Linking banks and startups. The future of banking.

Bas van de Louw, Sean Kouffeld, Jan-Paul van de Kerke

February 2017

The banking Landscape of the Future

Banks are at the center of discussion for the last couple of years. This is mainly due to their important role in the economy, as they are both the providers of liquidity and the safe-haven for savings. However, the position of these banks and their role in the economy is changing. Not only the banks, but also their environment is affected by, for example, technological progress. This progress shapes the and intensifies competition in the market. The banks are obliged to change as well, if they want to remain competitive. How do they have to change? Within this small blogpost we will share, with you, our view on the required changes in banking. We argue in favor of a risk advisory position in the economy. Banks will have to shift their focus on one of their main advantages, which is the assessment of risk and the analyzation of it. This advantage arises from experience and the large availability of data within the field. We introduce the notion of linkages, which implies that a bank is linked to another firm through either ownership or contracts. We argue that linkages between banks and (technological) startups will be at the root of banking in 5 to 10 years. These startups are more competitive and agile than large banks. This notion will later be explained into greater detail. The main takeaway is that banks can profit from these startups, but startups will also profit from a cooperation with banks. Their trust and risk expertise is argued to be

the main driver here. Let us first discuss some comparisons between the banks and the startups, to give a better overview of the situation nowadays.

Why would startups link with banks?

Over the last years, the banking environment has changed. Many innovations have been made by startups. These innovations helped the startups reach their customers better in the rapidly changing environment. Banks were unable to do this as succesfull as the startups, due to their size and management structure. This however is just one of many examples why startups might have advantages over banks. We will discuss a few more in this section, ranging from the use of different IT systems to providing tailor-made products.

As stated, there is a difference in the use of IT systems. A well-known fact is that banks use older, more reliable IT systems. These systems show lower breakdown rates, making them preferred over newer systems. However, we believe that startups use the more recent technologies allowing them to create, for example, new and easier payment methods. This in term makes them more competitive over banks.

Startups are also better in creating tailor-made products for their customers. The startups consist of small teams. These small teams know their consumers and are thereby able to know them on a more personal level. This allows them to provide better tailor-made products, in comparison to the large banks. In general, the customer only meets a bank in a couple of contact moments. Within these moments the client often interacts with different representatives of the bank. This relationship is less personal, and thereby less appreciated by clients.

In comparison to the small startups, the banks are unable to change rapidly. They face a higher degree of bureaucracy, which might slowdown this process as the firm needs approval of many different management levels. Startups are more flexible, because they have one owner which can decide whether to adjust or not. The big difference is therefore in the speed of adjusting; startups are much faster.

A large bank faces higher total costs than small startups, as they have higher fixed costs. The current, larger banks need: a main office, a human resource department and several small retail offices. For each of these points the bank has to pay a certain amount of costs. The startups pay only a small part of these fixed costs, as they require smaller offices for their employees. Startups are hereby able to offer lower fees to their customers. This makes them more attractive to them.

As an example of these startups one can consider the digital-only banking. The figure below shows the millions raised by these Digital-only banks.

These Digital-only banks are growing, and they are growing fast. These startup banks are able to continue growing as they require small office space. They do not have to spend a lot of money in expanding these offices. These foregone costs can be used to innovate and thereby create a higher value for both customers and the banks themselves.

Traditional banks and startups need each other to remain active. Larger banks need the startups to do their basic tasks in an efficient way. This can be done by using the technology and personal aspects of the startups. The startups can benefit from the larger banks by profiting from the banks reputation, databases, customer reach and risk assessment. Customers of the bank will adopt new products from the small startups more easily, as they are supported by the banks. Furthermore we expect that, with the help of big data, the small startup is better able to provide tailor-made products. The increased availability of background info makes this process easier. Customer reach and risk assessment are considered self-explanatory in this case.

Consequences of linkages for the market

The linkages of banks, together with startups, will have their effect on the future market. The market will be characterized by deepened competition, which in turn effects the banking distribution and landscape. This will be explained within this section, in which we discuss two different methods in which markets may be affected.

