Message To Banks: You Have Highly Valuable Assets That You Are Not Using To The Full
In the asymmetric war for the future of banking, incumbents need to bring into play valuable intangible assets that they hold: customers, partners, trust and licenses.
In The Counter-Industrial Revolution, I described how a profound change has taken place in our economy: intangible assets have replaced physical assets to become the principal source of wealth creation. Studies show that both superior productivity and returns on capital are primarily attributable to intangible assets 1. Moreover, intangible assets are different in significant respects: they are characterized by scalability, spill-overs and synergies. In addition, the value of intangibles is not inherent but depends on how they are brought into play and combined with other intangibles 2. In order to move from theory to practice, we chose to explore banking because this is the most intangible-intensive sector, but you don’t need to be a banker to read our analysis and make the connections to your own sector.
In banking, the battle of intangibles assets is already underway to determine who will rule the industry, is a prime example of asymmetric warfare. The FinTechs have the software, the global platforms have enormous customer bases, volumes of data and expertise in algorithms, while the incumbent banks have long-standing customer relationships, historic data, regulation and established brands.
Intangible assets can be broken down into two high-level categories: digital assets and non-digital assets. In another article, I examine strategies for banks to harness digital assets such as scalable digital operations, platforms, data and algorithms. Here, I explore how firms can succeed in the intangible economy through strategies based on non-digital intangible assets.
Information technology has changed the dynamics, increasing the value of non-digital intangible assets & making new strategies possible
The importance of non-digital intangible assets (such as brands, human capital and organization capital) has long been recognized, and they are no less important in the intangible economy. Arguably, there is even an added premium for excellence because scale effects increase the size of returns that are possible from superior brands, people and organization. Because they are so vital, this set of intangibles has received extensive coverage over the years. Instead, here I will focus on non-digital intangibles – customers, partners, trust and regulatory licences – that have historically attracted less attention. Moreover, IT has profoundly altered the dynamics around these assets, opening up new strategies and business models.
Customer relationships have long been recognized as a valuable asset for banks – the logic being that once someone is a customer, they are likely to buy future services. Many banks even put a value on this asset, calculating the lifetime value of a customer using factors such as expected balances, income from fees, cost to serve, etc. In an intangible economy, customers take on an even greater value when considered in the context of other intangible assets.
Digitization increases the value of customer relationships
In a platform economy, much of the value of customers comes from their ability to attract participants on both sides of the platform. A positive reinforcing loop is created: customers make the platform more attractive to FinTechs and other partners. These new partners increase the quality of the offer, which in turn brings in more customers. A vital point is that these additional business volumes are essential to profitability in an intangible economy that is characterized by returns to scale and high fixed costs/tiny variable costs.
In addition, customer relationships can drive revenue through synergies with other intangible assets. For instance, extra customers bring transaction data which is valuable in refining algorithms; while customers strengthen trust – “If everyone else trusts them they must be OK”. Furthermore, customers make a bank more attractive as a partner, which is significant in a landscape where partnerships are the basis of many new propositions (see below).
A final factor behind the increasing value of customers is that digitization has made it easier to combine products and services from multiple sources. Consider how simple it is to aggregate and keep up-to-date product data on a website, compared to the paper analogue of glossy brochures distributed to numerous offices and updated or replaced, perhaps at best monthly. Since products can be sourced from anywhere the value from owning the customer relationship increases, and in equal measure, the advantage of a traditional bank – combining product manufacture and distribution – decreases.
The pre-eminence of customer relationships as an intangible asset is illustrated by the way that challenger banks and FinTechs have prioritized customer acquisition. They have been quick to launch products that have a low regulatory threshold, such as pre-paid cards, and to adopt ‘freemium’ models in the way that many digital businesses have done. Credit Karma (credit advice) and Monzo (pre-paid cards) have both adopted the market entry strategy of offering free or near-free services. Once they have acquired a customer and built trust, they are in a position to sell higher-value services such as access to credit and a current account.
