The Fu­ture of Fi­nan­cial Ser­vices

What will fi­nan­cial ser­vices look like in 2035? Only one thing is cer­tain: Banks that fail to em­brace new and emerg­ing tech­nol­ogy will not sur­vive.

Rotman Management Magazine - - ROTMAN MANAGEMENT - By John Hull

What will fi­nan­cial ser­vices look like in 2035? One thing is cer­tain: Banks that fail to em­brace tech­no­log­i­cal ad­vances will not sur­vive.

if you wanted to book a flight from New York BACK IN THE 1980S, to London, you would con­tact a travel agent, who would check avail­abil­ity, present op­tions, re­ceive your in­struc­tions, and then fi­nally make a reser­va­tion. To­day, you are likely to go on­line and book di­rectly with the air­line. What has hap­pened here is a process known as dis­in­ter­me­di­a­tion. The travel agent as an in­ter­me­di­ary is no longer needed.

This does not mean that there is no need what­so­ever for in­ter­me­di­aries in the travel in­dus­try. On­line ser­vices such as Ex­pe­dia and Trav­e­loc­ity have sprung up to as­sist when cus­tomers want to quickly com­pare prices be­tween air­lines or hotels. How­ever, the na­ture of the in­ter­me­di­aries in the travel busi­ness has changed dra­mat­i­cally, and hu­man in­volve­ment has largely dis­ap­peared. The cre­ation of new tech­nol­ogy-based in­ter­me­di­aries like Ex­pe­dia and Trav­e­loc­ity is re­ferred to as rein­ter­me­di­a­tion.

Dis­in­ter­me­di­a­tion fol­lowed by rein­ter­me­di­a­tion is a com­mon pat­tern in tech­no­log­i­cal change. Like the travel agents of the 1980s, banks and other fi­nan­cial ser­vices com­pa­nies are in­ter­me­di­aries, and they are sim­i­larly in dan­ger of hav­ing the ser­vices they pro­vide dis­rupted.

In this ar­ti­cle I will dis­cuss some of the ways in which fi­nan­cial ser­vices will be im­pacted by fi­nance-re­lated tech­nol­ogy or ‘fin­tech’ go­ing for­ward. For in­ter­ested read­ers, a fuller dis­cus­sion of emerg­ing fin­tech in­no­va­tions is cov­ered in the re­cently re­leased fifth edi­tion of my book, Risk Man­age­ment and Fi­nan­cial In­sti­tu­tions.

Dis­rup­tions in Pay­ment Sys­tems

Tech­nol­ogy has al­ready had a huge ef­fect on the way pay­ments are made. As a so­ci­ety, we have moved from cash and cheques to credit and debit cards to the use of mo­bile wal­lets. In some re­spects, de­vel­op­ing coun­tries have pro­gressed even fur­ther in this di­rec­tion than de­vel­oped ones, in part be­cause tra­di­tional pay­ment sys­tems were not as well es­tab­lished. Many fin­tech start-ups are of­fer­ing new ser­vices, and some — such as Pay­pal, Ap­ple Pay, Google Wal­let and Ali­pay — are now large, wellestab­lished com­pa­nies.

The key at­tributes of a pay­ment method are speed, con­ve­nience, se­cu­rity, sim­plic­ity and cost. As a re­sult, ser­vices such as Pay­pal trans­fer funds al­most im­me­di­ately, and stor­ing credit card-like in­for­ma­tion in an iphone or sim­i­lar de­vice adds to the con­ve­nience for many con­sumers. In­deed, given the dom­i­nant po­si­tion of Ap­ple in the smart­phone mar­ket, it has been nat­u­ral for it to ex­pand into pay­ments, and some have spec­u­lated that it will not be long be­fore Ap­ple of­fers a wider range of bank­ing ser­vices. One can imag­ine that wear­ables such as watches or bracelets — or even im­plants — may be used in the same way as smart­phones to add to the con­ve­nience of mak­ing pay­ments.

