Where’s the AWS for Banking?

It’s Thanksgiving week in the US, and I spent my fourteen-hour flight home considering the question posed in this post’s title. In this post I will start from the abstract theory of the firm, then discuss the trend towards fragmentation in financial services, and finally lay out the vision for an industry structure where a bank charter is made available just like Amazon’s cloud computing services (happy tenth anniversary!).

Ronald Coase’s Theory of the Firm and Financial Services

Take a look at this list of the twenty largest financial services firms by revenue, in billions of dollars (I wanted to show this by enterprise value, but I don’t have access to CapIQ or Bloomberg anymore) — they’re very large:

Holy guaca-moley!

Why do firms exist? Here in the US, we participate in a more-or-less free-market economy, yet why do most of us work in corporations, for fixed salaries, in working relationships that rely on a sense of duty more than a desire for profit, where we make decisions in a dearth of pricing or market-based information? Ronald Coase’s formative work on the subject suggest that firms exist because of transaction costs associated with using the price mechanism. There are costs associated with market-based relationships such as contracting and the observation, analysis, and action of pricing information. At any time, there’s a conceptual equilibrium where the marginal costs meet the marginal benefits to determine the optimal average size of the firm in the economy.

In which direction is that equilibrium moving?

I would contend that in financial services (among other industries!), we are in a phase of increasing fragmentation. Firms are becoming increasingly specialized in their core competencies, and it takes an increasing number of firms to deliver a competitive product offering. I’ve posted about the unbundling of credit cards previously, but the trend I would like to discuss here goes beyond bundling, it has more to do with the vertical structure of the industry and how a financial product is created for the end user.

The Old vs. New Paradigm: How the Sausage is Made

This section is very much a straw man, and is meant to communicate the essence or spirit of where we’re coming from instead of the reality of where we’re coming from. This is a bit of an intellectual hedge on my part, but please humor me!

The old paradigm involves full-stack construction of financial products. A single entity, perhaps a depository institution, offers a financial product that it builds from scratch. Let’s take a simple checking account for example:

  • A general manager decides what features the account will have.
  • A marketing team attracts customers.
  • A compliance team ensures that the bank maintains good regulatory standing.
  • A bank has its own charter that provides access to the banking system.
  • A treasury team implements the systems to track the accounts and transactions.
  • A branch network interfaces with customers to deliver the product.
  • A risk team identifies fraudulent transactions or account openings.

The new paradigm involves highly-specialized firms that can focus on a specific value function of the product offering:

  • A general manager still decides what products and terms it will offer.
  • Affiliate marketing companies specialize in attracting and delivering the right customers.
  • Third-party counsel ensures that the product remains in good regulatory standing.
  • A chartered institution provides access to the banking system.
  • A software company provides the core-banking software to track accounts and transactions.
  • A PFM front-end application interfaces with customers to deliver the product.
  • Data and services providers deploy best-in-class risk models.

The old paradigm resembles a farm-to-table tavern, whereas we’re heading towards a modern shopping mall food court, where recipes themselves may be patented, the menus and ordering software are delivered as-a-service by a third party, and the food involves a complex supply chain with varieties of suppliers for each ingredient. It might be difficult to even say who is the primary proprietor or entrepreneur in this new world!

Why is this happening? I think this fragmentation is being driven by three factors:

  • Hacker Technologies
  • Financial Technologies
  • Competitive Pressures

Why is this happening? Hacker Technologies

Software developers are the ultimate entrepreneurs. Good software developers have an ethos of hackerism — embodying the idea that you can combine existing tools that others have built in novel and creative ways to achieve pretty much anything you can imagine. My favorite computer science professor, Sanjeev Khanna said during a randomized algorithms class, “the best computer scientists are the laziest ones”. This is also the essence of entrepreneurialism, to create value from thin air, to take a collection of resources and combine them in such a way that the new creation’s value is greater than the sum of the value of the components separately. When you work with software developers, you realize that the good ones know about and understand a lot of different technologies, and when and where to apply them. They don’t even need to be particularly adept at applying them! (The best engineers are, of course)

Hackers gonna hack

Because of all the investments in software development and technology (A side thought, I wonder how much have we invested, cumulatively as a species, on computer technology?), we are developing an understanding of how to make hacking easier, especially in software. We have developed protocols like HTTP-based restful JSON APIs that act like the universal system keeping the pieces snapped together in our lego-like creations. We understand how to write and develop APIs, how to handle security concerns across lego pieces, and how to organize and share resources across companies (consortium-as-a-service, anyone?). These developments have lowered the cost of market-based, inter-enterprise cooperation to build products, and financial services are no different.

Why is this happening? Financial Technologies

There have been some major advances in technologies that are relevant for financial services, and from the study of the management of technology we understand that incumbents are not good at incorporating new technologies (for one narrative amongst many on this topic see The Innovator’s Dilemma). These times of technological disturbance give an opportunity for new firms to develop valuable core competencies that incumbents cannot.

