Modular Financial Services: The New Shape of the Industry
Financial services have endured a turbulent 10 years, including a banking crisis, an economic downturn in the U.S. and Europe, sovereign debt crises and radical re-regulation. Yet the industry has emerged more or less intact. Banks and insurers look much as they did in 2006.
This should not be a surprise. Real threats to business models do not come from earnings volatility, such as experienced during the crisis and since. It comes from new ways of doing things that render old ways obsolete.
While the turmoil in the financial industry has been dramatic, other industries have been more radically transformed. For example, digital technology has disrupted the established business models in music and publishing.
But such a transformation is on the horizon for the financial services industry. We believe financial services are becoming “modular.”
Digital technology and consequent changes in consumer behavior will weaken the hold that suppliers have over their customers. New customer platforms will help structure solutions for consumers and guide them to a variety of suppliers, facilitating “dynamic switching” between suppliers to ensure customers always get the best deal. The number of financial service suppliers used by the average consumer will increase dramatically. We call this “modular demand.”
The supply side of the financial industry is also becoming more modular. Financial “products” are not physical objects but primarily contracts and advice, and the success of financial firms depends on their skill at processing information and making good decisions. As data becomes radically easier and cheaper to acquire, store, transfer and analyze, more specialist business models become viable, not only operating more efficiently, but also more seamlessly plugging into the supply chain. This is demonstrated by the visible rise of the Financial Technology (Fintech) sector, especially in payments.
Our 2016 report, Modular Financial Services: The New Shape of the Industry, characterizes four broad industry structures that already exist in different markets across the globe (see chart below). For example, Property & Casualty insurance in parts of Europe conforms to the modular demand model and in the UK, where the trend is the most advanced, aggregators’ share of sales has risen from 5 percent to 65 percent in the last decade.
Fund management is an advanced example of modular supply, with many fund managers focusing exclusively on investment decision-making and execution while outsourcing almost all other operations, from trade settlement to custody. U.S. mortgages are the best example of a fully modular market, with the government-sponsored agencies, Fannie Mae and Freddie Mac, allowing mortgage risk and funding to be shifted into the market for mortgage-backed securities. The demand side has had various modular structures, with brokers highly active before the crisis and now with major non-bank direct originators. Quicken, the largest online lender, now originates more mortgages than Bank of America.
Modular Services Put $1 Trillion Into Play
Modular financial services should be very good news for consumers, who will benefit from new services and higher price transparency. On first sight, however, it looks like bad news for existing firms as banks and insurers will find cross-selling and product cross-subsidization even more difficult. Also, the downward pressure on pricing and margin capture of third-party platforms will come with limited offsetting cost reductions. With distribution via third-party platforms, a major barrier to entry is eliminated: the cost of creating distribution channels.
Competition will multiply. And the innovations that lead to a modular supply side threaten to destroy the value of incumbent firms’ antiquated “plant and equipment.” We estimate that about $1 trillion of annual profits are at stake, available to new competitors or likely to be lost through tighter pricing.
But things need not work out badly for incumbents in a modular world. They can compete to become the “trusted platform,” likely having to give access to other providers, but capturing the margins that go to distribution. They also have the advantage of large existing customer bases, familiar brands and a variety of channels, each of which reinforces the others.
And in product provision, established firms have an accumulation of skills, experience and customer data to assess risk and set pricing, as well as vast quantities of capital. Not only is this important in capital-intensive parts of the business, but it means banks and insurers can buy competitors, such as Fintech startups, thereby acquiring skills and technology they lack.
Modular supply will also help established banks and insurers struggling with systems that are inflexible and expensive to run, on account of their age or messy post-merger integrations. The cost of overhauling them, which can run into the billions, makes sense only for the largest firms. Smaller firms will increasingly be able to simply abandon their systems, outsourcing most back-office processes to third party suppliers that will broaden their offerings and scale up their operations.
Incumbents’ greatest structural advantage has been regulation—in banking, at least. Government deposit protection gives banks a cheap source of stable funding unavailable to other lenders. This has proved critical not only in basic lending products, where margins are thin, but in credit cards. Monoline credit card businesses have found that smarter analytics cannot make up for expensive or unreliable funding; for example, Capital One has become a deposit-taking bank with a branch network. However, as policymakers wrestle with the digital world, some of this advantage will be threatened. Regulators may soon require banks and insurers to make information on their customers available to competitors. Much regulation is pushing in the same direction as technology, towards more competition and ease of switching.
Banks and insurers have adapted to new technology in the past and they will do so again. In 10 years’ time, when financial services will be more modular, today’s banks and insurers may look very different, but most of them will still be around.
Established firms will need to adapt rapidly to the modular industry structure. Some will try to compete with commerce and technology firms and build sophisticated customer platforms. Some will develop their products to concentrate on areas of sustainable advantage, making the most of multi-channel distribution. All will reinvent their back offices as supply chains.