Synergies between customer segments
An additional value of customers is that synergies can be created between customer segments. For example, incumbent banks with both merchant and retail customers have a real advantage over challenger banks which have a mainly retail presence. Incumbents can develop new propositions in a number of ways, such as using sales and customer data to provide merchants with a service to target offers at bank customers; delivering analytics and data services to merchants to bring insight into sales and customers; managing loyalty cards on behalf of retailers who lack the scale to offer their own loyalty schemes; aggregating loyalty points from merchants in a digital wallet and enabling them to be redeemed at POS; providing loans to customers at POS and thereby increasing merchant sales volumes; and offering payment on delivery services, perhaps with further credit options for customers or interim finance for merchants. Comparable opportunities are available right across commercial banking, where banks are able to bring distinct customer segments together and often sit on both sides of a transaction.
Customer communities add value to other customers
Banks can foster communities within their customer base. Fidor Bank, the German challenger bank, has established a community for its customers. In Fidor’s community zone, customers can ask personal finance questions to community experts and share views on emerging trends such as blockchain. Based on feedback from fellow community members, customers are even rewarded for contributing advice to the community. Likewise, customer communities come into play in the ultra-high-net-worth market, where individual customers value introductions and associations with other super-wealthy people.
Customer advice on new products
Firms can use customers as a source of knowledge around new products. By way of example, thanks to its 2012 acquisition of Instagram for $1 billion, Facebook has an ever-growing stock of public photos that have been labelled by Instagram customers. Facebook has employed these hashtags to train its AI picture recognition system. In a similar vein, several challenger banks have fostered an ecosystem of enthusiastic customers to act as testers of alpha and beta products. Monzo even publishes its roadmap on a collaboration site in the form of an agile product backlog where ‘Monzonauts’ can vote on features and functions.
The challenge is for the incumbents to be equally inventive in using their customer base to drive innovation and revenue growth – after all, these are some of the strongest cards that they hold.
Partners & Ecosystems
The industrial age was characterized by suppliers and supply-chains. In the intangible economy, models based on partners and ecosystems will prevail instead.
Platforms & software for partners
Many digital businesses derive enormous value from ecosystems: Uber has its drivers, Airbnb its homeowners, Amazon its network of suppliers and now Echo, Alexa and Dash. What ecosystems can banks build? Behind each area of banking lies a distinct business ecosystem – for example, in mortgages: real estate agents, surveyors, and removal and storage companies. In trade finance, the ecosystem is still more complex, comprising importers and exporters, financiers, shippers, consolidators, ports, export credit agents, insurers, as well as banks.
Turning an ecosystem into an asset requires not just contracts, relationships and trust, but also in today’s digital world, connectivity, data interfaces and – even more valuable – software. For instance, a foundational element in the business model of Airbnb and Uber is the software that their partners (‘suppliers’ in old thinking) use to run their business – without which, in fact, they would have no business. For banks, therefore, the prime opportunity lies in offering software that underpins each of these ecosystems, linking them into bank products and services.
Enriching customer propositions through partner products & services
Recent studies have highlighted scarcity as a critical driver of innovation, proving the truth of the saying that necessity is the mother of invention. So perhaps it is no surprise that in banking, it is the FinTechs with their scarce resources that have been most innovative in their use of partners. For instance, Starling Bank, the UK challenger bank, has developed an online marketplace where partners are brought together to offer wealth advice, international payments, pensions, mortgages, money management and a range of other services. Starling only went live in May 2017, but through its partnership strategy already offers a range of services that rivals that of incumbent banks of more than 200 years’ standing. These relationships are solidified as an asset because they are accessed via Starling’s mobile banking app with pre-built interfaces that integrate to customers’ accounts.
Accessing partner R&D
When it comes to the incumbent banks (especially large banks), in my experience they most frequently cite time-to-market as the main reason for partnering: “We could do it ourselves but we don’t have time.” Increasingly, however, the rationale for partnering will be accessing external R&D – after all, the easiest way to reduce R&D effort is to access someone else’s R&D. In a sense, intangible assets are mostly just accumulated R&D.
What has changed with the advent of global scalability based on digital assets is that specialists can earn sufficient revenue from a narrow niche to be able to ‘out-invest’ even large banks. In addition, niche players benefit from the ideas of their customers and developers. JP Morgan Chase (JPMC), the bank with one of the largest IT budgets in the world, could surely afford to build its own mortgage origination system; instead, JPMC has partnered with Roostify to access the ideas and code contributed by the firm and its numerous customers. In 2017, Roostify announced that external developers on its mortgage platform had come to outnumber its own in-house engineers. This indicates that there is little point in buying a FinTech because you would lose this flow of ideas and kill the golden goose.
