Banks and their business model

The major business model for large banks today are based on taking in deposit, add money from issuing bonds and other funding, and then use the money for making loans to private persons and companies. Interest in from loans is larger than interest out to depositors and bond investors. The margin is the net interest income to banks. For Nordea bank this business model accounts for 50 % of 2015 revenue, down from 54 % in 2014, and for DnB (the largest bank in Norway) it is 71 % in 2015 down from 78 % in 2014. The same trends are for most large banks in Europe.

Picture from: www.lookandlearn.com, artist: Pat Nicolle.

This business model was invented by the Medici family in Florence in Italy around 1450. Before that banks only took deposit and stored it safe for rich families. The Medici bank started to make loans to private persons and companies from the money their customer deposited. In addition they put some of their own money on the table (they was considered one of the riches families in Europe).  They even printed their own coin, the Florin that was used for trade among businesses all over Europe from 1450 to approximate 1650. (€ version zero)

We are at the brink of a paradigm shift now. TBTF (Too Big To Fail) is replaced by (TBTC) Too Big To Change, and is becoming a fundamental risk for all large banks. As the total loan market have increased by approximate 6 % every year last 3-4 years in Norway, large banks loan have increased by only 2-3 %. This means they lose their market share, and within another 10 year they are not any longer system critical financial institutions. The business model is simply not scalable any longer in the digital age.

PayPal, Apple Pay, Google Wallet, AliPay, Klarna and a bunch of other digital payment platforms takes part of banks payment income. Crowdfunding, peer2peer loans takes part of loans and corporate banking market. Bank Norwegian, IKANO, Audi bank, GE Money bank, and other nice banks takes part of the highly profitable loan market with a digital core and scalable business models. By digital core I do not mean digital lipstick, like Vipps from DnB or MobilePay from Danske Bank, I mean everything in the bank is digital, processes are based on digital support and employees are selected to fit the digital delivery.

As Chris Skinner write in his latest book “Value Web”, the biggest banking challenge is leadership”.

I am 100 % sure that the Blockchain technology will change the way most people do banking in the future. I will write a new post on Blockchain next week. The question is if banks will leverage or fail on the new technology. In the history many large companies managed to leverage on new technology like bookstore opening internet store to compete with Amazon and airline companies opening digital ticket booking and boarding pass by smartphones.  But many have also failed like Kodak and Nokia, trying to fight the technology rather than leverage on it.   

Are roBOTS the next technology focus for banks?

Are you irritated by Apps automatically updating and consuming your battery power by themselves on your smart phone? It might happen next generation mobile device infrastructure solves this problem. Remember Apps are installed on your mobile device, like old fashion software application.

1990’s

Some 20 years ago one bought application in the shop, received a CD and user manual and installed the software from the CD. The processor power was your computer or local network server.

2000’s

Then the web application hosted in the cloud took over and no need to install anything on the computer any longer. You needed only a web access and browser, the processor power was on the hosting server in the cloud.

2010’s

But when Apple launched App Store we went back to old days thinking, installing application on your device, using processor power on your mobile device. The apps need to be updated with last versions from time to time.

2020’s

Next move seems to be back in the cloud, also for mobile devices. Social media like Facebook and WeChat is more and more depending on text message infrastructure like the Facebook Messenger and WhatsApp (more than a trillion monthly active users). As Mark Zuckerberg of Facebook told us 12^th April, the next step is to add robotics on top of the text message infrastructure. Bots is short for robotics. Bots are usually powered by artificial intelligence that “understands” a text message. Bots are stored on cloud servers, NOT in your mobile device. And it uses a new business model, based on micro payment. Bots are MUCH faster than Apps, and have processor power thousands times of average Apps on a mobile device. This enables bots to analyze and make decisions for you on a more advanced level than an App.

If you want move money from one bank account to another, send a message to your bank “transfer 100 € from my main account to my saving account”. Or “pay Peter Pan 100 € tomorrow”. There are some security issues of cause, but this will be solved.

If you need a flight ticket send a text message to SAS “Book a flight next Monday around 10.00 from Copenhagen to Stockholm.”  The artificial Intelligence logic inside the bots choose what’s best for you and know your preferences, might  have access to your calendar, and the people you are supposed to meet. This takes you a few seconds, compared minutes to using the web or App today. And you will trust the bots to do excellent decisions on your behalf.

Vertical vs. horizontal banking infrastructure

Horizontal banking infrastructure

Back in 1980’s banks in the Nordic worked together when it comes to technology and payment solutions. In Norway we got “Bankenes Betalings Sentral” (BBS) (Banking Payment Central) a joint IT company to support payment between banks and their customers. In 2010 BBS was merged with PBS (Denmark) to make Nets as, and is now operating in Norway, Denmark and Sweden. As a result, payment in the Nordic was far much faster and better and efficient than anywhere else in the world. This has up to recently also given the effect that PayPal and other alternative payment platform has not gained high penetration.