The formation of linkages is a mutually beneficial relationship. The banks provide trustworthiness and is the portal to the consumer. Contemporary notions of trustworthiness are the banks’ balance sheet and in a less tacit way the image of the bank. The latter will be equally important in the future, but the former will provide some difficulties. Here we imply that a bank’s balance sheet will consist of shares in many smaller startups. Valuation of the bank will not only depend on the assets, but also on the position of the banks in the market. Here stronger linkages are worth more to the banks.

Linkage ownership also affects the structure of entities. The owners of a bank are not per se owners of the linkage, they have to cooperate in a network of startups to discuss the strategy of the linkage as a whole. Also the notion of excessive changeability has its repercussions for bank ownership (Boot, 2016). Excessive changeability refers to the proliferation of financial products to liquefy and hedge financial transactions. Boot (2014) argues that this excessive changeability could alter traditional ownership structures of banks because the technological progress allows new ownership products. Boot argues in favor of changing to a structure that allows for a more liquid ownership. This on its turn could lead to more opportunistic behaviour. Because ownership is more fluid and these owners are, unlike the partnership structure, not personally tied to their wealth to the bank. They could be prone to take on more risk.

When it comes to consequences between linkages, we argue that the banks that will not be successful in their attempts to form an efficient linkage will be priced out of the market. This is brought forth by a run on promising technologies of which the outcome will determine whether a bank survives or not. The newly incorporated technologies are the place where comparative advantages between linkages stem from. In our view, in the long run only a few of these linkages will be viable. The reproducibility of technological products makes upscaling less costly while keeping marginal costs low. This deepened competition will define the market between linkages.

Regulatory consequences of linkages.

As markets change, new regulations have to be put in place to ensure fair markets. At the moment de Nederlandsche Bank (DNB) is the supervisor for banks in the Netherlands. In Europe it is the European Central Bank (ECB). These parties set up rules for banks and punishes those that violate them. In order to adapt to the new markets, rules have to change. We propose the following rules: additional buffers, monopoly prevention and information protection.

The balance sheets have to include additional buffers, as banks will own a large amount of shares in small startups.. Since we expect banks to buy up more startups, the assets of the bank will include more of these type of assets. New regulations have to be put in place to keep the banks from becoming illiquid. This can occur if too many startups fail. The size of a buffer for these additional assets has to be based on a certain risk assessment. This assessment has to be carried out on a detailed level, as done by the supervisors. Data from the banks should be made available for these supervisors.

Regulations have to include monopoly prevention. We expect that only a few banks per country would remain active. The risk of deterring from a perfect competitive market to an oligopoly or monopoly would increase, if there are fewer banks active. Banking regulations should restrict these active banks from colluding. This should be done at a detailed level, in which regulations have to be put on the newly acquired startup firms. If a bank buys up all the startups for one type of product, they can acquire a monopoly position. Therefore, regulations have to be put in place to disallow acquiring more than a few of the same type of startup firms.

As banks will use more detailed personal information (by providing tailor-made lending), regulations should ensure the safekeeping of this information. In a world of technology, personal information becomes valuable. As banks will use specific customer data, the customers faces higher risks from data leakage. Regulations have to include higher requirements to, for example, prevent cyber-attacks.

Concluding remarks

This column discussed the banking landscape of the future. It emphasizes on a formation of linkages arisen from specialization in the banking sector. Banks will focus on risk advisory and smaller firms, addressed as startups in this context, specialize in producing the products and services. The latter are better at this due to specialization, flexibility, lower costs and innovative ways of working.

This new degree of cooperation has its effect on markets. Within the linkage it will be difficult to assess the value of the linkage as a whole. Moreover technological progress allows for new more swift ownership structures. This fluid ownership could trigger more short term incentives. Between the linkages the run on promising technologies will deepen competition. In the long run only a few of these linkages will be viable due to this competition.

These linkages impose challenges for regulators. Our proposition requires supervisors to work at a detailed level, to assess the new type of risk for banks and the market. We covered three main points, which are: preventing monopoly power, preventing over leveraging of the bank and the protection of personal data.


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Bas van de Louw

MSc Economics at Vrije Universiteit Amsterdam

Sean Kouffeld

MSc Economics at Vrije Universiteit Amsterdam

Jan-Paul van der Kerke

MSc Economics at Vrije Universiteit Amsterdam