The banking industry is being deconstructed, piece by piece

The banking industry is being deconstructed, piece by piece
Image: Irene Rinaldi for Quartz
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How many big banks does the world really need?

Not nearly as many as it did before 2008, when titans like Lehman Brothers ceased to exist, and others became a shadow of their former selves. Government watchdogs have since devised rules that make banks less likely to spin out of control, but also much less profitable. Interest rates have fallen through the floor in many countries, drying up the margin between bank deposits and loan rates—a core money-maker for lenders.

They are not exactly starving, but the pie has shrunk. A handful of mostly American banking giants—the likes of JPMorgan, Bank of America, and Citigroup—sit at the head of the table, at or near the top in the market-share rankings for trading, dealmaking, consumer banking, and much else besides. They may have more revenue and higher valuations than everyone else, but life is not necessarily easy. Everyone is questioning the big banks’ business models, trying to figure out how to make money in a world where regulation and technology have changed the game.

The middle ground is particularly precarious—lots of banks are caught between global titans and nimble specialists. Deutsche Bank, Germany’s biggest lender, is giving up on its global ambitions. Royal Bank of Scotland was humbled by the financial crisis, and is still mostly owned by the UK government following a bailout. Switzerland’s UBS and Credit Suisse have scaled back to focus on wealth management services for the rich.

“Before the financial crisis, one of the models that was growing was universal banking, having banks do many things,” says Francesc Rodriguez Tous, a finance professor at Cass Business School who has worked at the central banks in England, Germany, and Spain. “It worked until the crisis. Since then the trend has reversed.”

Beneath the surface, a host of specialized firms, many of which are run by ex-bankers from top-tier firms, are taking aim at the assortment of businesses that the leading financial institutions rely on. If they were just focused on one sector, they might not pose much of a risk to the world’s most valuable financial companies. Taken together, they encompass investment banking, retail banking, business banking, payments, trading, and research, giving banks a run for their money. “A lot of non-banking financial institutions are entering,” Rodriguez Tous says. “Competition is very, very high.”

Read on to meet the key players at the forefront of the revolution in banking, and their chances of disrupting the status quo.

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Table of contents

Investment banking: Don’t call it a boutique • Retail banking: Apps instead of branchesBusiness banking: Your loan officer is an algorithmPayments: Spending money to make moneyTrading: No humans, just robotsResearch: The price of freeFinal thoughts: What happens next

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Investment banking: Don’t call it a boutique

Roger Altman.
Roger Altman.
Image: Reuters/Nicholas Roberts

Evercore was founded in 1995 by Roger Altman, a former banker and deputy secretary of the US Treasury during the Clinton administration. (In 1974, he became Lehman Brothers’ youngest-ever partner, at age 28.)

Evercore has steadily marched up the investment banking league tables. In 2009, it ranked 12th in global mergers-and-acquisitions advisory fees. That was the year Altman stepped aside as chief executive, putting another Lehman alum named Ralph Schlosstein at the helm. Altman continued on as executive chairman.

A decade later, Evercore is poised to break into the top five for the first time, according to Refinitiv data. This year it has advised on deals like Occidental Petroleum’s $38 billion takeover of Anadarko Petroleum, which netted $53 million each in fees for Goldman Sachs and Evercore. “Our market position in advisory has never been stronger,” Schlosstein said in a July earnings call. “We also were involved in many of the largest transactions announced year-to-date.”

The company’s pitch is that it’s independent, meaning it’s not conflicted by competing priorities among divisions within the same bank. It doesn’t extend loans, for example, to a party that could benefit or lose out because of a deal.

The company has around 110 senior managing directors, the company’s most senior banking title, and it lures away seven or eight more from its competitors each year, Evercore CFO Robert Walsh said at a conference hosted by Credit Suisse in February. (On average, it promotes three bankers internally to its top ranks annually.) As Evercore has gotten bigger, it has tacked on other businesses that, among other things, include services like research, sales, and trading; a $10 billion wealth management operation; IPO advisory; and services to advise companies caught in the crosshairs of activist investors.

One of the limitations for specialized investment banks is that the US mega banks still offer a suite of other services, from lending and trading to treasury, that companies need and desire (even if there can be conflicts). And while Evercore’s stock has shot up more than 240% during the past decade, its $3.7 billion market value is still a fraction of the $350 billion that JPMorgan commands.