The payment infrastructure was vertical, whatever bank you used they was linked to the common payment infrastructure. If you for example had you bank account in Spare Bank 1, and used a ATM from Nordea bank, it worked perfectly well. And the cost for the customer was very low. When banks customer paid in store and online in Norway, they used “BankAxept” a joint payment solution. Up to recently almost all customer payment in restaurant, shops and store used the POS (Point of Sale) BankAxept solution. In contradiction to for example Germany where you needed to use ATM from the bank you banked with. Today most ATM uses Visa or MasterCard, and the effect is the same as in the Nordic, only that cost of withdraw from ATM is higher.

The beginning of the end?

In the Nordic banks started to balkanize this strategy some years ago. DnB have their Vipps, Danske Bank have their MobilePay, Spare Bank 1 has their MCash, Nordea have SWIPP, and so on.

Even if they use Nets for payment in the back, the front seen by the shops and customer have changed. Grocery stores, shop and restaurants need to have multiple payment solutions at their cash and payment counter as different bank is not seamlessly connected. The result is that stores and restaurant need to choose what bank and POS to bank with. Banks compete with each other to have most stores, restaurants and online-platforms on their customer list. (at least in Norway) This increases stores cost and complexity. And worse it increases frustrate of banks customers, both the end private person customer and the small and large stores.

And who is losing from this in the long run – banks are. On top it opens up for new payment platforms like Apple Pay, Google Wallets, Klarna, STREX and others where banks are not necessary a part of the payment value chain.

PSD2

PSD 2 (Payment Service Directive) is a new EU directive for vertical banking strategy. Banks have to open up for trusted 3^rd party software provider to aggregate information from all EU operating banks. This includes issuing payment transaction. I guess EU’s strategy is to create more competition among banks and give customer better services. PSD 2 is agreed on, and will come in full effect from 2019. Each country has some time to change their laws to align to PSD2.

As long as banks irritate customer and large store chain by Balkanizing the payment infrastructure the future becomes easier for 3^rd party providers to take large part of the payment volume in the future.

Vertical infrastructure

Once upon a time people banked with one bank, and some do still. You received your salary there, you have all your loans there, you have you MasterCard there and you do all your payment there. Some even used same brand for all their insurance.

You might call this a silo.

Not many people do the same today. They might have loan where the interest rate is lowest, Credit Card where fees are lowest or travel insurance is best and do their pension saving where expected profit and future money level is highest.

Younger people tend to swap banking more often than older people, focus on smarter banking and best-of-breed. Younger people become banks main customer in the future - the trend is clear.

  

The new programmable economy

I have been diving into the Blockchain technology last 4-5 months. The deeper I come the more I understand that this technology might change our future dramatically. It is not a next version of what we do today, it is something completely new.

I just read a Gartner document with the title “Hype Cycle for the programmable economy”. And I loved the word programmable, because that’s what this is all about.

I will not dive into Blockchain here, and recommend you to watch some of the videos on YouTube or read any of those hundreds of excellent articles online. In one “transaction” on the Blockchain one can store a script. This script can be triggered by an event.

Scrip might like this:

Peter transfer 100 Euro from his dya-2-day wallet 36273fae36462cce4637 to his pension fund wallet no 3217eah3523e25623526 every month the 10^th. When the amount is more than 100 000 Euro, the monthly amount is reduced to 25 Euro. When Peter is older than 70 years old, the transfer stops. If the interest rate is zero or below, do not transfer next month.

From http://www.dnacapsule.com/

The business logic is inside the transaction in the distributed database of Blockchain. The database is distributed, meaning that it is outside the bank’s technical infrastructure.  It is transparent to other banks, central bank and regulator. 

It is 100 % safe and with, if possible, better security that present payment and banking systems. It is something completely new.

This means that most of the computer system that all banks run today might be obsolete in 5 to 10 years, so are a lot of the processes internally in the bank. But is not only banks, it is telecom companies, supply chain management, hospitals, pharmacy industry, hotels, …. you name it.

Algorithm in the future of banking

This blogpost is based on an article in Harvard Business Review January-February. This again is based on the book Algorithm Need Managers too, by Michael Luca, John Kleinberg and Sendhi Mullainathan.

Algorithm and robots are on the agenda for most banks and financial institutions today. Big Data analytic can aggregate large number of data, both from internal sources in the bank, from the market (stock exchanges, Forex markets, interest market and other markets) and other external sources. It is the way we use the date and how we design our algorithm that makes the difference.  And that we do understand what algorithm is not good at.

