Virtual Banks

Virtual banks are flourishing as the gap between customers and financial services players rapidly widens. This new league of competitors has become a disruptive force on the industry as legacy banks are left trapped in an outdated and costly model.

Last month, the founder of Metro Bank teamed up with the former chief of First Direct to launch UK’s first fully digital lender.  Metro was a challenger bank in 2010; UK’s first new high street bank for 100 years.  Four years on, they are launching Atom Bank underlining the huge difference between banks that are born digital and those trying to make a costly old legacy system fit a virtual world.

A new generation of pure-play digital banks is emerging that greatly appeals to socially connected, digitally powered consumers who have no interest in multi-channel retail.  These nimble innovators are massive disrupters since they can build beachheads within small markets and quickly extend them outward.

With no legacy woes and able to buy a cheap off-the-shelf banking system, a new digital-only bank can offer better loan and deposit rates.  Two recent UK greenfield banks, Metro and Aldermore, set-up for between 10 and 15 million pounds.  The real kicker though is by renting, rather than buying or licensing core technology, startups like Atom can get a full service bank up and running in months with no initial capital outlay.  Under a ‘pay as you grow’ deal, where costs are tied to customer account numbers, new entrants can focus on building a brand rather than on technology and compliance.

What’s changed is that it is far cheaper now to set-up a new bank than to overhaul an old one.  Digital-only banks are miles ahead of incumbents which are losing the race against time to adjust to the disruptive force of platform technology.

Open distribution changes industry

The open distribution of the internet has irrevocably changed almost every company and it is no less true for the major banks.  They are challenged more than ever from a distribution perspective because the industry is moving at breakneck pace towards mobile.  A revolution is now underway in how the average person spends, moves and manages their money.  An undeniable shift in consumer behaviour:  the ubiquity of mobile devices, tablets and laptops all allow consumers to check balances, pay bills and apply for mortgages whenever they please.

Importantly, the competitive landscape has been transformed by the arrival of new non-bank startups (or apps) that are fast becoming the new face of their customers’ financial lives.  These innovative startups focus almost exclusively on user experience making the digital relationship personal and fun.  They have a huge influence on how people view their lenders and are designed specifically to replace banks.

The branch network and even telephony are in terminal decline.  Statistics tell us mobile will be the number one day-to-day channel for banking within two years.

As banking gets app-ified, the barriers to entry fall.  What happened with the Kindle and bookstores, iTunes and music stores, Megashare and movie theatres is happening to the banks.  We are seeing the complete disruption of the industry.  But unlike the music stores, book shops and movie theatres - that could at least claim to deliver a pleasant experience - no-one ever enjoyed going to a bank.  People were forced to physically visit a branch to qualify for banking products.  The barriers to entry were high for consumers.  Unfortunately for the banks, it’s actually easier to digitalise banking than almost any other product.

Right now they are being attacked throughout the value chain and there’s a good chance banks as we know them will disappear.  Peer-to-peer lending once looked so minimal that no-one paid attention until Lending Club and Prosper started seeing triple-digit growth.  With deposit gathering, Alibaba and e-Bay are good examples of what is in store.  Think how Alibaba is pushing to win not just in markets but also across markets.  Buy a new phone from them and it will come with a credit scheme, a credit card and a loan.  It has transformed retailing in China and now Alipay is a serious threat to Asia’s banks.

We have already seen a number of new players enter the payments space such as Isis, Square, PayPal, Google Wallet etc.  The loss of even 10% of this revenue (and data) would threaten the banks’ efficiency and the quality of their customer service.  It’s clear the threat from tech giants has gone way beyond payments with Facebook applying for an Electronic Money Institution license and Google creating platforms that allow startups to grow and immediately offer banking services.  BBVA chief Francisco González is one of the few bankers to publicly say banks that are not prepared for such new competitors face certain death.

Startups like Simple Bank (recently acquired by BBVA) are money transmission systems; they act as an agency for deposits and loans.  They make money by taking an interchange fee on debit card transactions and by sharing in its bank partners' interest margin.  BBVA acquired Simple for US$117 million for creating a new customer experience and thereby acquiring 100,000 customers within two years.  It cost Simple $18 million to launch.

Non-banks like Simple are born to move rapidly and stay ahead of the curve.  They operate their businesses at a fraction of the cost of the major banks.  Acquisition cost per US customer is $2-$20 versus $200-300 for the major banks depending on rewards.  The big banks can follow but they can never catch up.  They can’t move fast; they’re not agile enough.

By buying these startups, incumbents can migrate newer customers across and service them more cheaply.  The question, then, is can banks integrate these new systems to their existing platforms?  There are all sorts of dangers here.  The last year has seen a surge of glitches at several UK bank systems sagging under the strain of new modules and real-time payments.  That’s exactly what happens when transactions start to multiply and their systems aren't ready for it.  It makes it pretty hard for incumbents to compete.

The trouble with banks

Banks have responded by closing down branches and rolling out better digital services.  These are all positive signs, but they have made their run too late.  What many of them do not accept is that they may never catch up with the nimble and creative newcomers.

The investment question is where would you rather be?  The legacy banks are playing a defensive game whereas for online-only banks it’s all incremental revenue growth.  It’s important to be on the right side of change and we think with rapid changes in technology and consumer behavior, the disruption to banks raises questions about future growth.

For example, Australian banks - the most profitable in the developed world - are priced as if their current high returns will be retained.

We think most traditional banks have too much working against them.

