The battle for banking supremacy begins anew.
Introduction
Unbeknownst to most people, digital banking is not exactly a new concept. Back in 1988, Dutch bank ING established one of the world’s first relatively comprehensive digital infrastructures and began a process to integrate digital within their larger hierarchy of services. For almost 40 years, digital banking has been nothing but a facet of a larger, more diversified omnichannel approach. While one can argue that increasing dependence on technology over the past decade has inflated its importance, the directive from most banks has always remained directly opposed to a digital-only infrastructure. The idea of putting all your eggs in one basket has rarely ever worked out. However, that was before the pandemic arrived and changed everything. It was before digital banking shifted from being just another cog in the machine to something far bigger. The current powers of the financial world find themselves in the calm of a storm, beginning to brace themselves for a shakeup that will redefine banking and how consumers interact with the economy.
What is Digital Banking?
Digital banking refers to using online and/or mobile tools to access various financial services and activities that were historically only available through physical bank branches. Driven largely by individual consumers (mobile banking apps, personalized financial planning, contactless payments, voice banking, or on-demand loans), banks have expanded their digital offering to large and small corporations (cash flow forecast, working capital, artificial intelligence). Even though the needs of consumers and corporations are not exactly the same, they both have one thing in common that is now the new normal for our society: the need for real-time digital banking.
The acceptance of digital wallets by corporates and the use of digital wallets by consumers grew rapidly in 2020. They were used in 44.5% of the e-commerce transaction volume, up 6.5% from 2019 according to FIS from their annual global payment report. This growth was not just a product of the pandemic however, as in 2023 this percentage grew to 50%. This makes digital wallets the fastest growing payment method in global e-commerce and POS. Cards have also seen a rise in attraction, but in the context of digital wallets such as Apple Pay, Google Pay and PayPal. This shows the shifting consumer behavior towards a more digitalized world.
With each new release of digital payment data, it becomes clear that payments technology is the future, and a festering worry of becoming obsolete has left many institutions scrambling to adapt. In other words, a new-age fight for banking supremacy has begun.
The Shifting Landscape of Banking
Over the past few years, digital banking has become increasingly popular, and that is not exactly controversial to say. There have been heightened consumer demands for more efficient ways to access banking records and complete financial transactions outside of local branches which have led to the emergence of digital banking. Nearly all banks, large and small, have seen a spike in digital banking usage. For instance, Wells Fargo saw a 35% increase in remote check deposits and a 50% growth in online wire transfers compared to a year ago. The pandemic even pushed many customers to use mobile banking for the first time, especially in older cohorts. Alongside the pandemic, ease of use, lower fees, no overhead costs, and increased reliance on technology have all been seen as driving factors towards its particular rise in popularity.
Digital banking was also made easier to access. After COVID allowed regulators to relax restrictions on KYC (know your customer), barriers to entry became easier to bypass. Not only was it easier to attract customers through a shorter sign-up process, but it was easier to attract customers simply because people were losing trust in traditional banks. According to the 2022 Edelman Trust Barometer, which surveyed 36,000 people in 28 countries, trust in banks has now fallen below trust in digital payments, with 60% of respondents trusting digital payments and only 58% trusting banks. The stage was set for a new type of institution to take on traditional banks.
The Rise of Neobanks
Neobanks are fintech firms that offer apps, software, and other technologies to streamline mobile and online banking. These fintechs generally specialize in particular financial products, like checking and savings accounts. They also tend to be more simple and transparent than their megabank counterparts, even though many of them partner with such institutions to insure their financial products. The key differences where neobanks and traditional banks differ are 1. that they aren't chartered with state or federal regulators as banks, and 2. they provide a streamlined process designed mainly for mobile devices. They partner with traditional banks to federally insure customer deposits and to guarantee that they don't extend credit, such as overdrafts.
With the introduction of these new banks, legacy institutions are now being forced to adapt.
Existing core banking systems and applications—due to years of underinvestment—haven’t been optimized to take advantage of new technologies and application management approaches. They aren’t capable of supporting the market’s rising expectations and could soon expose traditional banks to additional risk and liability. The transition is no easy feat, but banks (and their service providers, such as IBM) can make the transition happen by doing two things well: Deploying a platform that can accommodate the old methods while providing and migrating to the new, as well as working with the service provider to integrate fintech capabilities into the platform’s ecosystem. As such, the financial institutions have lower barriers to adoption without the pain of integration.
Replacing fintech services is not the only model for success. Banks and fintech have already been successful in directly filling gaps that the bank cannot fill on its own in methods that don’t rely on a platform shift. However, the ability to integrate more often and quickly does mean that flexible banking, payments platform, and ecosystem will likely be more successful in the long run.
Another player now involved is the crypto firms. Current private digital currencies don't work well for making payments or saving for the future. Very few merchants accept them because of their fluctuating values and slow clearing times. It is possible future digital currencies could at least partially solve these problems, leading to greater adoption. However, widespread adoption of private digital currencies would carry important risks, to both the economy and the financial system. The issuer could go out of business, or fall victim to cyber theft. If these situations happened, it would lead to a loss of confidence in the payment system. Private digital currencies could potentially hurt the ability of a central bank to control inflation and act as the lender of last resort. Our policy tools, like the overnight interest rate and lending facilities, only work in fiat dollars. As a result of these concerns, the main threats to traditional banks have been neobanks, and they have been growing in their potential to transform the entire banking ecosystem.