The nature of contracts with FinTechs is also changing to reflect a more symbiotic relationship. Whereas a traditional contract would have taken the form of a straightforward buyer-supplier agreement, contracts with FinTechs often now include partnering commitments – for example, around access to customers and promotion.
Nearly all the large banks have now recognized that innovation cannot come only from within, and have established innovation networks in various forms. Barclays, for instance, runs a network of Accelerator programmes in London, New York and Tel Aviv, where cohorts of start-up businesses whose concept may be valuable to Barclays and its customers are hosted and mentored for 13 weeks before pitching to Barclays and potential investors. More recently, Barclays has added a new model aimed at building synergies with its corporate banking business – Eagle Labs across the UK provides advice and low-cost office services for start-ups in any discipline. This entrepreneurial community strengthens Barclays’ ties with local businesses and provides a way to tap into the new wave of fast-growing business banking customers. Similarly, Silicon Valley Bank, which as its name suggests focuses on entrepreneurs and fast-growing tech companies, offers its clients a network or ecosystem of other innovators, investors, advisors and lawyers, as well as banking services.
In some cases, banks have established internal innovation networks in order to forge ties with a FinTech ecosystem and drive innovation. BBVA (a multinational banking group based in Spain) has established a global network that already has over 150 members. Through a smart match-making system, the platform connects the services provided by start-ups and the needs of BBVA business units to create opportunities for both.
Ultimately, in the intangible economy, where ideas are the ultimate source of growth, collaboration with partners must form an essential pillar in any bank’s R&D strategy. This calls for a novel set of skills in seeking out the right partners and fostering partner ecosystems.
Trust has always been vital to finance, whether trust in a currency, a letter of credit or a deposit-holder. However, trust takes on added dimensions in a digital world where shopping, payments and other transactions are remote, and security is of paramount importance. What is more, in an economy based on intangible assets, trust assumes additional significance because it underpins other intangibles.
Trust underpins other intangible assets
Data is a precious commodity for banks in the intangible economy, but its value will in part be determined by the extent to which customers trust their bank to exploit their data appropriately and to store it securely. Here banks hold an advantage: in a survey by Gemalto, 33% of customers named their bank as the organization that they trust most to guarantee the security of personal data. This was almost three times more than trusted any other sector. As more and more services in banking and beyond are based on the aggregation of data, banks should exploit this advantage to become a trusted provider of data services.
As customers become more aware of the role of algorithms, trust in fair use of data will become indispensable. Moreover, customers will demand greater transparency around how decisions are made about them (and under GDPR, EU citizens have a ‘right of explanation’). In order to strengthen trust, banks may decide to publish their algorithms or the results of their algorithms. An interesting example of this approach comes from members of P2PFA, the UK peer-to-peer lenders’ association, who in order to bolster confidence in their alternative business model have collectively decided to publish their loan book data.
Alternatively, banks may seek to increase trust through independent verification and validation. Independent data ethics boards can be expected to emerge as a way to assure trust in ‘fair use of data’. Banks may even go so far as to demonstrate to customers exactly when and where they have used data about them. This would go some way to offsetting concerns about miss-selling. An exemplar in transparency around data use is the government of Estonia, which provides citizens with full visibility into when and why their data was used – even the names of officials who have accessed their data.
Finally, trust is the foundation of partnership. A bank’s ability to derive value from a network of partners will be decisively shaped by trust. Before entering a relationship, partners will ask themselves: Will they steal our ideas? Is their security adequate for our customers? and Will they act ethically, or is there a risk that our reputation will be damaged by their actions?
Dynamic reinforcing loops
Trust exemplifies a key feature of intangibles: that they operate as a dynamic system with reinforcing loops. Trust leads to more customers; more customers to more data; more data to better algorithms; better algorithms to more revenue; etc. The diagram below illustrates the inter-connectedness of intangible assets and shows how trust drives positive network effects.
While this cycle can work positively, it can also work in the opposite direction. Once trust declines and with it the number of customers, the cycle can go into reverse, creating a vicious circle. For example, multiple incidents relating to how Facebook handles data have impacted trust which has led to a decline in Facebook’s share price. In the last six months of 2018, when Facebook’s handling of customer data was constantly in the news, its share price fell by 32% (20% more than the Nasdaq). These systems’ dynamic effects heighten the need for new approaches to risk management, since the value of intangible assets is to a degree transitory. This stands in marked contrast to a business based on physical assets that have a much more durable value.
