Evolving Business models in banking
Traditional Banking business model
Centuries ago, when people needed money, they borrowed it in exchange for goods, properties, gold or just based on trust. Centuries later, nothing much has changed. Today banks are the institution of trust for people to keep their money or borrow when needed. With trust as their fundamental asset, banks have been serving people's needs with their money. They can make payments, borrow, invest, or save money for future needs. Banks have now involved themselves in each and every need of people.
As easy as it sounds, the banking business model is not as simple as a manufacturing business which manufactures goods at lower costs and sells them at a higher price. The margin becomes the profit for the companies. In a way, banks make money similarly, lending at a higher interest and depositing people’s money at a lower interest and hence making profits through the net interest margin. But banks are much more necessary for the economy than that. The most entrusted institution of any economy is its central bank. Central bank issues license to a select few institutions to run as banks. The central bank uses its regulations to monitor these banks and monetary policies to regulate the flow of credit into the economy. It entrusts these banks not just to act as a distributor of credit but to create credit in the process.
The Indian banking system, in particular, has evolved from the monopoly and bureaucratic approach of public sector banks to a competitive industry fighting for interest rate margins, burdened by the overheads of high operations costs and constantly challenged by revolutionary fintech firms backed by strong tech. Still, it will be ignorant not to acknowledge their growth over the past few decades. Every major Indian bank now has an online platform for catering end customers’ need; they are backed by a strong sales team which lead their distribution to sell loans and cross-sell products like mutual funds, insurance, and credit cards. This distribution network is backed by a network of branches across the remotest part of Indian geography. There are hardly any other businesses with a strong network of branches and salesmen like banks.
The banking industry globally is undergoing some major changes. Fundamentally 3 trends are emerging that will lead the change in the banking industry.
1. Declining Return on Equity:
Across the globe, banking ROEs (Return on equities) have been declining steadily. A large part of the bank’s revenue still comes from interest income. Declining ROEs of banks have pushed them to diversify their existing businesses and earn non-interest incomes, including Interchange fees, Commissions, Forex operations, Account management fees and Investments.
Indian banks have been no different; they have been faced with declining ROE and have been pushing their non-interest income by partnering with Insurance companies to cross-sell their products. Indian banks also have other subsidiaries, like some of the countries' biggest asset management companies in India. They act as distributors to sell their customer's mutual funds and other investment products. Indian banks have partnered with major credit card companies to provide payment solutions to their customers.
2. New Entrants: Digital-only banks, Neo banks and fintech have challenged the traditional banking models and have been performing well. If we ask what is the biggest asset of the banks. The answer can be lending power, distribution, branch network etc., But going back to fundamentals, the biggest asset for banks is still customer trust, and the second is data. Fintechs and neo banks have excelled in using customer data with their technology to devise optimized solutions for loan products and personal finance. Apart from that, digital-only banks and neo-banks have gained market leadership in payment solutions. Discount brokerage companies have established their market leadership in stock brokerage in no time. Banks rely heavily on their branch distribution network while fintech uses technology to scale their solution.
3. Wealth transfer:
As a natural phenomenon, a major wealth shift is happening worldwide from the previous generation to the new one. This is happening much faster in countries with a higher percentage of young population. It is estimated that over the coming 2 decades, a staggering $68 trillion will be passed from the Silent Generation (1946–64) and Generation X (1965–80) to millennials (1981–1996). Millennials and GenZs will also take the role of the bread earner of the family. This generation has an entirely different expectations and behaviour from the previous generations.
As this generation is becoming active bankers, banking trends have emerged due to their tech savviness. Banks are relying much more on digital distribution channels for their products, and their adoption is increasing as well.
With the declining profitability from the traditional way of banking, changing customer expectations and the threat of new entrants riding on strong tech and better customer experience, Banks face a unique challenge of sustainability. Banks with years of experience also carry their legacy systems, shortcomings, and lack of agility. Top-performing banks, especially in India, were riding on Strong sales channels, improving the on-branch experience, but digitalisation has changed the game. It’s not that banks are not adopting digital channels. Almost every bank now has Internet or Mobile banking applications. Apart from online distribution channels like Internet banking or mobile banking, Banks must also figure out how to tackle these fintech and challenger banks.
Assessing banking revenue streams
Currently, banks can cater to everything a person can do with money — Pay, Borrow, Invest or Save. Banks earn Interest income from loans, Interchange fees from credit card operators, investments in Government securities and other markets, Commissions from cross-selling mutual funds and insurance policies, and income from forex operations and Account management fees from their Wealth management services. We will try and categorize banking revenue into 3 sources — Payments (Fee income, commissions, forex income and interchange fees coming from credit cards, debit cards, Forex cards and other payment channels), Lending (Interest income from secured and unsecured loans) and Investment services (Account management fees, commissions, from Insurance, mutual fund houses, wealth management services, stock brokerage etc.)
The Fintech sector in India is growing at almost 25% CAGR and has entered almost every revenue source of banks. Few fintech firms facilitate banking revenue by being part of the value chain, few rely on banks for their business, some eat up the banking revenues, and others run parallel businesses without affecting or indulging in banking operations. Let us analyze each of these revenue streams of banks and see how Fintechs affect them.
Payments:
Payments in India have evolved like no other Industry in the past decade. Back in 2010 when cash payments used to be the norm, and only 5% of Indians had the Internet back then. Internet banking was the payment solution, but the applications were not user-friendly and had restricted P2P services.
Another mode of payment, card payments, had its own drawbacks; apart from the lack of access to these cards, the fees charged to merchants (1–2% of transaction value) were one of the main reasons why Payments through debit and credit card were not taking off.
With the introduction of India Stack, after the introduction of cheap internet Jio and with a push from the government for bank accounts, the payment industry changed forever. IMPS was relevant till 2016 as an Instant payment and clearing system. But it needed customers to log in to their Internet banking. Indian Fintech firms like Paytm have already launched wallets where users can load money and make instant payments. But the real push came after the introduction of UPI backed by NPCI. UPI changed the payment industry in India forever. From dependency on multiple intermediary parties for clearing and settlement, NPCI developed a 4 party payment system facilitated by NPCI servers amongst all 4 parties. Fintech firms like Paytm, PhonePe and GooglePay (Tez back then) developed specialized UI/UX for payments.
The real push for payments came after demonetization, and since then, UPI has not looked backwards. UPI grew from 0.26 crore transactions in 2016 to 3418 crore transactions in 2021. The graph has been exponential. According to the Economic Survey of 2023, UPI already accounts for 52% of digital transactions in India.
There is a big reason for banks to worry about UPI in payments. UPI does not involve and incentivize banks in any part of its value chain.
