How To Build A Bankby@abhishekkothari
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How To Build A Bank

by Abhishek KothariJuly 14th, 2017
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The future is being created as I write this article. I could not have dreamt of a future in which mathematics, hidden from plain sight in the guise of advanced technology platforms, will completely change the face of financial services. Bean counting also just got uber sophisticated.

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A Look At Alternate Models of Banking

The Best Way to Predict The Future is To Create It. — Abraham Lincoln

The future is being created as I write this article. I could not have dreamt of a future in which mathematics, hidden from plain sight in the guise of advanced technology platforms, will completely change the face of financial services. Bean counting also just got uber sophisticated.

Today, people talk about tech companies such as Apple and Amazon creating a bank of their own. Why is that? Think about it. These companies not only represent great client experience (measured through NPS and sheer growth) but more importantly, they have two tools in their arsenal: technology and balance sheet size.

I am not saying these companies will necessarily setup a bank but for every entrepreneur thinking of starting a new bank, expanding the box allotted to competitors to include a range of players with different strengths is oft repeated common sense.

We live in a world where video game currency (pieces of computer code) purchased and sold within games such as World of Warcraft could someday be known as the precursors of modern money under the name of Bitcoins/Cryptocurrencies (utilizing cryptography and distributed networks to spread securely).

Ironically, video game tokens remind me of the shells that our prehistoric ancestors used as money and possibly played with too. The question then becomes: have we evolved at all? But, that is a discussion for another time.

Today, technology is democratizing the creation of banks. Whether the new banks sustain turbulence, scale up and/or consolidate is a fascinating story to watch out for.

A Recommendation

For all of my readers, if you have not yet read Part 1 of this mini-series which began with the title “You can see Silicon Valley in a bank, Not a bank in Silicon Valley” please read it here.

Although this article can also be read on a standalone basis, I would recommend reading the first part to get a full picture of the state of play today.

The New Challengers

London today is widely regarded as the global leader in FinTech. Understandably, pure play digital banks such as Atom, Monzo, Starling etc. are based out of the UK. China is another rising star with WeBank and MyBank. Fidor and N26 are German players and Klarna is Swedish. Australia recently witnessed the creation of a “neobank” called Xinja.

My limited point here is digital banks are sprouting all across the world. A greater concentration happens to be in Europe. However, it could be a matter of time before payment processing FinTech players in India apply for a banking license.

Digibank in India is already an example of digital bank just like Ally bank in USA and B1NK in Kazhakstan. Tide Bank also offers a completely digital business banking account.

As per Let’s Talk Payments, almost 19% of the worlds FinTech startups it tracks are payment companies. PayTM is a great example in India.

Already, FinTech players in the payment space have started obtaining licenses. As per the Economist: “On June 19th 2017, Klarna, a Swedish payments firm valued at $2.25bn, became the latest — and the largest so far — to get one”

bKash in Bangladesh, M-Pesa in Kenya are also facilitating mobile to mobile payments and could scale up.

Bunq, a Dutch payments firm started just like Klarna but expanded to deposit accounts. Some, like N26 in Germany or Atom Bank in Britain, sought to be full-service, online retail banks from the outset. ClearBank, a new British clearing and settlement bank, wants to offer services to other firms. (source: the Economist)

What is important to note here is that any player dealing with money in different forms (including cryptocurrencies) can really think about becoming a bank. So, really the competition can come from literally any corner. While it is scary, it is also an exciting time for banks to remodel archaic systems and become the revitalized purveyors of financial inclusion, monetary and economic policy. In some senses, incumbents have a headstart.

Below is a chart depicting some of the new FinTech banks that have emerged:

I can go and discuss each individual entity but that would mean stating obvious facts and sparing you (my reader) the interesting journey of knowing different stories. Instead, I will focus on some of the essential elements of building a new age bank.

Here is an infographic from Let’s Talk Payments that asks a pertinent question: Is there a FinTech startup for each bank service?

How to Start A Digital Bank

In simple terms, a bank accepts deposits and lends money and earns a spread on the interest earned on loans and that paid on deposits called the Net Interest Margin. That’s a financial description but more importantly:

Keep Clients At The Heart of The Experience

It’s All About The Money, Honey

Either the management of a FinTech player has experience in traditional banking or has access to sources of capital i.e. Consortium. Of Qualified investors, Venture Capital, Private Equity, family, friends (multimillionaire friends not our average Joe). Later, obtaining revolving credit or other lines of credit from traditional financial institutions can be resorted to. Ironically, capital may be raised from the very business FinTech’s are trying to disrupt.

If the Net Interest Income or Cost of Credit of bad loans is higher than the cost of capital raised and/or fixed costs and overheads, the said the FinTech platform could quickly turn into a sinking ship. Because the cost of other funds is generally higher than the interest to be paid to depositors, raising deposits becomes inevitable. Later, scale becomes critical.

An Underserved Segment:

So much of the financial world is built on models. Consider for example, the FICO score which takes into account the length of credit history as a crucial factor in determining credit scores and rightly so-consistency is a great predictor. However, there could be young borrowers who don’t have a long credit history but some other compensating factor such as a great education. FinTech models incorporate some of these factors to serve an undeserved segment. Also, they could serve millennials or early emerging affluents who don’t have the savings yet to maintain a deposit account with high balance requirements. This could represent another underserved segment.