Se­cu­rity is a ma­jor is­sue for all forms of pay­ment. Tens of bil­lions of dol­lars are lost each year from credit card fraud. Embed­ding chips as well as mag­netic strips in cards helps, but does not elim­i­nate this prob­lem. We are likely to see big changes in the way fraud is avoided in the fu­ture. Al­ready, dig­i­tal wal­lets

are con­sid­ered to be more se­cure than credit cards, and many pay­ment providers, in­clud­ing banks, are in­ves­ti­gat­ing the use of ‘bio­met­ric au­tho­riza­tion’. Reti­nal scan­ning, fa­cial recog­ni­tion, voice au­then­ti­ca­tion, and even heart­beat mon­i­tor­ing are all be­ing con­sid­ered.

The costs of fraud are usu­ally borne by the pay­ments sys­tem provider, and are passed on to mer­chants in the form of fees. Pay­pal, for ex­am­ple, charged 2.9 per cent plus $0.30 per trans­ac­tion in mid-2017. Of course mer­chants, in turn, pass the fee on to con­sumers. Ev­ery­one there­fore has an in­ter­est in re­duc­ing fraud, and ap­proaches for mak­ing more se­cure pay­ments should be wel­comed.

In In­dia, mak­ing more peo­ple part of its fi­nan­cial ecosys­tem is an im­por­tant ob­jec­tive that is lay­ing the ground­work for a cash­less so­ci­ety. Al­ready, the gov­ern­ment has is­sued bio­met­ric IDS (in­volv­ing fin­ger­prints and reti­nal scans) to over one bil­lion peo­ple. These IDS have the ad­van­tage that some gov­ern­ment ben­e­fits can be dis­trib­uted with less in­volve­ment from in­ter­me­di­aries. Of course, some would ar­gue that the pro­vi­sion of bio­met­ric in­for­ma­tion is an un­ac­cept­able vi­o­la­tion of a per­son’s pri­vacy, and this may slow down its ac­cep­tance in de­vel­oped coun­tries.

Some pay­ment sys­tems al­low users to bor­row money. The in­ter­est rates charged by credit card com­pa­nies are very high, but it should be re­mem­bered that users do get free credit for the pe­riod of time be­tween a pur­chase and the next monthly due date. Pay­pal com­petes with this by of­fer­ing 14 days of free credit. It is likely that more con­ve­nient credit fa­cil­i­ties, tailored to the needs of users, will be de­vel­oped. Through its sub­sidiaries such as Ali­pay and My­bank, Alibaba is al­ready of­fer­ing many of the same ser­vices as banks.

What other ser­vices can be of­fered to make pay­ment sys­tems at­trac­tive? Many in­di­vid­u­als remit funds on a reg­u­lar ba­sis to fam­ily mem­bers in an­other coun­try, and the for­eign ex­change ser­vices as­so­ci­ated with those trans­ac­tions are likely to get more con­ve­nient and com­pet­i­tive. For busi­nesses, easy-to-use for­eign ex­change hedg­ing ser­vices that com­pete with those of­fered by banks are likely to be de­vel­oped. Fin­techs may also carry out so­phis­ti­cated analy­ses of sales to help a com­pany un­der­stand its cus­tomers bet­ter or pro­vide ac­count­ing ser­vices.

Of course, cus­tomers who pre­fer cash will con­tinue to ex­ist for some time. Some peo­ple have bad credit his­to­ries and do not qual­ify for credit cards, while oth­ers are too risk averse to give their credit card in­for­ma­tion to third par­ties. Ama­zon has rec­og­nized this and al­lows cus­tomers to open an ac­count at se­lected re­tail­ers by de­posit­ing cash. When goods are pur­chased, the ac­count is deb­ited.

Fi­nally, one as­pect of the dig­i­ti­za­tion of pay­ments is that it be­comes much eas­ier to col­lect data on a per­son’s spend­ing habits. This could be use­ful to banks when mak­ing credit de­ci­sions. Know­ing how a po­ten­tial bor­rower spends money can be al­most as im­por­tant as know­ing how much he or she earns.

