1 per cent of North American consumer banking revenue has migrated to new digital business models (either at new entrants or incumbents) but that this will increase to about 10 per cent by 2020 and 17 per cent by 2023.
We are in the early stages of the US and European consumer banking disruption cycle, therefore, we note that this estimate is subject to considerable forecast risk.
However, an open question remains as to whether incumbent banks in the US and Europe can embrace innovation, not just talk about blockchain and hack-a-thons, before fintech competitors gain scale and distribution.
Past the tipping point in China
In China, unlike the US or Europe, we are well past the tipping point of disruption.
China's e-commerce ecosystem is now larger than any other country in the world in terms of transaction volume. China's top fintech companies (such as Alipay or Tencent) often have as many, if not more, clients than the top banks.
China's top fintech players (such as Ant Financial or Lufax) often have well-resourced parent companies in e-commerce or finance that can sustain larger and more balance sheet-intensive businesses than Western venture capital-funded rivals.
China's fintech companies have grown fast due to a combination of: (1) high national Internet and mobile penetration, (2) a large e-commerce system with domestic Internet companies focused on payments, (3) relatively unsophisticated incumbent consumer banking, and (4) accommodative regulations.
While the US and Europe also share high mobile Internet savvy, their local Internet leaders have not as yet strategically focused on payments and finance, and their local consumer banks are more sophisticated.
Financial inclusion in emerging markets
Emerging markets often have a high percentage of unbanked population, relatively weak consumer banks, and a high penetration of mobile phones. Hence, they are ripe for fintech disruptions.
Kenya has led the way for almost a decade now with M-Pesa launching in Kenya in 2007 with currently 23 million active customers in 11 countries.
In next door Somalia - associated in the past few decades with political instability instead of financial innovation - mobile money is having an arguably even more profound impact with about 40 per cent of adults using mobile money.
Similarly, in the giant Asian countries such as India, Indonesia and the Philippines with an almost 400 million unbanked population, mobile money can also help solve a societal problem. Not surprisingly, policymakers look favourably at fintech as part of the solution to financial inclusion.
India: The next frontier?
Emerging markets do not follow a single path to digital finance growth. The success of mobile money in Kenya was driven by a significant investment in mobile money, the growth of a viable non-bank agent network, as well as proportional regulation.
By contrast, China has seen growth driven by a few Internet giants, such as the Alibaba ecosystem.
In India, the adoption of the Aadhar national biometric identity programme and the opening of over 200 million new bank accounts, have dramatically increased the customer base.
India, by its sheer population size of 1.2 billion and counting, low level of banking penetration, policy initiatives such as the Aadhar programme, and the ubiquity of mobile phones with around 80 per cent penetration, is one of the big opportunity spaces for fintech. The latest data shows India's mobile banking transaction value increased four times year-over-year in December 2015.
Payment space intensely contested
The payment space is the segment of finance that has been most challenged by tech-driven new entrants to date. From M-Pesa in Kenya, Tencent's WeChat red envelope in China, and the PayTM wallet in India, non-bank payment options are increasingly well adopted in their home markets.
Alipay and PayPal are leaders in ecommerce online payments. Although payment is a relatively small part of banks' revenue pool (around 7 per cent), the incumbent banks are at risk of losing important customer transaction data and client relationships.
In the Nordic region, banks have been successful to date in innovating and defending the P2P (peer to peer) consumer payment segment (eg DNB and VIPPS or Danske and MobilePay).
So far, US Internet giants, for example Google, Apple, Facebook, and Amazon, lag their Chinese counterparts on payments and financial services.
But given their consumer client reach and brand strength, it would be dangerous for incumbent banks to ignore their potential threats.
Marketplace or P2P lending
Online platforms that match borrowers and lenders have been around for a decade but have grown quickly in the last couple of years.
Total loans lent by online platforms remain small at less than 1 per cent of total loans outstanding in markets such as China, the US, and the UK.
However, the Chinese market is growing fast - it is about four times the absolute size of marketplace lending in the US and over 10 times the UK.
In China, P2P cumulative lending volumes today amount to about 3 per cent of system retail loans. But if we were to extrapolate the recent growth rate through the end of 2018, the Chinese P2P market would be about 9 per cent of total retail loans.
By contrast, the US P2P market is equivalent to just 0.7 per cent of total retail loans and even if we extrapolate recent loan growth to the end of 2018, the US P2P penetration rate would only be slightly above the current Chinese level.
Banking's Uber moment
Antony Jenkins, the former CEO of Barclays, talks about banks being at an "Uber moment" and argues that pressure from new technology-based competitors "will compel banks to significantly automate their business" and "that the number of branches and people may decline by as much as 50 per cent over the next years."
Mr Jenkins may well be right. The consumer banks in the US and Europe are at a tipping point in terms of branch distribution.
Northern Europe has already done a lot. Nordic and Dutch banks have cut total branch levels by around 50 per cent from recent peak levels.
We believe that from 2013 levels, the last reported branch and population data from the World Bank, developed market banks could cut branch numbers by another 30-50 per cent.
Norway's DNB, already operating in the developed market with the lowest branch penetration to population ratio, announced in late 2015 that they will further halve their branch network in 2016.
The US banks have up to now lagged their Nordic and European peers on branch reductions. But with the increased ubiquity of the mobile Internet, increasing fintech competition, and a sluggish revenue and profitability environment, we expect US banks to follow their EU peers in cutting branches.
Halving staff numbers
As noted by Jonathan Larsen, global head of retail and mortgages at Citi, the value of consumer banking will be in connectivity and not physical assets, which, Jonathan also refers to as banking's "Uber moment".
The future of branches in banking is about focusing on advisory and consultation rather than transactions.
The return on having a physical network is diminishing. Branches and associated staff costs make up about 65 per cent of the total retail cost base of a larger bank and a lot of these costs can be removed via automation.
The pace of staff reductions so far has been gradual, at about 2 per cent per year or around 11 to 13 per cent from peak levels pre-crisis.
We believe there could be another 30 per cent reduction in staff between 2015 and 2025, shifting from the recent 2 per cent per year decline to 3 per cent per year, mainly from retail banking automation.
From peak staffing levels pre-crisis, this would result in a 40 to 50 per cent decline, not far off Antony Jenkins' forecast. If the banking system in Europe, Japan, and the US operated with the same cost to income ratio as the best-in-class Nordic region, it would remove US$175 billion from their cost base, or 23 per cent, and add 39 per cent to the pre-tax profit of the banks in 2016.
Blockchain: the next big thing?
So far a lot of payments innovation has been focused on the "last mile", that is the user experience at the point of sale.
The existing payment infrastructure remains the backbone. But blockchain technology could be different. It could replace the current payment rail of centralised clearing with a distributed ledger for many aspects of financial services, especially in the B2B world.
Blockchain positives are based around its characteristics including decentralisation, programmability, and immutability.
It could also be a catalyst for the transformation of many existing legacy systems that operate with a high degree of robustness but may not be the most cost or capital efficient way of doing business.
However, there are also considerable negatives associated with the technology, not least of which is that it is currently still "bleeding edge" and lacks the robustness of existing payment systems such as Visa or Swift.
But even if blockchain does not end up replacing the core current financial infrastructure, it may be a catalyst to rethink and re-engineer legacy systems that could work more efficiently.
- The above is an excerpt from a 112-page Citi GPS report in March 2016: "Digital Disruption: How fintech is forcing banking to a tipping point".
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