The legacy clock is ticking

An independent commentator on financial markets and fintech through his blog, the Finanser.com, Chris Skinner is one of the biggest names in fintech today. He is the Chair of the European networking forum: the Financial Services Club and sits on the advisory boards of numerous companies including Innovate Finance, Moven, and Meniga. Chris has been voted one of the most influential people in banking by The Financial Brand. He is also one of the Top 5 most influential people on BankInfoSecurity’s list of information security leaders, as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal. 

In his recent visit to Karachi for a training workshop organized by Terrabiz group, BR Research had an interesting discussion with him on the digital revolution, the future of the banking industry, and its potential in Pakistan. Below are edited transcripts of the transcription.

BR Research: What are some of the key characteristics of a flexible regulatory framework for digital banking and mobile payments to allow the natural evolution or even experimentation of new products and services?

 Chris Skinner: The world’s leading-edge regulatory bodies are creating lighter regulations than one required for a full banking license. So we have the e-money licenses, payment processing licenses, and trusted third party licenses in Europe, because you don’t have to have overheads, governance, and capital requirements that we see in the banks, and that’s encouraging a lot of regulations. Regulators are also working with startups, which is what the regulatory sandboxes are all about. Set up by regulators, such as the Financial Conduct Authority in the UK, the regulatory sandbox is a platform where businesses can test innovative products, services, business models, and delivery mechanisms in a live environment. We are seeing big changes to encourage innovation.

BRR: How critical are the capital requirements?

 CS: That is one of the main differences. If you are running a full deposit bank service then generally you have to have several thousands of dollars of insurance capital for every customer. New banks have to have at least $20 million of capital on day one because of the guarantees that a regulator requires for full bank services, which is an inhibiting factor to any new bank launch. This is why you don’t see new bank startups in the digital world. Instead, you see specialist payment companies. The difference is that the e-money and payment licenses are for non-banking financial institutions that are not acting as a value store where people deposit their money.

BRR: Does that mean starting off with a digital bank is a fool’s dream and that only old legacy banks or only the big boys who have that kind of capital can do it?

CS: Not necessarily. A host of new banks are starting in Britain. I call them ‘boutique banks’ as they are not really proper banks. They are just dressing the banking service in a different way, but still have a full bank partner behind them. And then there are few like Atom, Monzo, Starling banks that have millions of dollars from day one because they have the ambition to be a full bank and they have guaranteed funding to be able to do that. There is a possibility, but you’ve got to be really incredible to launch a digital bank as a new startup because from day one you have to raise something like $20 million dollars as your capital.

BRR: How are banks responding globally (especially in developing economies) to the changing (digital) paradigm? Are they outsourcing digital functions, are they reinventing themselves, are they opening new digital subsidiaries, or perhaps a confluence of strategies?

 CS: In developing economies, banks are more innovative and embracing the digital than the legacy economies of Europe and America. This is mainly because their systems have only been developed in the last 15 years, in most instances, so they don’t have to reinvent themselves. They can add digital functions to a lot of what they had already implemented. It’s far easier to become a digital bank in a developing economy than to become one in a legacy economy.

BRR: But is there a yellow brick road in terms of strategy?

 CS: There is. And the first thing is to decide what kind of bank you are going to be in the future. Do you want to be a full service digital bank, or just going to be aggregating the APIs to give the front office a wonderful experience without caring about the back office?

Some banks outsource their digital back office. That’s quite a hard decision to take because if you take that decision then you are essentially saying that we are no longer going to be playing in the product or service area; instead, we are purely going to focus on the relationship and the customer experience. Others want to focus on their back office as their core competence and may want to outsource front office.

For a bank that has historically done all front, middle, and back offices, these are major strategic decisions to take. You have to find where you want to focus as your core competence, and that’s where you need to start your strategic planning.

BRR: Is the clock ticking fast? Should banks in Pakistan start panicking? 

 CS: The clock is ticking but it is ticking in five to seven-year cycles rather than five to seven-day cycles. So it’s not as fast a change as any other market space, but it is fast enough. I see a lot of banks think that they don’t have to change, and what I am trying to say is that they do. If they don’t, then they are going to have serious problems.

BRR: How can banks digitize their lending framework, especially in the SME area where documentation isn’t always proper?

 CS: Most banks in the digital space are taking the example from peer-to-peer lenders, doing it on the basis of, ‘what data can I get about the people applying for loans,’ and ‘how can I use that data to understand their risk structures.’ So most of it requires strong data, and trying to assess how can we lower the cost of loan applications.

The problem with incumbent banks is that they have an awful lot of overheads and people who do the analytics as they haven’t automated it; whereas the new digital banks come in, they start with data to do the analytics, through software and systems to make it an automated function.

BRR: Can you give us an example?

 CS: M-Bank in Poland has been challenged by a new lending company that could do loans in 15 minutes, whereas conventional banks were doing it in two days or more. The new competitor is doing everything based on a digital approach, which involved getting a lot of data on customers than was previously available. Plus, they are analysing the data in real time based on algorithms and softwares which is far cleverer and faster.

