Accelerating digital transformation in small banks

The banking sector stands at an important crossroads, propelled by swift advancements in artificial intelligence (AI) and digital technologies. Banks are faced with the choice of adapting quickly to a digital-first era to better serve their customers or an erosion in their customer base and financial strength.

Small banks, the lifeblood of local economies, are well placed to gain from digital transformation. It offers exciting opportunities to enhance operational efficiency, improve customer service and expand product offerings and their customer base. However, these banks face some particular challenges—how to prioritize digital investments over day-to-day operational expenditures, how to attract and retain the right talent to maximize gains from those IT investments and how to make substantive change amidst difficult economic and competitive conditions.

Speed is of the essence. Indeed, moving slowly is tantamount to moving backward in today’s digital-first economy. Yet, accelerating transformation doesn't mean sacrificing diligence; on the contrary, it necessitates heightened oversight and control to drive successful strategic change and secure a competitive stance in the long run.

• Digital transformation is inevitable: For small banks, revamping operations with digital technology is critical to competing in a market increasingly dominated by mobile banking and elevated customer expectations.
• The lifeline of fintech partnerships: Collaborating with fintechs could be highly beneficial, offering access to innovative tools to boost efficiency and enhance customer service without the prohibitive costs of building in-house capabilities.
• Elevating risk management: As small banks venture into fintech partnerships, a thoughtful approach to managing strategic, operational and compliance risks is required so they uphold customer trust and satisfy regulatory demands.

Pace and scale of industry change

The swift evolution of banking sector dynamics necessitates an immediate and strategic response. Fintech companies, known for their agile operations and digital-first strategies, are redefining banking services standards. Concurrently, larger banks are aggressively pursuing digital transformation, using their extensive resources to offer sophisticated digital banking experiences.

• Digital reshaping banking: Industry change is real. For example, the Federal Deposit Insurance Corporation (FDIC)[i] has highlighted a stark shift to mobile banking, away from online and branch-based banking. Banks are under pressure to integrate digital solutions to address these new demands.

• A fast-consolidating banking sector: This competitive environment is further strained by the banking sector's ongoing consolidation, evidenced by a halving in the number of banks insured by the FDIC in the last 20 years.[ii]This trend towards fewer, larger banks is felt disproportionately by smaller institutions.

• Customer expect tailored, digital-first offerings: Today's customers want seamless, intuitive and instant banking services. They expect banks to use new technologies to create better experiences. A 2023 Zendesk report[iii]found:

o?? 72% of customers want immediate service.

o?? 70% expect anyone they interact with to have full context.

o?? 62% think experiences should flow naturally between physical and digital.

o?? 62% agree personalized recommendations are better than general ones.

Data from the Federal Reserve[iv] suggests this change towards digital banking is increasingly pronounced for Generation X and younger generations. For small banks, meeting these digital-first expectations is central to customer retention and acquisition, necessitating significant operational and service transformations.

Fintech partnerships offer real opportunity

The reality is smaller banks are constrained in their ability to transform digitally. They already face tough economic conditions: community banks reported full-year 2023 net income of $26.6 billion, down $2 billion (7.1 percent) from the prior year.[v] The ever-increasing cost of regulatory compliance, especially for those banks passing important regulatory thresholds (e.g., $10 billion in assets), reduces funds available for technology investments.

That’s where fintech come in. The opportunities to partner with these innovative new companies are enormous. The Federal Reserve highlighted[vi] three types of partnerships for community banks:

• Operational technology partnerships: This is when a local bank uses technology from another company to make its own work processes or systems better and more efficient.
• Customer-oriented partnerships: This happens when a local bank works with another company to improve parts of its business that deal directly with customers, while the bank keeps its direct relationship with its customers.
• Front-end fintech partnerships: In this setup, a bank mixes its own systems with technology from a fintech company. The fintech company deals directly with the customers, providing them with banking products and services.

The relationship between small banks and fintechs can take various forms, from investments and alliances to commercial partnerships and technology integrations. Each model offers different advantages and challenges. For instance, a strategic investment in a fintech company can provide a bank with a direct stake in innovative technologies, while commercial partnerships might offer more flexibility to experiment with new services.