First, they’re faced with the cost of supporting and winding down extensive branch networks while simultaneously investing heavily in digital.  Some of their products look decent, even innovative.  But even though major lenders are using their financial strength and scale to try to stay up to speed, they can’t do it quickly, cheaply or easily.

Second, banks have highly integrated software systems which have become increasingly more complex with time and growth.  They already spend a fortune to keep these old legacy systems going and now have to invest billions of dollars more to modernise them.  Most banking platforms were designed in the 1960s and 1970s, and have been patched up over the years as lenders added ‘middleware’ to connect new modules with the core.

However, as we can see from some of the UK banks, this is no solution when the volume of transactions is growing so fast.  Platforms have to be able to integrate limitless volumes of data.  BBVA processed 96 million transactions per day back in 2007 when it overhauled core banking systems.  Today, it processes 260 million transactions.  By 2020 that number will exceed 1.4 billion.

BBVA, CBA and Garanti have bitten the bullet and installed brand new platforms.  Yet the complexity of bank infrastructure makes such overhauls risky.  With millions of customers, they can’t afford to mess up so progress is expensive and slow.  NAB’s software upgrade plan called for A$9 billion of spending over eight years and most of this was to check that a ‘safety net’ was in place for the new system so nothing would go wrong.

How can traditional banks compete with newcomers who can ensure a seamless customer experience?

Third, all banks must hold big capital reserves averaging about one-tenth of deposits.  A highly profitable bank can fund most of its own growth without having to raise additional capital.  But a legacy bank, facing more intense competition, may struggle to generate enough earnings to grow without asking shareholders for money.  It’s hard to get excited about a company that approaches shareholders for capital to maintain growth.  We think the new entrants are well-positioned to generate the excess profits needed to fund their own growth.

Why we like online banks

Higher profitability through faster growth is reason enough to like the low-cost newcomers.  Digital-only banks are small but can grow quickly and get scale quite fast.

They have a cost advantage which they can use to overcome customer inertia and friction.  It’s quite common for them to hand customers $100 if they open an everyday account.  These are unheard of rewards for everyday transactional accounts - and they’re very appealing to lots of people who like receiving a “gift” for their support.  Because they can offer more attractive rates through an engaging medium they quickly start to feel like ‘their’ bank.

Of course, there are challenges for online banks.  It’s easy for them to encourage people to open an account by paying better rates for deposits; it’s a much harder job to build a loan book in a sensible way and lend that money profitably.  US-based Discover Financial Services is a good example of an online bank that has solved the loan equation.  As a credit card business, Discover can get huge spreads that more than compensate for any write-offs. Traditionally a credit card-only lender in the US, it can raise deposits in at 2% and lend that money at 15%.  Since it already has relationships with a huge customer base, it can easily mop-up its smaller competitors by offering cardholders’ a range of other banking services.  With an efficiency ratio of 38%, costs are a lot lower than the big banks that sit at around 55% to 60%.

We think online banks are in pole position right now - especially when they’re operating in a large highly-fragmented market filled with inefficient competitors.  If these competitors come with a highly unionised work force so much the better.  We’ve looked for businesses in those geographies that really suit online banks - where they can more easily make a difference.

Besides the US, Europe is a great hunting ground.  The Italian and Spanish markets particularly suit as it’s a heavily over-branched market, lots of small credit unions and has a highly unionised workforce.  Typically, the traditional banks in these markets have little money to spend on IT despite charging lots of fees.  Reassuringly, they are unlikely to match a low-cost, no fee, online competitor, with a limited branch network, like Italy’s Mediobanca.

It’s an evolving sector.  And one we think worth examining as new entrants lead on both cost and service.  With a radically reduced cost base these new UK banks like Atom and Aldermore (another small challenger) can build a decent fee stream.  Since the UK mortgages market is controlled 60% by intermediaries, the newcomers can shift big volumes by offering a lower-priced mortgage.

Aldermore mostly lends to small and medium enterprises (SMEs) and homeowners.  To date, its lending growth has been explosive and the bank has had an excellent track record so far.  But then you would only expect problems to emerge as the book goes through its seasoning process.  Free from the legacies of banks:  obsolete systems and costly distribution networks it can, through a mix of owning and renting a simple system, introduce new products quickly.  Systems are built in a scalable way – so as the lender grows, it doesn't have to rebuild/change the systems.  Asset growth is 70%.  The fledgling bank broke even after two years of trading before generating a Return on Equity of 11% for 2013.

Also, new rules allow UK startup banks to open with less capital to help them compete with established lenders.  They can operate with tier one capital of just 4.5 per cent of their risk-adjusted assets, instead of 7 per cent.

Many startups buy their infrastructure from Fiserv, Misys and Temenos, installing licensed software in their data centre.  Third party technology that has existed for years on a licensed basis is now available as ‘software as a service’ in the UK.  Banks can opt for a software provider to host and manage the whole banking system for them on a cost-per-client basis.

The ‘shared risk’ model is cheap from a capital perspective.  It’s not particularly cheap from an operating cost perspective although as the customer account numbers increase, the ‘rental’ will decrease.  Otherwise, the model would not work.  With this kind of partnership, Atom reckons its cost income ratio will be 30% - half that of typical banks.  In the US, the ‘shared risk’ model is not new but will likely become more popular as bank customers lead a digital life.  Atom executives feel this strategy would work elsewhere but want to establish it in the UK first.

We continue to look for opportunities in the online-only space.  The incumbents are on the back foot.  Most have yet to bite the bullet and transform from the foundation up.  We agree with González who says the really important decisions in digital banking were taken seven years ago.  For the incumbents it all feels too late.

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