The traditional banks already had the customer and they already knew what the customer profile was like, they just hadn’t put it into a real time system. The new competitors were using customers’ social profile as well as financial profile to assess risks, whereas the traditional banks tend to purely use your financial profile and your credit history. It doesn’t mean that they cannot use their social profile; it’s just that they haven’t gotten that capability as yet to use their own internal data, let alone external data.

Imagine you have never had financial dealings; you are a young person who is just coming out of school and just going to university. Is there something that tells me that I can give you a loan? The answer is yes, I can use your social profile. For example, SOFI – a billion-dollar American Fintech which stands for social finance – is looking at students graduating from Ivy League universities and saying, ‘based on your social profile, I will lend you money now, instead of trying to get your attention when you are thirty and rich.’

BRR: What are their default risks in comparison to traditional banks?

 CS: Most peer-to-peer lenders effectively use the same credit bureaus and credit registry that are used by banks. But they also use your financial data, your social data, and your behavioral data, that they learn through lending over the course of years. The default ratio of peer-to-peer lenders is far less than a bank’s. In the case of Zopa, they have learned through behavioral models, analytics, social profiles, algorisms that certain people have higher or lower risks, and their default rate is nearly a third of banks’ default rate. So these guys understand risks better than the banks.

BRR: Digital revolution is being touted as the fourth industrial revolution. In so far as third revolution is concerned, Pakistan and many other developing economies are mostly consumers of knowledge than being producers of it; we can buy the fanciest of plants, key chemicals or machineries for our industries but we don’t produce them. Is the 4th revolution different; will it allow Pakistan and other developing economies to be producers of knowledge (technology) as well?

 CS: The production of goods and services in industrial revolution often involved high capital and large manufacturing processes that were expensive. In the digital revolution, anybody can offer a service from their bedroom. There are no capital costs to create something imaginative; all you need is just a platform. And that is why we are seeing the companies growing through the network, like Ubers and the AirBnbs, where the company is just starting in someone’s garage.

The cost of everything is coming down. For instance, China is constructing housing in 24 hours by using 3-D printed moulds of the building, and admittedly the cost of buying the printer is a factor but it doesn’t mean it is prohibitive. There is nothing to stop anybody from anything in digital revolution because the cost of assets, the cost of development, and the cost of starting up has collapsed.

BRR: Before the industrial revolution, the idea of intellectual property rights was little known, if known at all. Knowledge moved freely. In the fourth revolution, will IPR continue to foster the digital divide between the rich/poor, individually and between nations?

 CS: I am hoping we have democratized the planet; that we have reduced the barriers between rich and poor countries. So digital, particularly mobile broadband will become inclusive of everybody and, therefore, everybody will have the same opportunities to create intellectual property. But that’s not a realistic view; that’s an optimistic view, because certainly two-thirds of the people who are not included in creating knowledge and services now have the opportunity to be included.

In the case of banking specifically, most of the APIs, for instance, are taking a fee per transaction but the fee is minimal, so unlike visa and master cards where you might pay two or three percent, these guys are offering the same capabilities for 0.2 percent, and again it’s because they are starting with a digital platform with very little overheads.

BRR: Our understanding is that the new economic model will morph into what can be called democratisation of production – more and more average Joes will be producing some small thing or another and selling over e-commerce or other futuristic platforms. And this would eventually force banks to re-strategize their business models to focus on even the ‘S’ part of the SMEs. What is your reading? 

 CS: That is 100 percent the point I was making about the fourth revolution. We democratise the planet by including everyone in the network. Soon for the first time in human history, seven and a half billion people in this world can all transact trade, create, and share those innovations with the world. If you got something that is of interest to Karachi or Kuala Lumpur, Tuscany or Columbia, then you are going to make them aware of it through the network and social media, within seconds.   Anyone with an idea can potentially become a millionaire if it’s a good idea, and the planet likes that idea.

A great example is crowd-funding. The guy who created Indiegogo, which is one of the biggest US crowd-funding sites, has collapsed the historical process involving an awful lot of energy and capital. Traditionally, if you had a good idea you had to go to the bank and say, ‘here is my idea, will you fund me,’ and if the bank did fund you then a lot of that funding went to announcing to the marketplace that you have got a fantastic new product.

What’s happening with crowd-funding is that you just announce to the market that you have got an idea and if the market likes the idea they fund you. You don’t need a bank. The bank was looking at you as a high-risk start up, because they have no idea what your market is and whether it exists, and whether you are worth funding. Now the market tells you directly whether you are worth funding.

It is the democratising of production, where everyone can get involved; everyone can create and sell half way across the world because they are on the network. In such an environment, banks would have to become very nimble to be able to deal with this changing economy.

BRR: It is said that fintech is not going to take away all clients from traditional banks; they will take away only the smallest and cheapest ones. But given that the future of oil, textile, meat, etc. industries looks very different from today, are the typical big ticket corporate borrowers going to be around for banks? 