On the other hand, small and medium enterprises could be an underserved segment too. Quite often, the level of revenue and or processes needed to appease traditional commercial banks may not have been achieved by small entrepreneurs.

FinTech banks promise of inclusion can be an ideal use of technology. This idea is reminiscent of a quote by Muhammad Yunus, the founder of Grameen Bank- a micro finance institution in Bangladesh.

The poor themselves can create a poverty-free world. All we have to do is to free them from the chains that we have put around them!

This implies that Inclusion must precede profits. A mission that is easier said than done in today’s world but with a healthy public private partnership, the first steps can be taken.

Regulatory Approval:

In the absence of deposits today, FinTech players use part of their capital raised from various investors to lend or go public to raise capital.

However, to truly create a bank, a FinTech player has to obtain a license as a depository institution which is harder than it sounds.

Regulators should be viewed as a bridge between clients and financial service entities. Regulators want to see both succeed.

Today, in the USA, the FDIC (Federal Deposit Insurance Corporation) insures a part of the depositors balance. In the event of a run on the bank (liquidity crisis) i.e. people lining up for blocks on end to withdraw money from a branch or an ATM, the FDIC will guarantee that the depositors get their money back up to $250,000.

The Office of the Comptroller of Currency issued a “Draft Licensing Manual Supplement for Evaluating Charter Applications From Financial Technology Companies in March 2017. This opens up the doors for FinTech players to begin their journey towards being a bank.

In the US, there are many state and federal regulators to comply with before becoming a full fledged bank. Although difficult, the journey has begun. In contrast, in the UK, the Financial Services Authority is the primary regulator.

So, geographies that have adopted a more aggressive stance towards accommodating digital banks have seen the emergence of many new players.

Of course, nothing stops incumbent banks from setting up a completely independent subsidiary that is a pure play digital bank. Swish in Sweden and Zelle Pay in the US are already examples of incumbents rushing into the peer to peer payments app arena.

In fact, risk management which has generally been a great strength of banks can be significantly enhanced with rapid client acquisition at lower cost.

IT Infrastructure:

FinTech entities have an option to adopt a ‘Full Stack’ approach i.e. build their digital systems from the ground up or take over legacy systems from an older institution. Some banks in the UK such as Starling built it’s IT systems from the ground up whereas Atom bank uses commoditized software. FinTech players also need to start with working in a sandbox with incumbent banks/regulators and use their API’s to access common client data. API’s are Application Programming Interfaces (API’s) — call them a glue that connects a FinTech players program with an incumbents programs and allows an app to authenticate and alter clients data with their permission.

What is a Sandbox? An API sandbox is a test environment that resembles a live production environment which developers can use to test out to understand how the API’s they need will interact with their own programming API’s.

The U.K. Government created a regulatory sandbox in 2015 to help foster innovation.

Attractive Pricing

Since a pure play digital bank has no legacy infrastructure, it may be able to offer a better interest rate than other players. This is a great client acquisition tool as it tries to mitigate the switching cost of a client from incumbents. However, it is only superior service that can keep clients with the new banks.

ATM Network:

While not essential, an ATM network that allows full service debit card withdrawals maybe an attractive add-on. Don’t have your own ATM’s? No problem. Use somebody else’s. For instance, First Data offers ATM & Network Solutions for banks. One of the earlier players in this arena was a startup called Simple which leveraged First Data’s STAR ATM network.

A Blockchain Ledger:

A distributed database or a Blockchain ledger to record transactions immutably.

In the future, Blockchain ledgers can also facilitate international money transfers that are almost instantaneous, immutable and cheaper.

A Blockchain that incorporates the fastest growing language in the world — Emojis can be a truly fun experience. Think Venmo on Blockchain.

Obviously, it takes a LOT more to establish a bank: gaining trust, a sound management team, a customer support team, a client experience team, marketing, robo advisors, smart contracts etc.

I have highlighted some of the basic ingredients (through the build your own bank framework) above to explain the digital banks that have emerged and are emerging soon.

Final Thoughts

Personally, I have not built a bank. Neither can I see the future with clarity.

But, I have tried to capture the essential elements of a new age bank (through the lens of building a new bank) in an era where technology has removed a lot of the frictions in creating a bank.

Secondly, creating a bank is one thing and standing the ravages of time is quite another. Sustainability and scalability are a function of consistent building of trust and amazing client experience.

Lastly, never lose sight of the problems a business is solving for. Ultimately, the goal is not to disrupt any industry but it is to make people’s lives easier. Disruption comes with evolution — only the adaptable survive.

In the third part of this mini series, I will discuss future scenarios that could unfold. In doing so, I want to foster a larger debate centered on one simple question: Is amazing client experience another name for ‘living for others’? Of course, there is an economic reward in the end.

Any discussion of financial technology will be incomplete without discussing its impact on humanity.

Therefore, I leave you with one thought:

Is business a form of altruism? (a case of serving others first and profit following as good ‘Karma’)

Disclaimer: All of the views expressed above are my personal views and do not reflect the opinions of any other entity.

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You can also follow me on twitter: @akothari_mba