Dis­rup­tions in Lend­ing

In some large banks, loan of­fi­cers are al­ready be­ing re­placed by sys­tems in­volv­ing machine learn­ing. Given enough data about a bank’slending­ex­pe­ri­ence,itis­rec­og­nizedthata­ma­chine­learn­ing al­go­rithm can sort good loans from bad as well as — or bet­ter than — a hu­man be­ing. In prin­ci­ple, a machine learn­ing pro­gram can be more ob­jec­tive and ex­hibit less bias than a hu­man.

Else­where on the lend­ing front, peer to peer lend­ing (P2P) is gain­ing ground. This is the prac­tice of lend­ing money to an in­di­vid­ual or busi­ness through an on­line plat­form that matches lenders with bor­row­ers. Like the travel in­dus­try, peer-to-peer (P2P) lend­ing in­volves dis­in­ter­me­di­a­tion fol­lowed by rein­ter­me­di­a­tion. Banks are no longer the sole in­ter­me­di­aries, and new in­ter­me­di­aries are be­ing set up to pro­vide ser­vices such as:

• Ver­i­fy­ing the bor­rower’s iden­tity, bank ac­count, em­ploy­ment, in­come, and so on;

• As­sess­ing the bor­rower’s credit risk and, if the bor­rower is ap­proved, de­ter­min­ing the ap­pro­pri­ate in­ter­est rate; and

• At­tempt­ing to col­lect pay­ments from bor­row­ers who are in de­fault.

Many bor­row­ers who use P2P plat­forms have al­ready been re­fused by banks, so the in­ter­est rates can be quite high com­pared with con­ven­tional loans (but lower than the rates on credit card bal­ances and other sources of credit for moder­ate- to high-risk bor­row­ers).

P2P lend­ing plat­forms such as Pros­per and Lend­ing Club as­sign a credit rat­ing to a bor­rower in much the same way that a bank does. Lend­ing Club, for ex­am­ple, cat­e­go­rizes bor­row­ers by as­sign­ing a let­ter grade be­tween A and G. The in­ter­est rate charged to the less credit-wor­thy bor­row­ers is higher than to A-grade bor­row­ers, but the ex­pected loss from de­faults is also higher. Sta­tis­tics pub­lished by Lend­ing Club in June 2017 show that both in­ter­est rates and loan losses are higher than on most loans made by banks; how­ever, the net an­nual re­turns that in­vestors re­ceive on av­er­age are quite at­trac­tive com­pared with other op­por­tu­ni­ties.

The fees at P2P lenders can be quite high. At Lend­ing Club, the bor­rower pays an orig­i­na­tion fee typ­i­cally be­tween 1% and 5% of the amount bor­rowed. The lender pays a ser­vice fee (typ­i­cally about 1%) on pay­ments re­ceived and may also have to pay costs as­so­ci­ated with col­lec­tions on delin­quent ac­counts.

Some lend­ing plat­forms can be crit­i­cized be­cause they have no ‘skin in the game’. If loans do not per­form as well as ex­pected, the lender bears the en­tire cost. One ex­cep­tion is Up­start (started by for­mer Google em­ploy­ees in 2014), which has a dif­fer­ent model from Lend­ing Club and Pros­per. It charges bor­row­ers an orig­i­na­tion fee but does not charge lenders a fee. It uses the orig­i­na­tion fee to re­im­burse lenders if a loan de­faults, giv­ing it a stake in the per­for­mance of the loan. Its credit as­sess­ments have proven to be quite ac­cu­rate, and it has grown quickly.

P2P lend­ing has not been im­mune to scan­dal. The founder of Lend­ing Club (which used an IPO to be­come a pub­lic com­pany in 2014) had to step down in 2016 as a re­sult of a gov­er­nance scan­dal — but the com­pany seems to have bounced back. And in China, retail in­vestors have lost bil­lions of dol­lars in in­ci­dents where P2P plat­form op­er­a­tors have sim­ply dis­ap­peared with in­vestors’ cash. This has led to a crack­down on the in­dus­try by Chi­nese reg­u­la­tors.

All fi­nan­cial in­no­va­tions are li­able to have ‘teething trou­bles’ of this sort. In­deed, banks over their long his­tory have had their fair share of scan­dals. The real ques­tion for P2P lend­ing is whether it will make in­roads into tra­di­tional bank lend­ing. Will P2P lend­ing be­come a widely used op­tion for fi­nanc­ing the pur­chase of cars and houses? Will P2P be­tween cor­po­ra­tions be­come more com­mon? Be­cause these plat­forms are rel­a­tively new, it will be in­ter­est­ing to see how they per­form in an eco­nomic down­turn or when in­ter­est rates in­crease.