Likelihood of disruption: HIGH—it’s already happened

Players to watch:

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Retail banking: No branches, just apps

Anne Boden.
Anne Boden.
Image: Starling

Starling built its bank from scratch for less than £20 million ($25 million). To put that in context, JPMorgan reportedly sunk $100 million into its Chase Pay app, which didn’t catch on and is being shut down. That’s also less than the $30 million bonus that JPMorgan CEO Jamie Dimon got last year.

The digital UK bank is getting traction. Starling was founded in 2014 by CEO Anne Boden, formerly an executive at RBS and UBS. She says her experience at big banks taught her that they are hopelessly mired in bureaucracy, saddled with outdated systems that can’t create the slick mobile apps we routinely use in other aspects of our lives.

The company has around 800,000 accounts, about double the number it had in February. For comparison, Barclays has 5.4 million digital only (pdf) customers, up from 5 million at the end of 2018. Monzo, another neobank based in London, has more than 2 million. Starling and Monzo don’t have branches, but they are licensed banks and have government deposit insurance protection.

They are part of growing legion of branchless banks that have sprung up around the world, from Germany to Brazil, that are easy to access via your mobile phone. They vary widely, from full-fledged banks like Starling, to Curve, a financial platform that’s designed to aggregate all your information together into one app (but lets bona fide banks handle the plumbing). Some of these upstarts, like Starling, say they have a plan to profitability (like payment services, personal loans, small business lending, and selling its banking software to other financial institutions). Others, like Berlin-based N26, say profitability isn’t a “core metric” (paywall).

Many digital startups acknowledge that big banks will copy them sooner or later, but say they are nimble enough to stay a few steps ahead. The neobanks’ operating costs are much lower than a traditional lender, at around £20 to £50 per customer, compared more than £170 for the incumbents, according to a report by Accenture.

Some are less sure, and think traditional banks are already closing the gap. And when they do, the thinking goes, the big institutions will roll out whizzy features inspired by fintech competitors to a captive base of millions of customers.

“I’m not the sort of person who thinks the bank industry is going to be obliterated tomorrow, because I do think the banks can change and get into the mode of transformation,” says Antony Jenkins, the former CEO of Barclays and founder of 10x Future Technologies, which sells cloud-based computing platforms to banks. “There’s still an opportunity there. They have many, many strengths and they need to be able to leverage them.”

That’s why some investors are buying stakes in companies that offer software and services to get big banks up to speed. Zeta, an Indian startup that was recently valued at $300 million (pdf), sells neobank-style systems to financial companies. Bank software company Temenos bought Kony, a banking software-as-as-a-service company, for $559 million. Investors backing these sorts of companies think neobanks are changing the industry primarily by forcing more established banks to up their game.

Likelihood of disruption: LOW—retail banks have been adapting to technology for centuries

Players to watch:

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Business banking: Your loan officer is an algorithm

For a while, venture capital investors thought fintech firms might have found a way to out-bank the banks. Financing for small companies has always been tricky, and lending to them didn’t snap back after the financial crisis like it did for bigger companies. Federal Reserve data in 2015 signaled that the smaller the company, the more likely it was to face a financing shortfall. The US experience is by no means unique—research in the UK shows similar discrepancies.

Online platforms, like peer-to-peer lending, seemed to be the answer. In 2014, US fintech investment more than doubled from the year before, to almost $10 billion, according to data in Fintech, Small Business, & the American Dream by Karen Mills, a senior fellow at Harvard Business School. LendingClub went public in December of that year, a deal that valued the then eight-year-old company at around $5 billion. The company charged a fee to match borrowers with mom-and-pop investors as well as institutions.

Since then, early pioneers like LendingClub, which now has a market capitalization of about $1.1 billion, have stumbled. The digital startups proved that there was demand, and they showed that this type of financing could be processed much more quickly and simply online. Banks, however, have access to cheaper funding and capital. Startups have burned through prodigious amount of money to acquire customers: LendingClub and OnDeck were spending around $2,500 to $3,500 per loan to acquire new customers in 2015, according to Mills’s book. By comparison, a regional lender in New England in 2017 was spending an average of $500 for small business loans under $100,000.

Despite the peer-to-peer lenders’ struggles, the battle for the small business loan isn’t over. Silicon Valley payment companies are also making billions of dollars of loans: Two people spearheading these efforts are PayPal’s Darrell Esch, who spent 14 years at Bank of America, and Square’s Jacqueline Reses, who was at Goldman Sachs for seven.

PayPal says it is providing $1 billion of credit to small business each quarter, more than half of which goes to US firms. Square made $528 million of loans in the second quarter of this year, a 36% increase from the same period in 2018.