However, engaging with fintechs can be challenging. Their service offerings and pricing structures tend to be highly skewed to larger banks and many fintechs do not take the time to understand and meet the specific needs of community banks. Moreover, the sheer number of small banks and fintechs makes it hard to find the right partners; to both sides, it can feel like finding a needle in a haystack.

National and local banking associations are increasingly playing an important role in this context. They are hosting in-person or virtual forums for their members to meet fintechs. Some are going further by developing direct partnerships with fintechs to offer white label offerings to their members. Such offerings have to be scaled to smaller banks and at a price point that is reasonable for these institutions.

“By collaborating with associations and fintech companies, community banks can leverage collective expertise and cutting-edge technology. This partnership not only creates cost efficiencies but also ensures that we provide our customers with the most advanced, secure, and user-friendly banking solutions available. It's about pooling resources and creating scale to bring about mutual benefits—enhancing competitive edge while delivering superior value to the communities we serve.” – Richard Perez, VP for Innovation, Texas Bankers Association

Thorough partnership assessment

Federal and state banking regulators have been increasingly demanding in their expectations of how smaller (and larger) banks manage their fintech relationships, for example, in their 2021 guidance on community banks’ due diligence of fintechs.[vii] They have shown a willingness to call out banks that do not meet their expectations, as seen in several FDIC public consent orders in the second half of 2023.

Banks need a solid approach to assess potential fintech relationships:

• Clear and aligned strategic clarity digital ambitions: Significant fintech partnerships should support the bank's long-term objectives, such expanding into new markets, enhancing customer experience or improving operational efficiency. According to Boston Consulting Group, banks that align their digital transformation efforts with their strategic goals are twice as likely to achieve breakthrough performance.[viii]
• Comprehensive assessment framework: Banks’ frameworks should consider strategic alignment, cultural fit and technological compatibility (including the technology ecosystem, scalability and integration capabilities). Federal regulators expect banks’ due diligence to cover each fintech’s market position, overall business, financial strength, ownership structure, leadership team and legal and compliance record.
• Compliance and risk assessment and monitoring: Regulators’ most demanding expectations relate to a fintech’s ability to comply with all relevant banking regulations, licensing requirements and supervisory expectations. Through regulations, guidance and enforcement activity, regulators have highlighted a range of risks that smaller banks have to manage in their fintech arrangements:

o?? Strategic risk: There's a risk that a fintech partnership may not align with the bank's strategic objectives or fail to deliver the expected value. Regular strategic reviews and performance monitoring can help manage this risk.

o?? Consumer compliance: Fintech products and services must comply with existing consumer protection laws and regulations. This includes adherence to fair lending practices, transparent disclosure requirements and the prevention of unfair, deceptive or abusive acts or practices.

o?? Privacy and data protection: With an increasing volume of personal data being processed, privacy and data protection are paramount. Banks must confirm fintech partners adhere to stringent data protection standards, such as the California Consumer Privacy Act, to safeguard customer information.

o?? Operational resilience: The reliance on fintech solutions can expose banks to operational risks, including system failures, downtime and service disruptions. Maintaining operational resilience requires robust contingency planning and continuous monitoring of fintech partners' operational capabilities.

o?? Cybersecurity threats: Cybersecurity is a central concern because fintech partnerships often involve the integration of digital platforms, increasing the potential attack surface for cyber threats. Banks must have comprehensive cybersecurity measures in place, including encryption, intrusion detection systems and regular security assessments.

o?? Anti-money laundering (AML) and counter-terrorist financing (CTF): Banks must validate that fintech partners have robust AML and CTF controls in place to prevent misuse of financial services for illegal purposes.

o?? Intellectual property: Collaborating with fintechs can raise issues around the ownership and protection of intellectual property. Clear agreements defining the ownership rights of developed technologies and solutions are essential.