Dis­rup­tions in Wealth Man­age­ment

Wealth man­age­ment has tra­di­tion­ally been very prof­itable for banks. Fees are of­ten in the 1% to 1.5% range of the amount in­vested per year and can be much more when hid­den fees as­so­ci­ated with mu­tual fund in­vest­ments and trad­ing costs are taken into ac­count. Once a client’s risk ap­petite has been as­sessed, wealth man­age­ment in­volves find­ing ap­pro­pri­ate in­vest­ments for the client.

John Bogle took the first step to­ward re­duc­ing the costs of in­vest­ing with the first in­dex fund in 1975. In­dex funds have since be­come very pop­u­lar, charg­ing fees as low as 0.15% with no hu­man in­ter­ven­tion re­quired in the form of a wealth man­ager. Robo-ad­vi­sors first ap­peared in about 2010. In most coun­tries they must reg­is­ter with the au­thor­i­ties and are sub­ject to reg­u­la­tion. Robo ad­vi­sors like Wealth­front and Bet­ter­ment pro­vide dig­i­tal plat­forms where in­vestors ex­press their risk pref­er­ences. A port­fo­lio is then cho­sen, and go­ing for­ward, is au­to­mat­i­cally re­bal­anced as nec­es­sary. There is very lit­tle hu­man in­ter­ven­tion, and fees are lower than those charged by tra­di­tional wealth man­agers — typ­i­cally 0.50% to 0.75% of the amount in­vested per year. Some banks and other wealth man­agers are now re­spond­ing to this com­pe­ti­tion by of­fer­ing their own au­to­mated wealth man­age­ment ser­vices. In­deed, those that fail to do this are un­likely to sur­vive. Providers of in­dex mu­tual funds, such as Van­guard, are also ac­tive in this space.

Robo ad­vi­sors are mak­ing in­vest­ment ad­vice avail­able to a much wider range of in­di­vid­u­als. In­vestors can start with as lit­tle as $500 or $1,000 — whereas a tra­di­tional wealth man­ager might re­quire a min­i­mum in­vest­ment of $50,000. In its early days robo-ad­vis­ing tended to at­tract young in­vestors with small amounts to in­vest, but a much wider range of in­vestors, in­clud­ing those clas­si­fied as ‘high net worth’ and HENRYS (high earn­ers not rich yet) are now us­ing these ser­vices. Robo ad­vi­sors make it easy for clients to add to their funds un­der man­age­ment on a reg­u­lar ba­sis. Ar­guably they serve an im­por­tant role in so­ci­ety by en­cour­ag­ing peo­ple to save when they might not other­wise do so.

Un­til now, the main in­no­va­tion un­der­ly­ing robo-ad­vis­ing has been the de­liv­ery of ser­vices in a cheaper, novel way that many in­vestors find ap­peal­ing. The in­vest­ment strate­gies un­der­ly­ing the ad­vice given are usu­ally sim­i­lar to those that have been used by the in­vest­ment in­dus­try for many years. Tax-re­lated strate­gies (such as tax-loss har­vest­ing) are of­ten in­cor­po­rated into the ad­vice that is given. There is plenty of scope for these strate­gies to be­come more so­phis­ti­cated: In­vest­ments can be bet­ter di­ver­si­fied in­ter­na­tion­ally and across sec­tors; and they can be bet­ter tar­geted to the goals of the in­vestor, tak­ing into ac­count the in­vestor’s age, re­tire­ment plans, etc.

In 1992, Fis­cher Black and Robert Lit­ter­man at Gold­man Sachs pub­lished a widely used way of in­cor­po­rat­ing the views of in­vestors in the se­lec­tion of a port­fo­lio. Robo ad­vi­sors may find ways of ex­pand­ing the range of al­ter­na­tives of­fered to in­vestors us­ing this tech­nol­ogy. Al­ter­na­tive sets of views with ra­tio­nales could be pre­sented, with in­vestors be­ing in­vited to choose be­tween them. It might even be pos­si­ble to let the views of the in­vestor be a less struc­tured di­rect in­put to the deter­mi­na­tion of the port­fo­lio.

