The allure of disruption

Disruptor or disrupted? Financial services firms are determined to avoid being the latter. However, the operational straitjacket of regulation (not to mention legacy systems, structures and fiefdoms) often stifles attempts at being the former. With FinTech firms stepping up to offer new models for conducting traditional business, banks are in danger of being wrong-footed or outpaced by newcomers looking to disintermediate incumbent firms.

“The worst case scenario is they get displaced and are no longer leading incumbents,” says John Hagel, US-based co-chair of Deloitte’s Center for the Edge. “They will not close up shop, but will they be leaders in the relevant market segments? No.”

In a recent paper, entitled ‘Patterns of Disruption – Impact on Wholesale Banking’, Hagel and Val Srinivas, research leader for banking and capital markets at Deloitte’s Center for Financial Services, outlined the effect of digital transformation and a long-term public policy shift towards economic liberalisation – which they term the ‘Big Shift’ – on banks and other financial service providers.

Responding to disruption is no easy task for banks in the current market environment. Almost all banks are under considerable pressure to increase profitability and reduce costs. Investment banks saw return on equity in 2015 fall to somewhere between 6% and 6.7% according to industry estimates, down by some 30% on the previous year. Capital adequacy requirements have led banks to reduce risk-taking activity considerably.

For less capital-intensive activity in the retail and wholesale markets, low or negative interest rates are crushing margins. Wholesale banking has been a solid business for many banks in post-crisis markets, yet an increased emphasis on know-your-customer requirements, risk management and transparency is adding to costs. All the more reason for banks to take control of the situation.

“There is no question that it’s challenging; the regulatory environment imposes a lot of constraints on activity,” says Hagel. “Having said that, banks often use regulation as an excuse for not acting; within limits, there are things they can start to do in certain areas, starting to build more focus or revenue around a certain type of product or service and demonstrate to the regulators that they are doing this in a responsible way. Over time that gives more latitude to pursue those opportunities.”

From push to pull

The uncharted waters in which banks now swim make traditional ‘push’ models for resource mobilisation inefficient, Hagel and Srinivas argue, as they require a clear demand forecast to determine which resources should be pooled. Uncertain markets require a ‘pull’ model to be adopted, in which a range of potential resources are identified and made accessible, so that they can be pulled together as and when they are needed.

Responding to the disruptive approach will not be easy, the pair acknowledge, and may require firms to cannibalise existing current revenue, write off assets on the balance sheet and rethink key assumptions about what delivers business success.

Other industries offer examples of the risk that disintermediation poses. Over the last ten years, firms like Apple, Netflix and Amazon have taken pole position in the digital-only entertainment businesses, winning market share from established firms with both technology expertise and licencing rights such as Sony and AOL Time Warner.

There are already clear incursions into the wholesale banking space by non-banks, not necessarily from FinTech startups. Cash-rich corporates are funding supply chain partners and asset managers are moving into shortterm funding of trade finance. The Financial Stability Board estimates shadow banking assets grew by over 10% to reach US$36 trillion by the end of 2014.

To avoid disintermediation, banks can learn to take advantage of patterns of disruption. According to Hagel and Srinivas, these break into two main groups: the transformation of the value/price equation via a “radical redefinition” of product, pricing and processes; and the “unleashing” of network effects. Three specific patterns are useful to the wholesale banking business.

The first of these is the expansion of market reach. By deploying platforms that help to connect fragmented buyers and sellers, working 24/7 and globally, firms can work with smaller players particularly in specialist products and gradually build critical mass.

The second pattern that banks can use is to turn products into product platforms, based on a foundation of core functionality that can subsequently be built upon by third parties in order to provide tailored services that more directly meet customer needs.

The third pattern, that of connecting peers, is more speculative, according to Hagel and Srinivas. With a focus on the benefits of “greater speed and lower cost in transactions”, a practical example is the use of distributed ledger technology in order to reduce the number of intermediaries in the transaction lifecycle. Subsequently, greater access to data about transactions can enrich learning about activity that creates more value over time.

From theory to practice

These may appear attractive models to follow in theory, but the existing set of constraints and priorities can make them difficult for banks to put into practice. Adopting large-scale change is beyond most firms, given the cost and complexity involved, and the existing operational burdens they face. Srinivas recommends a cautious approach. “Pick areas of exploration away from the core, because they can be pretty disruptive and you will see a lot of ‘antibodies’ coming at you,” he says.

Cultural change will also be necessary if firms are to move away from a focus in the quarterly view, targeting instead the successful execution of a longer term strategy.

“How do you model the incentive structure to ensure that everybody is onboard and they are willing to look at more the long-term implications and the big picture?” Srinivas asks. Although that is a universal problem, it can be more problematic in businesses such as finance given the nature of existing incentive structures.

“We counsel clients that small moves, smartly made, can set big things in motion,” says Hagel. “Resist the temptation to go with massive transformational approaches and start small. Learn as you go, get some experience, build credibility, address the regulatory issues as they emerge, evolve some kind of accommodation with the regulatory environment that serves the needs of all sides. But the key is to get started with small moves so start moving now.”

Find out more from industry experts at ’ Patterns of disruption in wholesale banking ’, which takes place on Monday 26 September at Sibos 2016 Geneva.