According to a survey by Duff & Phelps, financial institutions typically spend 4% of their total revenue on compliance, and these costs could rise to 10% by 2022. Digitization has altered the dynamics here, driving up the cost of regulatory change. Although information technology facilitates regulatory compliance, by the same token, changes must be made in IT systems to ensure that they reflect the latest processing and reporting requirements. Anecdotal evidence from banks suggests that regulation accounts for up to a third of IT budgets. The impact is not just financial – regulatory compliance takes up change capacity that could be used for developing new products and services.
Licences are an asset from which returns need to be maximized
Rather than looking upon compliance costs as nothing more than an overhead, firms should think about a regulatory licence as an asset and ask what additional revenue can be generated from the asset, just as they would with excess capacity in a production line. The options here are to drive increased volumes by marketing services to other banks and non-banking entities or to enter other geographic markets to which licences can be passported.
Of course, there is an opposite strategy, which is to minimize regulatory costs by accessing services that require a regulatory licence from another party, or by acquiring regulatory licences that permit high-value activities but come with a lower regulatory overhead. Examples of low-cost high-return licences are e-money licences and third-party registrations under Payment Services Directive 2.
An interesting case of this line of thinking around regulation comes from ClearBank, the UK's first new clearing bank in more than 250 years. Although ClearBank does have a retail presence, it also has a real focus on offering clearing services to other challenger banks, enabling them to reduce regulatory costs, while driving revenue for ClearBank and reduce its own transaction costs.
Potential to scale digital operations will lead banks to acquire licences in new jurisdictions
Regulatory licences have risen to prominence as key assets for an additional reason. Since banks that are built digitally from front to back have the potential to scale, it is inevitable that they will seek to exploit scalability by entering new geographic markets, operating on a global or at least cross-region basis. This, of course, means that new licences are required or licences must be passported.
Again, digitization is changing the dynamics: once operations are digitized it is much easier to enter new markets. For instance, few local staff need to be recruited or branches acquired. Indeed, as more and more bank operations are digitized (for example, through robot-advice and automated lending) it will become possible to offer more sophisticated and profitable banking products on a global or cross-regional basis. The rapid expansion of WeChat and Alipay across south-east Asia illustrates the ease with which digital-only players can move across borders; as does N26, the German mobile-only bank, now Europe’s most valuable FinTech, which has expanded quickly across the EU and is now moving to the USA. The speed of a bank’s expansion will be dictated as much as anything by its ability to acquire and manage new regulatory licences.
In regulatory licences, we see another manifestation of how an intangible economy, characterized by scalability and concentration effects, calls for much starker, black-and-white strategic choices. You are either in or you are out, and if you are in, you need to be committed.
Digitization has changed the dynamics, increasing the value of intangible assets and opening up the potential for new strategies and business models. For challengers, this is where they are most lacking; for incumbents, this is the advantage that they hold and need to bring into play. Customers and partners have become critical business assets, yet the value of both is highly dependent on trust which takes years to build but can be undermined quickly. At the same time, an inevitable consequence of the increasing value of intangibles assets is that banks need to take greater steps to protect their intellectual capital.
The challenges for banks are first, recognizing how intangible assets have altered the landscape; and second, acquiring the skills needed to succeed in this new world of expressions such as ‘creative synergies’ and ‘fostering of ecosystems’ – not naturally associated with banking.
1 Susana Ferreira and Kirk Hamilton, ‘Comprehensive Wealth, Intangible Capital, and Development’, World Bank Policy Research Working Paper 5452, 2010; Carol Corrado and Charles Hulten, ‘How do you measure a technological revolution?’ American Economic Review, 2010; Meghana Ayyagari, Asli Demirguc-Kunt and Vojislav Maksimovic, ‘Who are America’s Star Firms?’, World Bank Policy Research Working Paper 8534, 2018; Nicolas Crouzet and Janice Eberly, ‘Intangibles, Investment, and Efficiency’, AEA Papers and Proceedings 108, 2018
2 Jonathan Haskel and Stian Westlake, ‘Capitalism without Capital’, Princeton University Press, 2018