Hu­man in­vestors are sub­ject to nu­mer­ous bi­ases: They are re­luc­tant to sell losers, they chase trends, and they get dis­il­lu­sioned and exit eq­uity mar­kets when they should stay for the long term. It is of­ten the abil­ity to avoid these bi­ases that dis­tin­guishes a pro­fes­sional in­vestor from an ama­teur. Robo ad­vi­sors could try to stop in­vestors from fall­ing vic­tim to these bi­ases by de­vel­op­ing in­no­va­tive ways of ex­plain­ing them. Fi­nally, roboad­vis­ing could be com­bined with other fi­nan­cial in­no­va­tions so that a per­cent­age of a client’s funds is al­lo­cated to P2P lend­ing or eq­uity crowd­fund­ing.

Robo ad­vis­ing has al­ready be­come an im­por­tant part of the fi­nan­cial land­scape and is likely to be­come more widely used as the mil­len­nial gen­er­a­tion ac­cu­mu­lates wealth. For this gen­er­a­tion, it is much cooler to in­vest with an iphone than make a trip to the bank. How­ever, it is worth sound­ing a note of cau­tion: Eq­uity mar­kets per­formed re­ally well in the years fol­low­ing the start of robo ad­vis­ing in 2010. Its ap­peal may de­cline when there is a down­turn and the clients of robo ad­vi­sors — many of whom have never in­vested be­fore — com­plain about los­ing money. It is hoped that these ad­vi­sors will be able to ed­u­cate in­vestors on the im­por­tance of staying fo­cused on the long term.

How Fi­nan­cial In­sti­tu­tions Should Re­spond

Banks must care­fully eval­u­ate how con­sumer be­hav­iour is be­ing af­fected by tech­no­log­i­cal change — and take steps to change their busi­ness model ac­cord­ingly. East­man Ko­dak is one com­pany that did not sur­vive tech­no­log­i­cal change — even though it was aware of the changes tak­ing place in its in­dus­try. In­deed, the first dig­i­tal cam­era was cre­ated in 1975 by a Ko­dak en­gi­neer, and the com­pany in­vested bil­lions in the new tech­nol­ogy. Where did it go wrong?

While the com­pany un­der­stood the new tech­nol­ogy, it failed to ap­pre­ci­ate the way it was chang­ing con­sumer be­hav­iour un­til it was too late. Ko­dak coined the term ‘Ko­dak mo­ment’, which it used ex­ten­sively in its pro­mo­tions to con­vince peo­ple that they should al­ways have a cam­era on hand loaded with Ko­dak film, ready to cap­ture im­por­tant mo­ments. Some would ar­gue that the com­pany could have ex­trap­o­lated from its sales pitch to rec­og­nize the ac­tual busi­ness it was in: Ko­dak was in the imag­ing or mo­ment-shar­ing busi­ness, not the film busi­ness. Its im­plicit be­lief that de­mand for hard-copy pho­to­graphs would con­tinue ul­ti­mately doomed it.

The dis­rup­tion of large fi­nan­cial in­sti­tu­tions does not seem to be hap­pen­ing as quickly as that of Ko­dak, and banks have a

num­ber of com­pet­i­tive ad­van­tages: They are well cap­i­tal­ized (al­though the same is true of Ap­ple, Google and Alibaba); they un­der­stand how to deal with the highly reg­u­lated en­vi­ron­ment they op­er­ate in (some­thing many fin­tech start-ups find dif­fi­cult); and they have a huge cus­tomer base that mostly trusts them (al­though the 2008 fi­nan­cial cri­sis eroded that trust).

