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Digital disruption and the Royal Commission

Hip to be square …

Recently, I walked into the San Francisco offices of payments firm Square. It’s a very different scene from the typical corporate office. There are chess boards in booths, internal platforms for meetings and headphone-wearing workers staring at screens full of code. However, behind all these tech clichés, what has made Square a success is its singular focus on empowering the small business entrepreneur. Square now has the chance, with millions of users, to broaden its service offering and grow with them.

… or wedge shaped

Many successful finance disruptors create a wedge. They enter a niche of financial services with a unique mission and low-cost access to customers that allows them to scale. Then they extend the offering to something broader that could threaten the role of incumbents.

Looking across US Fintech success stories so far, many have followed this path, and the emerging backdrop in Australia is creating similar conditions, making the ground more fertile for disruptors.

Some key examples of US fintech disruptors include:

  • Square, which started with pain-saving payment terminals for small business that now extend to an ecosystem of credit, cash and software services.
  • UK-based Revolut, which has acquired two million customers (almost exclusively by word-of-mouth) to a prepaid currency card that offers no foreign exchange spread or fees. It is now rapidly adding further products.
  • the original fintech pioneer PayPal, which accessed customers via the unique channel of eBay before becoming the trusted vehicle for internet payments for 200 million+ accounts; it continues to promise 20% growth rates.

All of these companies started narrowly, whereas those that have failed have generally had issues with the cost of customer acquisition or gone head to head with major banks.

What will force Australia’s wedge?

In the US (and UK), ‘payments’ or ‘specialised lending’ have been key areas for disruption, but this hasn’t happened meaningfully in Australia yet. Advancing technology and changing customer behavior supports fintech disruption, but the challenges of earning trust and acquiring new customers loom large. Australian banks have defended well, and been innovative themselves, but they could now be exposed to a different challenge.

My historical view had been that a focus on business-to-business activities and partnering with the large players would be the path to success for both Fintechs and incumbents in Australia, with large banks proving particularly resilient. But given the fragmenting effect that the ongoing Financial Services Royal Commission is likely to have on the incumbents, should we be more open minded to the little guys?

Filling the space left by risk aversion

The biggest takeaway from the Royal Commission hearings may be on governance. The impact on the mindset of boards and management towards risk aversion creates scope for disruption to have a bigger impact than otherwise. It’s possible that risk aversion will create a space, or wedge, in financial services that may be filled by disruptive firms.

Risk aversion may create years of additional compliance spend and internal focus, leading to management actions that aren’t consistent with defending against disruption.

We are already seeing this backdrop driving Australian banks away from any business line that is ‘non-core’ or places reputation at undue risk. Wealth platforms, third party originated lending, auto lending, insurance, overseas subsidiaries and high-risk lending are some of the examples.

A look into customer futures

Exiting a lot of these relationship-building products not only gives up the profit pools, but also the data insights that could unlock the types of platform-style services customers might want in the future.

The scope for financial concierge-type services (cash flow management, digital wallets, artificial intelligence driven wealth advice) as possible future product ranges for digital banking is yet to be fully explored. If banks give up many of their peripheral services and associated data, it seems likely they would be less ready to enable future digital platforms.

It could be argued Australian banks have been living in a constrained oligopoly, where protecting margins and market share has been easy. Going forward, we could see the banks fight over a narrower set of products and this arguably means a weakening in the market structure. The recent breakaway by NAB on mortgage re-pricing may be an early example.

This narrowness should make banks better at compliantly delivering core products but may create the space for new players to drive a wedge and disrupt them. Throw in the ongoing litigation and a major adjustment from responsible lending scrutiny and we could see incumbent banks relinquish their natural advantages.

Don’t discount disruption for Australian banks

This leads to the question of whether Australian banks can find a digital cost reduction story to drive growth. The path to much lower digitised cost bases appears long and distant. Some US groups like Bank of America and American Express have managed to reduce nominal costs, though this was typically through traditional ‘low hanging fruit’ cost-cutting. Most US banks, in fact, are not seeing anything better than flat costs, and view the tech spending ‘arms race’ as ongoing.

Australian bank share prices currently reflect expectations of low growth, returns on equity remaining below historical levels and little benefit given to the banks for the healthy state of Australian corporates.

The Royal Commission has seen investors overreact on some factors, and if the banks can mount the perceived comeback that has been evident in some of the US banks, they might even be considered cheap at the moment. However, the bad news is that a return to the banking glory days (once the dust has settled on the Royal Commission) is likely to be compromised by meaningful disruption by non-bank players. This is in part due to the risk- averse regulatory and management response.

Now is not the time to ‘discount’ the impact of disruption. We see this creating a long, slow burn of subdued aggregate earnings and relatively static share prices for the banks.


Matthew Davidson is a Senior Research Analyst at Martin Currie Australia, a Legg Mason affiliate. Legg Mason is a sponsor of Cuffelinks. This article is for general information only and does not consider the circumstances of any individual.

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