A Completely New Economic Infrastructure
The digital banking space is expected to radically change, and has already been experiencing tailwinds pointing to growth. Margins of traditional banks have been shrinking, as McKinsey estimates that margins shrank more than 25% in the past 15 years. They also expect a further 20% shrinkage in the next decade. Though regulation and competition among traditional banks remains a threat, the larger concern is the rise of digital payment products and neobanks.
Take Chime for example. Chime is widely regarded as the US’s largest neobank, with an astounding growth of 7.4 million users in 2019 to an estimated 38 million users in 2024 according to a Cornerstone survey. Stunningly, over 60% of Chime’s customers use Chime as their primary bank, even though it is not backed by physical branches. Consumers are becoming increasingly drawn to Chime’s fee-free business model, while still offering solutions that typical banks provide such as debit, credit and savings accounts, access to over 60,000 ATMs for free, and a credit building service. This shows that consumers are increasingly comfortable with digital banking systems; they no longer need a physical branch or physical cash to feel comfortable with their banking institution, and they enjoy the convenience of mobile banking.
Furthermore, traditional banks have estimated that digitalization is the key to their own success. In 2019, Citi estimated that digitalization could cut banks’ operating costs by 30-50%, as there will be a need for fewer branches and employees. The desire to accelerate this transformation was emphasized by Citi in 2021 when they exited consumer banking in 13 markets across Asia, Europe and the Middle East, perhaps due to their expanding digital banking capabilities. On the contrary, it is estimated that bank revenues would decrease 10-30% in the near future due to higher transparency and increasing competition. Banks must fight to keep their market share, and digitalization is the key to maintaining a competitive advantage over peers such as Chime.
This digitalization trend has been working for banks that are able to implement it. A survey by Accenture has suggested that digital maturity is associated with increased profitability. Financial institutions that were “digitally focused” carried a ~20% higher valuation than non-digital peers, while a separate 2019 report outlined that digitally focused banks have seen a ROE increase of 0.9% over 10 years while their non-digital counterparts saw a decline of 1.1%. In a more recent article, McKinsey estimated that the digital transformation is becoming increasingly more challenging as the average age of IT applications in banks continues to increase, rewarding those traditional banks that are able to digitize over peers that are stuck in the past.
Current Environment of Digital Banking
Digital banking today is not the same as it was in 2021. Valuations have declined significantly, and overall deal activity has slowed as interest rates have remained elevated. A great example of this is Chime, which was noted for its strength earlier in this article. Despite its fast growing customer base and its efficiency in capturing the US banking market, its 2021 valuation of $25 billion has dropped to around $8 billion according to 2023 secondary market activity, and to around $6.5 billion today according to Caplight. This decline in valuation is seen across the board by companies in the fintech space, and the overall hesitancy to invest in these companies has halted investment.
Though valuations have been dropping, we see a much brighter outlook when it comes to the user expansion of digital banks. Openbank, operated by Santander, announced recently that it would expand into the US. Its deposit base of $13B is the highest in Europe by any neobank, which brings a strong potential to disrupt the US market, and it proves that the digital transformation of traditional banks is still very popular. This growth in popularity is not exclusive to Openbank either, as data according to App Radar revealed that in 2023, digital banks had 18M more app downloads than their legacy counterparts. This all reveals the compelling shift towards digital banking from a consumer standpoint, which has not slowed down despite valuations dropping.
An additional catalyst to the space will be potential IPOs. Chime, which was discussed earlier for seeing a declining valuation, is rumored to be exploring an IPO despite it likely not being able to receive the same amount of cash injection as it would have in 2021. Forbes reported that this IPO is likely to come in 2025. The other large fintech company that is expected to IPO soon is Stripe, which is a payments infrastructure company. Though not the same as a digital bank, the IPO of Stripe would be a catalyst for investment in the digital banking space if done correctly, as it would revive investor confidence after the sharp valuation declines in 2023. It would also encourage more digital banks to pursue an IPO if it is successful, bringing more cash into the space and increasing the number of eyes on digital banking technology, potentially bringing new consumers.
What does the future hold?
Financial technology and digital banking has been growing at multiple fronts. Neobanks and digital wallets are significant sources of growth, while other topics left undiscussed in this article such as the rise of A2A payments and the rise of BNPL should not be ignored. It is also important to consider that global ecommerce growth is rapidly expanding, with an expected CAGR between 2023-2027 expected to be 9% (more than double the CAGR of POS transactions).
The digital transformation of our everyday banking is clearly not just a COVID trend, despite what deal activity and valuations may tell you. Banks are rapidly expanding their digital capabilities, and the increasing market share of digital banks cannot be ignored. McKinsey reported in 2023 that only 30% of banks that had undergone a digital transformation successfully implemented their digital strategy. This failure will separate the banks which will be able to weather the digital age, and the ones which will be lost in the past.