Netflix had a million dollar competition some years ago to develop an algorithm that could identify which movies a given user would like, teams of data sciences joined forces and produced a winner. But it was one that applied to DVD – and as Netflix user’s transitioned to streaming movies, their preference shifted in ways that didn’t match the algorithm prediction. It is a difference between movie one would like to buy and the movie one would like to stream now.

Within marketing there are algorithms that estimate what information users are likely to click on. Google have such algorithm. The target of clicks for the marketing company is to sell more, generate revenue and profit. Most of these clickable algorithm does not estimate efficiency of sale and profit, “only” what generates most clicks. It is important to know what these kinds of algorithms is good at and what they are not so good at.  

In the latest Avengers movie, Tony Stark (also known as Iron Man) created Ultron, an artificial intelligence defense system tasked with protecting earth. But Ultron interprets the task literally, concluding that the best way to save the earth is to destroy all humans.

This is the core of an algorithm – is does exactly what it is designed to do. We human might have soft goal. For example it might be best to have a short time loss, for a long time profit. We might strive for equality – even if it causes organizational pain in the short term.

Often one algorithm is used in different situation. There are a lot of example where for example a marketing algorithm works perfect in one country, but not at all in another country. So - design you algorithm for each situation is of extreme importance.

Also remember that correlation still doesn’t mean causation. Suppose that an algorithm predicts that short tweets will get re tweet more often than longer ones. This does not in any way suggest that you should shorten you tweets. This is a prediction, not advice. It works as a prediction because there are many other factors that correlate with short tweets than make them effective. This is also why it fails as advice: Shortening your tweets will not necessarily change those other factors.  

New technology like Blockchain enables banks to easier automate and leverage on technologies like robots and algorithm.

When will banks really leverage on Blockchain?

Most banks today invest in the Blockchain technology. But so far none have launched a “killer app” or any user case that could not be done better with the “old” technology. But I think it is only a question about time before someone present something with real value.

The technology is far too premature to add real value to banks as it is now. Diving into the technology is a about basic discussions like record size, programming language, how to design smart contract script classes, what platform to choose (Chain, Eris, Intel, IBM Open ledger, Ethereum on Microsoft Azure, Ripple, etc.). And I guess there will be more platforms in this competition soon.

Then it is the question on consensus mechanism, what is safe enough and compliant to regulations. And finally the speed & scalability issue. No one have so far managed to set up a Blockchain network in a sufficient size handling 15 000 to 20 000 transactions per second. 

Despite the fact of maturity; bank, tele companies, companies within logistics and other sectors worldwide invest billions of USD in research, piloting and testing this new technology.  Something will change, that is for sure.

I was presenting at BSK Blockchain day on Thursday last week giving 5 reasons for why Blockchain MIGHT revolutionize the financial industry. It is not difficult to find even more reasons. BSK is a union of Norwegian banks.  In the audience were approximate 150 people from many banks, central banks and financial authorities.

https://www.fno.no/contentassets/d30e15c520ab45bcafbfbc74e3aa41ea/program-for-fagdag-om-blockchain.pdf

So back to the question, when?

My guestimate is 1-2 year before the technology is ready enough for a “killer app”. During this time banks will pilot, get some experience and get their “hands dirty”. Then when the technology is mature enough they are ready to launch real value, in 3 to 5 years from now.  Remember, at one point in time banks need to integrate the new technology into their legacy IT architecture. At larger banks this is often a complicated and a time consuming project.

Experience in technology last few years shows that a “fast follower” strategy is not a good strategy, and I guess same thing this time.

SWIFT - Will banks use Blockchain, the technology behind Bitcoin?

Yes they will.

At least they have decided to put a lot of energy and investment into finding out if they can use it. Nordea and SEB in the Nordic are members of the DLG (Distributed Ledger Group) together with some 40 other banks, including Goldman Sachs, Citibank, BBVA and Santander. There are other groups of banks as well.

Blockchain may completely revolutionize the whole banking industry.

It might enable you to pay your invoices at close to zero cost and in seconds. Even payment cross borders of countries will be low cost and almost instant. The technology also enables contract to be shared and securely signed between banks and customers, so called “smart contracts”. “Smart contracts” might also include a Java Script type of macro, for example “First change ownership of the asset, then do the payment”.

I will come back with a better description on the Blockchain technology within a few weeks. 

For now I will just inform you that I will be on a Blockchain panel at SWIFT Nordic conference in Oslo early March.  

Have a look, agenda day 2:

https://www.swift.com/insights/events/swift-nordics-regional-conference-2016