These companies use transaction data from payments to make lending decisions. They say automation is the future for small loans: credit decisions are nearly instant, and the funds are transferred almost immediately. The platforms resemble Alipay, the Chinese fintech giant, whose MYBank brand uses the so-called 3-1-0 model: borrowers complete online loan applications in three minutes, get approval in one second, with zero human touch. MYbank provided more than 1 trillion yuan ($148 billion) of financial support to small and micro enterprises last year, and 96% of those were in loan amounts of less than 1 million yuan.

The credit algorithms developed by lenders like Square and PayPal will face their first serious test when the economy hits its next major speed bump, as it will reveal the quality of those lending decisions. Given time, large banks that already have lots of customers and low-cost funding could develop their own snazzy online interfaces backed by clever algorithms. As with retail banking, this could see the incumbents chase away the challengers.

Some think, though, that a significant regulatory shakeup is coming. In the UK, for example, open banking regulations allow users to share their data with any company they choose to. That means the monopolies over the financial data collected by banks, payment companies, and other financial companies should, in theory, be over. Open banking is seen as a boost to competition and could gain currency among policymakers in the US as well.

“It will put everyone on a level playing field,” says Mills, who was administrator of the small business administration during the Obama presidency. If customers truly own their data, you’ll be able to “push it to whoever you want. You’ll use whoever has the best customer experience and price,” she says.

Likelihood of disruption: LOW—banks have a funding and customer-acquisition advantage, for now

Players to watch:

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Payments: Spending money to make money

Pieter van der Does.
Pieter van der Does.
Image: Adyen

Adyen isn’t a startup: co-founders Pieter van der Does and Arnout Schuijff started the Dutch payment company some 13 years ago. Its Surinamese name means “start over again,” which is fitting because this is the founders’ second enterprise. They also started Bibit, a payment tech company they sold to Royal Bank of Scotland in 2004.

The Amsterdam-based firm counts companies like Tiffany, Spotify, and eBay among its customers, and the digital payments flowing through its system are growing rapidly, as more buying and selling takes place online and through payment cards and apps. Around $23 trillion worth of card payments took place around the world in 2017, a figure that’s forecast to increase to $52 trillion by 2026, according to Nilson data cited by Adyen.

Adyen promises merchants like Tiffany one streamlined system to deal with the tangle of different forms of payments preferred by customers, whether that’s a QR-code transaction by a Chinese customer using Alipay or contactless payment by a Brit using their NatWest debit card. The company argues that many of the incumbent systems were designed for the offline world of card payments, and haven’t kept up as apps and digital commerce come into play.

Adyen’s processing volume has ramped up in recent years: it handled €104 billion ($114 billion) worth of transactions during the first half of this year, a 50% increase from the same period in 2018, and €32 billion in all of 2015. The increase in its share price has been even more impressive, having soared more than 170% since its IPO in June 2018.

Card payments have been, and remain, a money-maker for banks, but they face renewed competition from tech firms like Adyen. Adyen is taking market share from “banks, but also the incumbents,” says van der Does. (Indeed, ask Square.) Some of the established, non-bank players include First Data and Worldpay, as well as big financial institutions like Bank of America, Citigroup, and JPMorgan.

Likelihood of disruption: HIGH—payment fintechs are profitable and growing fast

Players to watch:

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Trading: No humans, just robots

XTX is a trading firm that doesn’t rely on human traders. The company was founded in 2015 by co-CEO Alex Gerko. A decade ago, he was a quantitative foreign-exchange trader at Deutsche Bank, a period when the German institution was the world’s biggest currency trader. London-based XTX, which has around 100 employees, was the third-ranked global currency trader last year, behind JPMorgan and UBS, respectively, according to a Euromoney survey. Deutsche Bank was eighth.

Zar Amrolia, previously the global head of foreign-exchange at Deutsche Bank, has been XTX’s other co-CEO for about four years. Gerko and Amrolia, typical of people who work in the electronic trading industry, have deep expertise in mathematics: Gerko has a PhD in math from Moscow State University, while Amrolia has his from Oxford.

Electronic exchanges rely on algorithmic trading firms to provide a steady churn of quotes: When an investor wants to buy or sell a stock, for example, an up-to-date bid or offer is available because these companies are constantly trading and updating their quotes with the latest information gleaned from exchanges around the world. If all goes well, automated trading firms have a symbiotic relationship with the exchanges. Virtu, one of the biggest traders, is reportedly on the other side of about a fifth of all US stock trades.