One area of technological innovation is regulatory. I do consider regulation and government technologies (so does Sid Meier!). To friends who have been grumbling about the most recent election cycle as evidence of the shortcomings of the American system, I would remind them that Winston Churchill famously said, “Democracy is the worst form of government, except for all the others.” While Silicon Valley technologists and Fortune 500 captains of industry alike bemoan the slow pace of innovation, and the general perception is that changes to government and regulation are reactionary rather than proactive, they do occur. For example, the OCC is currently considering a new fintech charter (search “grant national charters to fintech companies”). The incumbents are less likely than upstarts to use these new regulatory technologies to their advantage.

For business-nerd hipsters, “Big Data” and “Blockchain” are overly-used and -mainstream terms, but like Justin Bieber you boycott them at your own peril (hate if you will, but I have put my proclivities and prejudices aside and succumbed to Bieber-fever).

Big Data and Blockchain: on the verge of greatness in 2016

The incumbents are paying a lot of attention to these two broad categories and have a lot more resources than upstarts do. Nonetheless the playing field has been leveled.

Why is this happening? Competitive Pressures

This is a simple concept, but regulation disproportionately impacts incumbents, because they already have sunk costs and boots on the ground. Upstarts are agile and can create anew without legacy systems to convert and make compliant. Goldman Sachs equity research (March 2015) can say the rest better than I possibly can:

New challengers are threatening the large financial services incumbents’ profit pools. I wrote recently about the credit card being unbundled by marketplace lending and real-time payments — this is but one example amongst many of financial products being unbundled and offered in a best-in-class product like Transferwise (retail FX and remittance), Venmo (peer-to-peer payments), Dwolla (business-to-consumer payments), or Xero (cash management software combined imminently with financial services for small businesses). Goldmans Sachs’ equity research report (March 2015), states their expectation that “$11bn annual profit [is] at risk to leave the banking system.” In a way, this paragraph is less a cause than an effect of this thesis on fragmentation? Long live competitive free markets!

Introducing: The Bank of Web Services

Innovation in the financial services space is limited by the fact that we don’t have an AWS of banking. Today, for the most part, we rely on the banks to innovate, and they’re too focused on being banks to do a great job of it. There are, of course, non-bank innovators that fill in the gaps, such as in marketplace lending, payments, and PFM, but their ability to innovate and create new financial products are severely limited by their connection to a bank charter, and they depend heavily on chartered institutions. They can’t hack. For example, almost all non-bank products use the same three providers (Yodlee, Plaid, or Intuit) as their data connection to banks. Everyone is using these same sets of APIs that still use screen scraping in the back-end, and it is hard to create a differentiated and compelling product experience because the incumbents aren’t limited by these third-party APIs. There are only a few boring types of lego pieces available, and they’re all in the same three colors.

This Bank of Web Services, as I shall call it, would focus solely on providing financial services through APIs. The product dashboards would be secondary and administrative in nature. Its primary customers would be software and application developers, instead of the consumer or enterprise end users of the financial services. The integration between non-financial services and financial services could then be tightly coupled, and any application can offer access to financial services in a native way. You don’t need to be in your bank app to access banking services.

In the US, BBVA is leading the charge, but SVB (who acquired Standard Treasury, YC’13, which tried to implement exactly this model), Wells Fargo, Capital One, and others are close behind. However, like discussed above, they are incentivized to drag their feet, for the same reason Apple ignored music streaming — it cannibalizes their existing businesses. The incumbents have mostly limited their activities in “API Banking” or “Open Banking” to hackathon sandbox APIs and very limited public APIs. The European Parliament has actually introduced legislation to force this issue by regulation. “PSD2” requires European banks to provide third-party read and write access to customer accounts.

There are also upstarts providing fintech companies with “charter relief”, but they are woefully lacking in technological capabilities and prioritization. For example, Cross River Bank was in the news recently for raising venture capital. However, it and its peers do not appear to be hacker-friendly or hacker-focused. Where are their API docs? Git repositories? Open-source communities? Hackathon events? General support and love for startups? Medium posts about this topic?

When this Bank of Web Services is created, it will allow a hundred fintech flowers to bloom. Here are a few examples of possible blossoms:

  • Accounting, cash management, and ERP become one
  • A PFM (the operating system of retail finance?) where you can provision new accounts and have direct and full access to best-in-breed retail products in an application marketplace (FX, remittance, lending, roboadvisors, payments, insurance, etc.)
  • Financial services for things — in the internet of things, an object like your fridge can become a banked entity and have its own bank account for transactions
  • Marketplaces like Airbnb, Uber, and Instawork gain tighter control over financial services, and can offer financial services to both sides of the marketplace directly
  • A cashless personal portfolio or PFM where personal income and expenses are immediately translated into and out of yielding assets (like stocks, fixed income securities), so that consumers no longer hold any non-yielding monies

Will an incumbent get there first? Or a startup? Creating a de novo bank has gotten significantly harder since the financial recession, although the FDIC is taking steps to make it easier most recently.

Who wants to start a bank with me?