One can spec­u­late that fi­nan­cial in­sti­tu­tions are not as vul­ner­a­ble as Ko­dak in that many peo­ple are less in­clined to ex­per­i­ment with the way their money is han­dled than with the way they take photos. Also, many start-ups need es­tab­lished fi­nan­cial in­sti­tu­tions to of­fer their prod­ucts. How­ever, there are some im­por­tant warn­ing signs that banks should re­spond to. The Mil­len­nial Dis­rup­tion In­dex sur­vey in­di­cated that 71 per cent of mil­len­ni­als in the U.S. would rather visit the den­tist than lis­ten to what banks are say­ing, while 73 per cent would rather han­dle their fi­nan­cial needs through Google, Ama­zon, Ap­ple, Pay­pal or Square. Mil­len­ni­als also voted four lead­ing U.S. banks among their ‘least- loved brands’.

Ko­dak was ul­ti­mately ren­dered ir­rel­e­vant by the dig­i­tal cam­eras in­cor­po­rated in smart­phones and nat­u­rally, fi­nan­cial in­sti­tu­tions do not want to be­come sim­i­larly ir­rel­e­vant. Al­ready, they have rec­og­nized the need to of­fer mo­bile apps for pay­ments, wealth man­age­ment and a host of other ser­vices; but it is im­por­tant for them to em­brace tech­no­log­i­cal change it­self, not just to pay lip ser­vice to it. The fact is, tech­no­log­i­cal change in the fi­nan­cial sec­tor will con­tinue at an ac­cel­er­at­ing rate, and in many cases it will erode the prof­its banks pre­vi­ously re­lied upon from their tra­di­tional ac­tiv­i­ties (as was the case for Ko­dak). Be­ing flex­i­ble enough to ad­just will be a con­tin­u­ing chal­lenge.

The new ser­vices de­vel­oped by banks need to be con­ve­nient and de­signed so that young peo­ple clas­sify them as ‘cool’ while older peo­ple find them easy to use. Some fi­nan­cial in­sti­tu­tions have de­vel­oped new ser­vices in-house; some have bought start-ups that have al­ready de­vel­oped the ser­vices; and some have en­tered into part­ner­ships with start-ups. The first al­ter­na­tive — al­though the least ex­pen­sive and most ap­peal­ing to many in the fi­nan­cial sec­tor—can be quite dif­fi­cult, given the com­pla­cent cul­ture that of­ten per­me­ates large com­pa­nies. The sec­ond and third al­ter­na­tives can be used as a way of dis­rupt­ing the cul­ture and ac­cel­er­at­ing change. Some banks have found it use­ful to cre­ate an or­ga­ni­za­tion­ally dis­tinct unit that has the abil­ity to bring in out­side tal­ent when nec­es­sary and can part­ner with start-ups.

In clos­ing

The banks that sur­vive the dis­rup­tive forces de­scribed herein will have to cut costs by mak­ing big re­duc­tions in the num­ber of branches they run and the num­ber of peo­ple they em­ploy. To keep the ser­vices they of­fer up to date, they will have no choice but to form part­ner­ships with many dif­fer­ent tech­nol­ogy firms. In the realm of fi­nan­cial ser­vices, one thing is cer­tain: There is no avoid­ing the grow­ing wave of tech­no­log­i­cal change.

John Hull is the Maple Fi­nan­cial Chair in De­riv­a­tives and Risk Man­age­ment, Uni­ver­sity Pro­fes­sor and Pro­fes­sor of Fi­nance at the Rot­man School of Man­age­ment. He is Co-di­rec­tor of the Rot­man Mas­ter of Fi­nance pro­gram and the Rot­man Mas­ter of Fi­nan­cial Risk Man­age­ment pro­gram. He is also a co-founder of Fin­hub, a Rot­man ini­tia­tive for ed­u­ca­tion and re­search in fi­nan­cial in­no­va­tion. The 10th edi­tion of his book, Op­tions, Fu­tures, and Other De­riv­a­tives (Pear­son) was re­leased in Jan­uary 2017 and the fifth edi­tion of Risk Man­age­ment and Fi­nan­cial In­sti­tu­tions (Wi­ley) was re­leased in Fe­bru­ary 2018. This ar­ti­cle is an adapted ex­cerpt from the new chap­ter in the lat­ter book.

Rot­man fac­ulty re­search is ranked in the top 10 world­wide by the Fi­nan­cial Times.

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