Why isn't Banking more Boring? Part Five

In this instalment we return to the claim we made in Part One - that over the next three to five years it is reasonable to expect that one or more banks will emerge that demonstrate the banking-equivalent of Musk’s "boring" strategy. A bank that is based on a platform architecture that enables it to have and maintain a strategic cost advantage and - crucially - has the ability to leverage it for scale acquisitions. We have positioned how something like this might be possible. However, is it probable?

Tunnel Boring 3: Rise of the machines

Setting aside macroeconomic conditions, the pressure to further lower costs across the industry comes from three main sources - New Entrants, Marketplace Banks and Open Banking

• Most new entrant banks believe they will have a strategic cost income ratio advantage if, or when, they reach scale as mature businesses. In the UK, Atom Bank chairman Anthony Thomson has said that as a mature business he expects the bank to have a cost income ratio of under 30%. A recent KPMG report on UK challenger banks reinforces this position across a range of institutions, with most not even claiming the building-free and people-light operating models of digital-only entrants like Atom. The appearance of service and platform providers such as 10X Future Technologies, Clear.Bank, Leveris, ThoughtMachine suggests a wider belief in the opportunity to introduce enabling platforms that will support a more cost-efficient and flexible operating model. The picture outside of the UK is no different, with entrants such as solarisBank being a prime example of the evolution that is happening
• Marketplace Banks and their curated FinTech partners will add to the pressure on the overall industry cost base. Their business models might be different but the impact will be the same for incumbent institutions. Loss of revenue and further cost reduction required. The ecosystem response may provide some relief, but the pressure is already being felt and will likely increase
• Finally Open Banking will bring further changes. Customers will be able to access a wider range of distributors, prices will become more transparent and the "ownership" of customer relationships will change. Notwithstanding the growth upside of becoming a product manufacturer to a wider range of distributors (including Marketplace Banks), the pressure towards a significantly more cost-effective operating model across the industry will continue to build.

Of course new entrants cannot exploit their cost advantage without scale and reaching scale is the hardest part of being a new entrant. Attracting and creating new customers is costly and is one of the key reasons incumbent banks haven't been substantially disrupted yet. Notwithstanding whether or not you believe in the death of the advertising industrial complex, attraction together with funding remains a significant hurdle to overcome.

However, imagine a scenario in two to three years time where a new entrant has scaled modestly and reached, say, one million customers. If this happens, what expectation might this create?

As an investor in an existing scaled business looking from the outside-in, the differences in operating model - digital-only vs. digital-channel & people & buildings - are likely to be discounted very quickly (especially given the general industry trend towards fewer buildings and less people). Instead you are likely to focus on how a business with a million customers can be run with no more than a few hundred employees. Your attention may turn to how that advantage can be applied to the business you are invested in.

Alternatively, looking from the inside-out, your consideration may turn to how customers can be acquired more quickly, perhaps inorganically. A reverse takeover, where a small bank with a significant cost advantage acquires a struggling, larger bank. Unlikely? It has happened before and could happen again.

The key question, then, is whether or not in the next three to five years these forces can create the expectation of a new cost income ratio norm of < 25%? I think it is delicately balanced between possible and probable, but it won't require much to push it over the edge.

The key to good decisions is not knowledge, it is understanding (M. Gladwell)

There is a lot of general theorising and academic research about the impact technology innovation will have on the structure of industries and their participants. Some of these are generalisations of specific disruptions that have happened already, e.g. Uber, Airbnb, Netflix, whilst others take established models of industries and participants and analyse the impact that technology changes will have. These include

• Fjords' Hourglass Brands trend, which predicts the brand landscape is polarising into huge platforms that can either do everything or provide a service ecosystem, whilst others will specialise with unique focus and clear purpose
• Prof. Richard Tee, who looked at the interplay between environmental drivers and enterprise-level actions to understand how these affect the architecture and design evolution of industry platforms
• Philip Evans, who starts with vertically-integrated value chains and concludes that through the reduction in transaction costs (enabled by technology) the business architecture of many industries will become industry stacks
• Prof. Martin Kenney and Prof. John Zysman who look more broadly at the rise of the platform economy and conclude that the 10x technologies—the cloud, big data, algorithms, and platforms—will not dictate our future, but how we deploy and use them will.

In banking there have been numerous similar discussions from industry participants and experts such as Ben Robinson, Philippe Gellis, Ron Shevlin and Chris Skinner. Whilst these all present subtly different views, they all predict or advocate the emergence or adoption of different business models, participant structures and overall industry structure.

Given all of this, will the tipping point be reached just by waiting long enough for these forces to take effect? Is it really just a matter of time?

I don't think so. It will be a matter of understanding

• Brooks' observation that over time new technology makes accidental complexity tend to zero doesn't mean that we inevitably get closer to the essential solution. We still have to understand the right problem to solve and then choose to solve it with the appropriate abstractions
• Ford's observation that we choose to put a lot of square pegs in round holes presents a continued impediment to reaching the tipping point. The root of this is the absence of collective understanding and agreement on what we are optimising for and how to optimise for it with new technologies
• The complications of moving from one operating model and enabling technology architecture to a new operating model and technology architecture need to be understood in-depth so that new design choices can be made to do it cheaper, faster and with less risk than before.

Reaching the tipping point will therefore - in my view - require one or more existing participants to generate new understanding and then make different choices than before. The sort of choice we have positioned here - to engineer a new architecture and operating model and plot a path to it.

Whilst difficult to do it represents a significant opportunity. And if the tipping point does turn out to be just a matter of time, the case for the offence and defence will likely turn out to be the same. We will cover that in the final instalment.