The 1997 Nobel Prize winner and distinguished academic, Robert C. Merton, was in Sydney last week, and we talked about the value of ‘trust’ in financial institutions. He argued trust is a key strategic asset which creates growth opportunities and defends against competition. It allows deeper customer engagement across products and services. Then in a presentation at Dimensional Fund Advisors, he spoke specifically on the trust problems faced by fintechs:
“There will be strong challenges for change to the areas of financial services involving processes (eg clearing and settling, title insurance, payments) and in any activity that involves little judgement (since) transparent services do not require trust.
FinTech alone will have greater difficulties in disrupting services and products which are ‘inherently opaque’ (ie cannot be made transparent) such as financial advice, solutions and most integrated financial products. As with medical advice, the only means of providing those services and products is through trust. Technology by itself is not a substitute for trust.
Technology to succeed will have to partner with providers that can provide the trust asset, since it cannot create trust by itself.”
We’d be interested in reader comments on the ‘trust asset’ at the Commonwealth Bank in the context of the AUSTRAC investigation and the financial advice and personal insurance issues in recent years. The Bank just announced an increase in net profit to $10 billion, a rise in annual dividend to $4.29 rewarding 800,000 shareholders and 333,000 new home loans in FY2017. Looks like plenty of trust there, but The Australian Financial Review called it “the contradiction of the country’s most hated company”.
Do you agree with Merton? Is it really that difficult for a new fintech to build trust?
In this article, former senior bank executive, John Chauvel, offers his perspective after experience on both sides of the fence.
Banks, fintechs and trust
Trust has been on the minds of bank CEOs lately. Many of the products and services they offer are sold on the basis of trust, although customers also require good service and value for money. The ‘bundling’ of banking products around trust has seen Australian banks become the largest companies in the country. Bundling has been sensible for both the bank and the customer, but does it make sense going forward?
The seeds of trust come from the banks’ deposit taking capabilities. Back in the 17th and 18th century, merchants stored gold for safekeeping with locksmiths with private vaults. The locksmiths issued ‘receipts’ of ownership, which could be used as currency for conducting trade because they were backed by gold, the most trusted store of wealth.
This is similar to banking today when depositing money with a bank. The deposit appears as a ‘credit’ balance in my bank account (or an entry on the right-hand side of the bank’s ledger indicating they owe me money). Through a combination of the bank’s reputation, regulation and a guarantee from the Australian government (via the Financial Claims Scheme) I am so certain that this ledger entry will be honoured that I think of it as money.
Once the bank stores my money for safekeeping, it is natural for me to trust them with transferring it to third parties. I need 100% confidence that this can be done properly so I can do normal things like buy food, shelter and settle debts. Banks over many decades have built complex systems to ensure transactions like these are performed promptly, accurately and reliably.
The trust we have in a bank’s ability to store and transfer money is so profound that, in fact, any time we think of doing anything with money we naturally think of a bank. Like for example, how to convert it, invest it or borrow it. Banks have become good at bundling these other services because of their proximity to our money and their ability to leverage the existing systems they have. However, the provision of these services rely less on trust and more on good service and value for money.
Borrowing is different to depositing
Take borrowing for example. If I have borrowed money from a bank, do I need to trust the bank to be able to repay my loan? Of course not, as the entire trust equation is reversed. The competency to lend money is completely different from the competency to store and transfer it. However, because of trusted relationships, access to personal financial information, the cost and complexity of data management and integrity and, quite importantly, access to capital, banks have had little competition for the provision of this service.
From a borrowers’ perspective I should be most attracted to the lender who is best skilled at assessing my credit risk, offers me the best terms and conditions, offers me the lowest interest rate and can fund me when they say they will. With the development of financial technology (fintech) and dis-intermediation, the party who can do all this is not necessarily a bank.
If a mortgage is broken down into its parts – including designing the loan, assessing the borrower, processing and funding – banks do all of these things, but so can a lot of other companies. And often they do them better.
Unbundling of trust
It is unlikely the unbundling of trust will come about overnight, but it has begun.
Banks have ceded much of the customer service function in loan origination to mortgage brokers. They have spent billions building integrated wealth and insurance businesses on the presumption that cross selling these products would increase their rate of return, but instead have generated poor returns and reputational damage. They have pulled back from business and corporate lending, which have been a drag on shareholder returns.
Policy makers have long questioned the efficiency of banks borrowing billions of dollars in wholesale domestic and offshore markets just to hold loan assets on their balance sheets. Wholesale investors can, arguably, hold these loans just as effectively.
Fintechs and technology do things better
Fintechs are adept at using technology to do things smartly, quickly and cheaply. In many cases, they provide a better product for the customer than banks, particularly activities that require good service and value for money, like online lending. Access to wholesale capital markets removes a further layer of intermediation and cost. Banks will try to replicate fintechs, however, trust aside, the playing field has become a lot more even today than it was a decade ago.
The core competencies that banks can retreat to are deposit taking, transaction banking and liquidity management which require access to liquidity when needed. However, even some of these are under threat from fintechs. The ‘distributed ledger’, aka blockchain, challenges one of the core reasons for a bank’s existence, as a trusted store and transferrer of money. In offering a completely different basis of ‘trust’, these new technologies eliminate the need for the trusted intermediary role that banks have played.
Moreover, this new generation of technologies does not rely on the vast and expensive IT systems the banks have invested in, and have no doubt viewed as a source of ongoing competitive advantage.
Big banks face a great and possibly existential challenge. New entrants offer niche products and services better targeted to customers. Technology drives down costs and turns scale on its head. Open architectures and new regulations enable information exchange undermining the power of incumbency and assumed trust.
Bank CEOs possibly have more than just trust on their minds.
John Chauvel is a former senior debt capital markets executive with a major bank and a current fintech entrepreneur.
We welcome your constructive comments on this article, Robert Merton’s opinions, events at CBA and whether the case for a banking Royal Commission has changed.