What’s now changing is that specialized trading firms are increasingly trading directly with big investment companies. Trading firms like XTX, Chicago-based Jump, New York-based Jane Street, and others may have 100 or more big investors as clients, depending on the asset class (stocks, bonds, foreign exchange, and so on).

An example is Invesco, an investment company headquartered in Atlanta that has $1.2 trillion of assets under management. A portion of its trading in stocks and exchange-traded funds now takes place with Jane Street, according to regulatory filings, instead of just Wall Street dealers.

The extent to which automated traders are going head-to-head with the big banks depends on the type of asset involved. Foreign exchange, a market that is highly electronic, has been gobbled up by the computerized firms, and the same is true for much of the stock market and parts of the $16 trillion market for US Treasury bonds. The robots have been slower to win over corporate debt and loans, which are much less standardized than stocks, government bonds, and currencies.

And the big banks still have an important advantage: They provide the market plumbing and credit lines that traders and investors rely on to buy and sell securities. Without that leverage, trading would dry up for many institutions.

Likelihood of disruption: MEDIUM—traders and investors still rely on banks

Players to watch: 

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Research: The price of free

One of the bizarre features of so-called high finance is that investment companies consume millions of research reports from Wall Street banks each year, but until recently these investors had little idea how much they were paying for it. The cost was buried in the fees that brokers charge for executing trades: Investment managers would send some of their trades to certain bank brokers to make sure they got access to their analyst reports. This system was profitable for brokers, but it raised questions about the quality of those trades (which were on behalf of clients), and about the value for money of these services.

That’s why European watchdogs put a stop to the practice. Since the beginning of 2018, according to the region’s Mifid II regulations, investment firms have to pay for research and trade-execution services separately. Vicky Sanders, co-founder of RSRCHXchange, a virtual library for research content, says the idea has spread: Many big asset managers are global, and they allocate to fund managers all over the world, so they’ve been applying the premise elsewhere and asking more questions about costs.

After the dot-com bubble in the early 2000s, US regulators took aim at conflicts of interest on Wall Street between research analysts and brokers. Unlike Europe’s new regulations, those restrictions, announced in 2003, didn’t address the commingling of commissions from trading and research.

Mifid II caused an earthquake in the market for research last year, and it’s not yet clear how things will settle down. Investment research was a $20 billion global market, according to some estimates, before the European regulation came along. It shrank in Europe by about 30% the after the rules came into force, Sanders says.

The immediate shock may have helped the big global banks, as research became a volume business. Smaller providers with fewer customers came under pressure. But the industry is in flux—Sanders says there’s growing recognition that quantity and quality aren’t the same thing. Some investors are increasingly willing to pay up for the true specialist who offers insightful research.

Likelihood of disruption: MEDIUM—big bank analysts still have a powerful brand

Players to watch:

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Final thoughts: What happens next

The banking industry has changed immensely since Lehman Brothers collapsed a decade ago. The most aggressive financial engineering is mostly finished, and so are the blockbuster profits and returns. To make sure banks stay afloat during the next downturn, regulators have forced them to build up extra capital cushions as well as limited their actions to keep them from spinning out of control.

The long-held notion that bigger is better is also being challenged. “We’ve been trying to assess what is really the benefit of having universal banks where there are economies of scope. Not only of scale, of being bigger, but also of having different activities,” says Rodriguez Tous. “So far the academic consensus is that we haven’t found much of these benefits.”

Even so, a few huge, globe-spanning universal banks have managed to stay ahead of the pack, cementing their status as “too big to fail.” Others have rationalized their operations and reduced their geographic footprints. But investors aren’t very optimistic about the future profitability of the industry as a whole, saddling it with lower valuations than the tech-enabled challengers chipping away at banks’ businesses.

Are the big financial firms now less likely to blow up? Probably.  Is the financial system overall safer? That is less clear.

It’s hard to imagine that a payment company or upstart digital bank is going to be the source of the next financial crisis. But it is entirely feasible that a panic could arise from a cyber attack or a runaway algorithm. Hedge funds and private equity firms could build up the type of risky bets that have destabilized markets in the past. Watchdogs have to figure out how, and how much, to oversee new types of systemic infrastructure like cloud computing.

If anything, big banks are probably the least likely source of the next meltdown. But that may not be much comfort.

“You might get banks to be safer, or simpler, or both things at the same time,” says Rodriguez Tous. “But then obviously part of the operations that banks were doing do not disappear. They just move somewhere else.”