Legacy Banks Too Costly For Our Digital-First World

Digital challenger banks have been on the fringes for over a decade, with some notable successes, primarily in Europe, where banking is highly concentrated in a few old, large banks and negative interest rates force a fee-centric business model.

The COVID-19 pandemic is accelerating the world’s move to digital everything — online meetings, online shopping, streaming movies, online banking, and more. Just as traditional retail, despite having web sites, ecommerce and apps, can’t win against Amazon, traditional banks will not be able to compete against digital-only alternatives. Its just a matter of time, and that time is now much closer than before.

Traditional banks built their business in the physical world — you spend $3M to place a branch in a decent neighborhood and you go about gathering cheap deposits (Chase “High Yield” savings now pays 0.1%) and finding borrowers locally. The easiest way for a bank to mitigate credit risk is literally by lending to people you know in neighborhoods you know. Yet, the borrowers would just as likely prefer to sit in their home or office and find the best mortgage or business loan online — but banks make that difficult and really press you to come into the branch. Why? To generate decent branch economics (justify that $3M investment), to pay branch employee salaries (it costs an average $1M per year to run a branch), and to cross-sell.

That’s fine for the bank but these are not things that customers value. Customers want convenience, speed, transparency, and security at a low cost. Unfortunately, traditional banks are not built to provide low cost and their cultures are rarely, if ever, about convenience, speed, or even transparency. Just look at how complicated they make their fee schedules.

Traditional banks are powered by legacy technology — software systems that are often from the late 1980s — that is 40 years old tech! (I know first-hand because I was a COBOL programmer in the late ’80s). But, how old is your laptop? Your phone? In an effort to keep up, banks plug new tech on top of the old tech, because you just can’t change tires and engines while driving down the road. Now, a legacy bank’s new website and phone apps might look cool and even work well but, they don’t reduce any IT costs for the bank — they actually add costs. As for ‘digital transformations’, those take 3–5 years, costs north of $300M and fail to meet expectations 70% of the time.

Major banks spend north of $10Bn/year on IT, and yet 70% of that is purely maintenance spend to “keep the lights on”. The $3Bn in innovation/ development spend is massive but it simply does not reduce the $7Bn spent on maintenance every year. Banking seems to be the one place where Moore’s Law is actually inverted — every year the cost of computing actually goes up!

What this means for bank customers (depositors and borrowers alike) is that deposit interest rates are anemic (or, in cases such as in Europe, are actually negative) and borrowing rates are considerably higher than they need to be. In the US, a typical bank might pay 0.1% interest to gather funds in deposits and then lends them out in collateralized mortgages at an average of over 3.25% — which happen to be historical lows.

That means the bank takes over 3% to cover their costs and profits. And, just as gas will fill the chamber, costs grow to fill the available space provided by revenues. All traditional banks have similar costs structures…product/market fit was discovered hundreds of years ago and the model is largely unchanged since the de’ Medici family pioneered modern banking. Branch costs correlate to real estate and construction costs, which correlate to the wealth of local economies. Same for salaries. As for IT, just 3 companies command a 93% market share for core banking software in the USA and they all price about the same (roughly its $1 per account monthly).

As for “neo-banks” (non-bank fintechs), they are yet more new tech on top of the old tech. Your typical neo-bank (a la Chime, Varo, MoneyLion, etc) is basically a prepaid card powered by a 3rd party processore (eg. Galileo, Marqeta, FirstData) sitting on top of card issuer bank (eg. Bancorp, MetaBank, Lincoln Savings) that runs on top of one of the 3 major bank core software platforms referenced above. These “neo-banks” are charged roughly $2 per account monthly by their banks. Now, because they don’t have branches, their costs are lower overall. Whereas a typical full-service bank might have costs of around $10/month per account, a neo-bank might operate at half that expense (yet with great variability due to marketing expense). But, ultimately, a neo-bank can’t get away from the $2/month base charge levied by their bank. And, typically, they don’t do lending and, even if they do, their source of funds is not cheap deposits but, instead if venture capital or hedge fund wholesale debt financing.

Pure digital (real) banks are few and far between. DBS in India, Webank in China, Banco Original in Brazil, Fidor, Solaris and N26 in Germany, Revolut, Monzo, and Starling in the UK are notable. These standouts not only might garner hyper growth and ‘unicorn’ status but also demonstrate economies of scale unlike traditional banks. In a legacy bank, you add 100,000 customers and your IT bill from Fiserv or FIS goes up $100,000 a month; in a neo-bank, you add 100,000 cardholders and the bill from your bank goes up $200,000 a month (pretty simple to figure this one out: $100k goes to the IT companies and $100k goes to the bank). But, a pure digital bank operating mostly proprietary software systems whose vendors are not part of an oligopoly, actually sees lower variable costs as it adds customers. This is what excites venture investors and drives unicorn status. And, it’s what allows a pure digital bank, in particular a cloud-native digital bank, to lower its fees, increase its deposit rates and lower their lending rates. Instead of needing 3.25% spread to cover costs and profits, a digital-only bank can operate profitably at a 2% spread at scale.

If you prefer to shop at Amazon, or buy your music online instead of a record store (!), or book your travel online instead of at a travel agency (!), you likely now prefer to bank and borrow online. Sure, traditional banks offer that but if the deposit rate is 0% and the borrow rate is 3.25% vs a online-only bank deposit rate of 0.5% and borrow rate of 2.5%, where are you going to take your business?

Convenience, speed, transparency, security and cost. I cannot imagine an argument that any one of those is better in a brick’n’click’n’mortar bank than in a purely digital bank.

The author is CEO of Medici Bank, a cloud-native, digital only bank charted in the USA and built to bank companies and individuals from around the world.

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