The Modality Shift of Banking – Part 3

Massive spend on innovation at the front-end of retail financial services

Putting aside conjecture of whether or not we are in a bubble at the moment around tech, social media, and mobile services (which I believe we very well could be), the reality is we are seeing a flurry of massive investment in new distribution models and organizations acting as either technology or behavioral enablers. We’re used to seeing big numbers for M&A activity in banking, but we’re not used to seeing such a flood of start-ups and non-traditional competitors facing off against traditional players at the retail side of the business.

To date, there has been more than $7Bn in private equity, venture capital and private investment made into non-traditional financial services start-ups that challenge existing models. This is the first time globally that there has been this scale of challenge to the traditional retail financial services space from start-ups in the technology arena. To illustrate the level of activity, here are just a few recent investments in the New York fintech space alone (source: Quora):

SecondMarket ($15mm)- marketplace for illiquid financial instruments; secondmarket.com
Kapitall ($7.3mm)- discount brokerage with gaming elements; kapitall.com
Betterment ($3mm)- online brokerage for small investors; betterment.com
Plastyc ($2mm)- mobile based banking for the underbanked; plastyc.com
AxialMarket ($2mm)-
online middle market i-bank; axialmarket.com
BankSimple ($3mm)- online/mobile banking interface; banksimple.com
Covestor ($11mm)- platform to find SMA providers and invest with amateur traders; covestor.com
Hedgeable- next generation investment management firm; hedgeable.com

However, in addition to these plays you have very some serious initiatives now doing major business in the space that used to be considered the sole domain of ‘banks’. Here are four examples:

Personal Financial Management

Mint was acquired by Intuit in September of 2009 for $170m. Mint has experienced meteoric growth in customer base. Today Mint has more than 5m customers willingly giving their personal financial data, bank account and spending information to receive the benefits of fine tuned recommendations for financial services investments and credit products.

Businesses like SmartyPig, which has a collaborative play with the industry, are very successful at stimulating simple behaviors like savings for specific goals. SmartyPig has raised over $1.2Bn in deposits for the partners banks it works with such as Citi, West Bank, BBVA, ANZ, etc. They utilize social media to encourage your friends and family to assist you in your savings goals. For example, my kids were able to use SmartyPig to solicit assistance from their grandparents, uncles, aunties, etc to help with their savings goal.

Admittedly, we also seen Blippy and Wesabe crash and burn in recent times. However, the readiness of the investment community to experiment in the space of services that are complimentary or competing directly with traditional FIs is clearly increasing.

P2P Lending

Lending Club, Prosper and Zopa are just three examples of recent successes in the P2P lending space. Lending Club is lending around $20m a month in loans, and have lent more than $300m, with an average loan size around US$10,000. In France, FriendsClear has recently announced that Crédit Agricole will be joining their efforts in a collaboration of sorts; exactly how this will work is still under wraps.

Zopa has lent more than £150m which means they are now approaching a 2% market share of the total UK retail lending market. Zopa’s average loan size is around GBP 5,000, but what is more significant is their Non-Performing Loans (NPL) ratio. Major U.K. banks typically recorded NPL ratios in the 2%-3% range from the mid-1990s through to 2007, but by the end of 2009 Lloyd TSB’s gross NPL was as up to 8.9% and HSBC’s hovering around 3% (source: Standard and Poors). So how did Zopa perform in this environment? Zopa’s NPL ratio sits at around .9%. That’s 10% of Lloyds and 1/3rd of the best bank in the UK HSBC!

Zopa's NPL Ratio is 10% that of Lloyds TSB in the UK

So how is it that a social network that lends money between its participants is better at managing loan risk than banks that have been at this for hundreds of years?

The key here is the positive psychology of social networks versus banks. If I lend money off a bank and I’m having difficulty paying that back due to loss of income, or just having a hard time making ends meet, I’m likely to let the loan slip and wait for the bank to chase me. P2P networks like Zopa, on the other hand, are finding customers proactively contacting them to make payment arrangements when they can’t meet their monthly commitment. Why?

Firstly, there are people at the end of the loan – not a big bad bank who “can afford the loss”. Secondly, the fact that there are people at the end of the loan versus a bank means that people are more inclined to prioritize paying back their loan to other people, over that of a large institution. This positive peer pressure is producing astounding results. I also asked Giles Andrews from Zopa about why he thought Zopa was better at managing lending risk than banks…

“I think our low defaults aren’t just because of P2P but because we built a better credit model, taking more account of over-indebtedness and affordability than banks”
Giles Andrews, CEO, Zopa.co.uk

Who would have thought that social networks would be better, safer, and more efficient at lending than retail banks?

In fact, P2P lending has been so successful that in recent times both Umpqua Bank and Fidor Bank (a start-up online, direct bank in Germany) have incorporated some P2P as a component of their bank platforms. Why take all the risk yourself as a bank, when some customers are willing to cover the risk themselves? But don’t think that P2P is just easy money. Wall Street Journal reported in June of this year that 90% of Lending Club’s applications were refused.

Maybe that’s why P2P is good business – because they actually take fewer risks than banks?

Pre-paid debit cards, E-Money Licenses and Payments

Amex, Greendot, NetSpend and Walmart are just three organizations that have recently made big pushes into the prepaid debit card arena in the US alone. Significantly, the US now has 40-60 million underbanked consumers (source: FDIC, Financial Times), half of whom have college degrees, and 25% of whom are prime credit rated. Many of these are opting out of the traditional banking system, but carry a pre-paid debit card. The pre-paid debit card industry will account for more than $200 Billion in funds by the end of 2011 along (source: Packaged Facts).

Top 5 reasons people get a prepaid Debit Card

The financial crisis has accelerated the increase in those whom no longer participate in the formal banking system. Since the financial crisis 60% of new mobile phone users in the United States have been no-contract, pre-paid phone users.

“As an economy becomes richer and incomes rise, the normal expectation is that the proportion of the unbanked population falls and does not rise as is now happening in the United States…”
Washington Post, December, 2009

Combined with increased account fees from big banks recently affected by reduction in interchange revenue, and modality changes, I think we can expect that increasingly customers who don’t need complex banking relationships will opt out of the banking system by using prepaid debit cards and in the future prepaid wallets enabled via NFC and mobile Apps.

In the UK Google, O2, BT and others are looking seriously at the combination of prepaid debit cards type functionality into a wallet. Google already launched their Google Wallet earlier this year, and we can only see more and more of this action in the coming months.

The raft of P2P payments, mobile payments and mobile enablement are bewildering at the moment. Undoubtedly, we’ll see many variations of mobile payments in the near future. With PayPal predicting $3 Billion in mobile payments in 2011 alone, the future of mobile-based prepaid debit cards looks very healthy.

Conclusions

We’ve never had such a concerted, technology-led explosion of retail financial services solutions that are directly in competition with the traditional players in the space. While some of these initiatives are complementary, increasingly we’re seeing startups that realize you don’t need a banking license to play on the fringes of the banking system. When you only know one way of running your business you will be increasingly challenged by customers who don’t relate to the questions you ask, the processes you have in place, and the insistance on using outdated physical artifacts and networks.

This is the first time we’ve seen a global attempt at reinventing the way banking fits into our lives on a day-to-day basis, and it is bound to create massive friction for a sector known to be very attached to traditional modes and models. One thing is clear, increasingly banks will be competing with new businesses that are faster, better, more relevant and aggressive than the long-held bastions of traditional savings and loans.

These businesses will embrace and exploit changing modality. These businesses will love disruptive customer behavior, they’ll encourage it!

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