All these risks present as vendor risks that need to be well managed in line 2023 interagency guidance issued in 2023 on third party risk management.[ix] As then-Acting Comptroller of the Currency Michael J Hsu asked, in 2022, “How do banks and their third parties view and treat customers in bank-fintech arrangements—when do customers go from being the client to becoming the product and how are consumer protections maintained? How resilient are banking services to stress at fintechs? What happens when fintechs fail? How are bank and fintech business models changing and how are incompatibilities reconciled?”[x]

Rigorous implementation and execution

For small banks, the successful implementation and execution of digital and fintech initiatives requires hands-on management:

• Strong governance: Effective implementation of digital initiatives begins with a clear roadmap that aligns with the institution's strategic goals. It is important to establish a governance framework to oversee implementation with clear objectives and key results (OKRs), milestones, key performance indicators (KPIs) and key risk indicators (KRIs). Executive management should establish cross-functional teams so integration of digital solutions spans the organization, including all key groups, including risk management and compliance, early in the process.
• Managed change: Actively managing organizational change is foundational. Effective communication and stakeholder engagement mitigates resistance and fosters an environment conducive to change. Senior management has to visibly lead and champion change, emphasizing the importance of urgency, identifying powerful and respected change agents and generating and celebrating near-term wins.
• Innovative culture: Fostering an innovation culture requires more than just engaging with fintechs; it demands a shift in mindset across the organization. Encouraging experimentation, celebrating failures as learning opportunities and promoting cross-departmental collaboration are effective strategies.
• Enabled employees: Purposeful, targeted investments in staff training and development enable the workforce to be equipped with necessary skills to adapt to new technologies and processes. Tailored training programs that focus on digital literacy, data analytics and customer-centric service design enhance staff capabilities and confidence in delivering digital banking services.
• Clear customer communications: Communicating the nature and benefits of fintech partnerships to customers builds trust and manages expectations. Transparency about how these partnerships expand product offerings or enhance customer experience reinforces customer loyalty. Banks should use multiple communication channels and feedback mechanisms to effectively convey their message and capture and adapt to customer feedback so it drives loyalty and adoption.
• Tracked and measured success: Proper oversight of the bank’s fintech partnership supports the realization of expected benefits, manages risks and conveys a sense of strong oversight to regulators. Senior management—and boards of directors for truly strategic relationships—should receive routine reporting on OKRs, progress against milestones, KPIs and KRIs.

Conclusion: Time to act

Small banks have long shown an ability to adapt and remain customer centric. The sheer scale of the US banking sector, consolidation notwithstanding, shows these institutions’ staying power. However, the pace of transformation in the banking industry, driven by advancements in digital banking and fintech players, is significant and, arguably, unprecedented. Customers expect more accessible, tailored, interactive, cheaper and diversified products and services.

Some smaller banks have found ways to invest in their own digital transformation and be successful. But many don’t have the resources to go it alone. Those institutions have to look to fintechs for solutions. Such partnerships offer potential opportunities to retain customers, improve operating efficiency, drive up profitability and even target customers beyond their typically geographic footprint. They can enable banks to transform much faster than otherwise.

But, finding, evaluating, selecting and managing fintech partners is no easy task. A strategic, thoughtful and thorough approach is required to be successful and to meet evermore demanding regulatory requirements.

Authored in collaboration with Kimberly Askwith , President, Wedge.

[i] Federal Deposit Insurance Corporation. (2019). 2019 FDIC National Survey of Unbanked and Underbanked Households.

[ii] Federal Deposit Insurance Corporation. (2023). Statistics at a Glance: Quarterly Banking Profile.

[iii] Zendesk. (2024). Customer experience in banking.

[iv] Federal Reserve. (2022). Market readiness brief: Faster, mobile payments go mainstream as Gen X usage catches up to millennials.

[v] Federal Reserve Bank of Kansas City. (2013). Community bank funding is getting costlier and riskier.

[vi] Federal Reserve. (2021). Community Bank Access to Innovation Through Partnerships. https://www.federalreserve.gov/publications/files/community-bank-access-to-innovation-through-partnerships-202109.pdf

[vii] Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency. (2024, May). Third-Party Risk Management: A Guide for Community Banks.

[viii] Boston Consulting Group. (2021). Digital Transformation in Banking: The Future is Now. BCG.on Consulting Group/

[ix] Federal Deposit Insurance Corporation. (2023). Interagency guidance on third-party relationships: Risk management.

[x] Hsu, M. J. (2022, September 7). Safeguarding trust in banking: An update. Acting Comptroller of the Currency Remarks at the TCH + BPI Annual Conference.