 CS: Banks were built to fund the industry, and a lot of the industry that were created are now becoming last century. A good example is oil and fossil fuel. We all know it will be replaced by solar and wind. Elon Musk recently called Australian government and said ‘I will solve your energy problem in South Australia within three months and if I don’t then you don’t have to pay me, and his project is all about solar power for the whole of South Australia.

There is a sea change of old industries to new industries from industrial to digital, and what a bank has to do is to say where the future is going to be, is it going to be trying to support their traditional customers and traditional markets or new customers and new markets.

Look at China’s Ant Financials; their strategy is very clear, they want to have an inclusive strategy for everybody to be able to pay for almost nothing. Within one app, you go from social to commercial to financial without feeling any change in the app.

For example, you are going to see the movie Fast and Furious 8; you are talking to your friends on the app, you pre-order the blue-ray, or the streaming version when it comes out, then you hear there is a crowd-funding project for Fast and Furious 9 and you invest in that because you want to be first at the premier of the movie; and you get to go to the premier of the movie, and you get to buy the whole lot of collectibles at the same time – and all of this in one single app rather than toggling between different web pages.

BRR: Is Trump phenomena a challenge to this whole thesis? And how should governments respond? 

 CS: Globalisation is unstoppable because you have a network now that is global. Whether Donald Trump or Erdogan or anybody wants to stop it, they can’t stop the global network, building relationships across borders. If people want to buy from a Kenyan farm or China or Madagascar then so be it. There is no stopping it.

That is a big challenge for governments. It’s easy if you have physical movement of products and services across borders because you can tax it. When you have digital movements across border then it is difficult to tax. There are fundamental challenges in governments. I am not sure how they would resolve this but the bottom line is if people can buy far cheaper from a thousand miles away than a mile away then they will buy from a thousand miles away.

Money was created by governments to control their economies and communities. If you have money without government then there is an issue; the nation state becomes powerless. The libertarians like the idea of the democractised world, using democractised value structure based on Bitcoin for example. But my view is that the nation state will eventually find some equilibrium and a way in that community to stop that from happening.

BRR: Being a value store, and a traditional institution of trust, can’t a bank act as an intermediary?

 CS: I think it comes down to the hybrid model of fintech and bank. Fintechs are focusing on the more liberal capabilities of funding and access to funds. For example, crowd-funding or peer-to-peer approach brings a more social democractised way of dealing with the money.

What’s happening in the hybrid approach is that some banks are becoming the platforms for those services. A few years ago, Caixa Bank in Spain created a model where if you wanted to invest in a crowd-funding or a peer-to-peer manner then you could do that through the bank’s platform, and through that you would get the bank’s protection of your funds, at the same time enabling you to join through the social peer-to-peer structure.

I think over time banks will engage in hybrid model – more liberal services for accessing funds or finances for mom and pop stores. They are high-risk for these banks. In the UK, the Metro Bank, which is a new bank, partnered with Zopa, which is the newest peer-to-peer lender, and they’re saying ‘if you want to lend via Zopa, you can do it using our (Metro Bank’s) platform so that it becomes protected under the banks rules.’

In Metro Bank’s case, they are not charging anything for this because they are saying that this adds extra choice to our customers and therefore it is in the interest of good customer service. And this takes us back to curating a platform; if banks want to curate lots of apps, APIs, and analytics on their platform, they are doing that because they are choosing to give their customers the best experience. For an incumbent bank with 20 million customers, that’s where they should be focusing their efforts rather than competing with fintechs.

 BRR: You mentioned that exciting new products are emerging from Africa in digital banking/mobile payments space. Could you give a generalized sense of those techs and how localized are they?

 CS: This is just bubbling at the moment. The main innovation I am seeing in Africa is they are looking at the digital identity scheme based on your mobile SIM/chip, a biometric, and a shared database using distributed ledger technology. If they build that then it is likely to be used globally. It would be very cheap, efficient and secure.

But this is one of the several things that are happening in Africa at the moment because they haven’t had any kind of banking and technology before, and now they are inventing whole new ways of inventing money, value stores, and value exchange. Assuming that they do those cheaply, securely, and efficiently, then I am very sure other economies will copy them because they would be far more efficient than what we have got in the legacy economies.

BRR: Distributed ledger/blockchain will be based on consensus. If consensus servers say that the file is genuine (whatever the file is: currency, passport, deed, etc.) then the file would be construed as genuine. But couldn’t there be fake servers or a way to cheat the system to prove that a file is genuine or fake?

 CS: It depends how the system is created. In the banking system, they are creating it as a private database ledger system and by private I mean you have to get permission to get on that network and prove that you are a bank. That’s how banks are creating their distributed ledger systems.

In the Bitcoin network, yes you could have fake servers. But you would have to have ownership of 51 percent of the network if you are going to make that happen and it is incredibly difficult to do so. No one owns this network; it is democratised, and it is distributed across the world by people who use Bitcoins.  This is why a distributed ledger is far more robust than a centralized system; because in the centralized system, you only have one server to attack. In a distributed system, you have hundreds of thousands of servers to attack. It is far more difficult.

Copyright Business Recorder, 2017