Adversity for Banks, Fintechs in the 2nd Half of 2023
The financial services industry is facing multiple challenges (from Q1 and Q2) — affecting its overall performance and when a rebound takes place.
Coming out of 2022, investment funding into startups was already on the decline. Many fintech companies made tough choices in cutting back on staffing, eliminating new projects, being acquisition targets for competitors, or shutting down completely.
Fintechs weren’t the only players having to shut down. Three established, mid-sized banks suffered a failure earlier this year — Silicon Valley Bank, Silvergate, and Signature Bank. These collapses had ripple effects globally, especially for other regional banks. First Republic Bank soon followed. Discussions of mergers between smaller financial institutions seems to be a strong option as well — PacWest and Banc of California plan to become a merged entity (announcement made end of July).
The drop in funding and uncertainty among financial institutions stem from a combined ‘storm’ of economic and industry factors. Here are the top 5 challenges, with analysis on what each means for banks and fintechs.
Rising interest rates
The Fed raised rates in February, March, May, and July. These rate hikes have a dual impact: (i) lending products (e.g home & auto loans, credit cards) become more expensive for consumers, and (ii) competition amongst banks forces new offers of higher yields on customer deposits.
BANKS:
The competition for deposits means financial institutions must increase what they offered as APYs (annual percentage yields) from earlier in the year. It’s becomes more expensive for banks to keep the same deposit balances in 2022, from leaving in 2023.
Smaller & mid-sized institutions compete heavily on yields offered to clients since they lack the reach and digital capabilities of large, mega banks.
If financial institutions struggle to maintain deposit balances, there’s less funds available for them to provide loan products and charge higher APRs (annual percentage rates). This impacts the ability to generate revenue and maintain their own operations.
FINTECHS:
Mid & high income demographic segments (banking with fintechs) will be also be looking for higher APYs on their deposits. Since switching providers is easier through these non-banks, the risk is higher in both retaining this existing tier of clients AND acquiring new customers.
For fintechs focused on underserved communities, high yield deposit products are a minimal priority due to low account balances.
This segment of users (living paycheck-to-paycheck) is more concerned with access to credit through advances and small-dollar loans. The higher rates increase the cost of capital in offering unsecured credit, which makes it more difficult for fintech startups to offer customized lending products to this demographic.
The high-level expectation is that the Fed Funds rate will remain elevated through the end of the year (at least). Banks will need to find a balance in attracting new deposits at a cost level which allows for a sustainable net interest margin (NIM). Consumer-facing fintechs will shift towards specialty services and unique user groups, instead a broad offering that may get lost in a saturated market.
Bank disruptions (tech issues & failures)
Bank of America, Wells Fargo, and other top banks struggled with major tech outages (in branches & digital apps) earlier this year.
Mid-sized and regional banks are still making strategic adjustments based on failures at the end of Q1 (Silicon Valley Bank, Signature Bank, Silvergate).
BANKS:
In 2023, digital transformation is still a loaded topic for financial institutions — many of which are struggling to keep up with modern-day features & services. Major outages are linked to legacy infrastructure that banks are unable to ‘rip & replace’ easily.
The common option is working with fintechs that can deliver better connectivity and data access through APIs (application programming interfaces).
Banks who are slow to implement a tech strategy will risk being left behind by competitors.
With recent bank collapses, regulators are expected to increase reserve requirements of financial institutions (both mid & large size) to avoid further interruptions. This will reduce the capital available for banks to lend and generate revenue.
FINTECHS:
Fintech startups have numerous opportunities to form supportive partnerships that enable improvements with infrastructure, data management, risk & operations, and user-specific functionality.
For fintechs relying on banks as infrastructure partners in white-labeled products (such as Banking-as-a-Service), business continuity becomes a concern. If banks can no longer fulfill obligations of their own retail clients, they also wouldn’t be able to manage those as a 3rd-party channel partner.
Technology struggles within the banking sector are a constant, but the issue has become more public this year in light of major, operational challenges. Despite the lack of a rapid solution, financial institutions can still take steps toward improvement this year by partnering or acquiring modern solution providers.
Higher capital requirements (to avoid future disruptions) may force some regional banks & credit unions to merge, or be acquired by competitors in order to stay in business. The only other option would be to shut down.
Regulatory pressure & activity
Third-party oversight of fintech partnerships and the impact of lending offerings (especially Buy Now Pay Later, BNPL) have increased monitoring across the industry. Crypto in the US is still under scrutiny from regulators regarding classification as securities -- impacting access to these platforms.
BANKS:
More regulatory pressure for financial institutions, this time in the area of powering fintechs with white-labeled products. The licensed entity has the ultimate responsibility from the regulator’s perspective, yet most partner banks are smaller institutions with limited resources — balancing direct clients AND those of a fintech.
The majority of US banks are still planning to stay away from crypto activity (or any type of affiliation). Until clear guidance comes from the SEC and other agencies, banks remain focused on fiat-only operations.
FINTECHS:
The pressure from regulators on partner banks is trickling down to fintechs. The mindset shifted towards shared responsibility for risk & compliance management (instead of it all falling on financial institutions).
For fintechs with value propositions linked to crypto, there’s been a transition to not serving the US market, removing crypto completely from their platform and focusing on banking, or shutting down. Very few US crypto companies will be able to stay alive without a fiat on & off ramp to enable access to crypto.
The level of activity from US regulators is not going away anytime soon. Concerns on shadow banking, consumer protection, and preventing negative, industry-wide events (such as the collapse of crypto exchanges and banks) has agencies on high-alert. Both banks & fintechs must do their part to show a rigorous approach toward compliance monitoring.
Demand for top digital experiences
Financial institutions struggle to meet higher standards in user experience. Collaboration with fintechs (or acquisitions) enable banks to speed up implementing a modern & scalable solution for clients.
BANKS:
Beyond large entities (such as JPMorgan Chase, Bank of America, Wells Fargo), many financial institutions are unable to accommodate a modern-day banking experience.
Lack of user functionality impacts customer service scores and the amount of transaction activity that a client can perform. Declining levels of activity result in missed opportunities to generate revenue and increase customer loyalty.
FINTECHS:
Fintechs are prime partners for banks looking to improve their digital experience. Able to design, implement, and launch quickly, these startups have enhanced what’s possible for financial institutions (faster than in-house capabilities).
However, this market has become saturated with companies offering low-cost solutions through outsourcing staffing companies. This can lead to a disjointed integration that lacks quality project ownership and ongoing maintenance.
As the best area for direct partnerships, banks and fintechs will continue to partner towards better customer journeys. The responsibility lies on financial institutions to make the move and choose the right provider for their customers.
Cyber security
Account takeover, phishing, and incidents of social engineering scams were abundant in the first half of 2023. Banks (and fintechs partnering with them) need robust vendor offerings that consolidate fraud coverage and enhance prevention.
BANKS:
Financial institutions have risk management in their DNA and take a narrowed ‘guardrails’ approach into what’s allowed by users (e.g. transaction limits, frequency, payment capabilities, etc.).
However, banks lack the technical & operational functionality (in-house) to proactively prevent fraudulent activity from users.
FINTECHS:
Compliance & risk startups are well-positioned to support financial institutions by reviewing multiple data sources and implementing risk models (based on expected user behavior & anomalies).
These companies may provide other services such as user verification & onboarding, account opening requests, payment processing, and back-office administrative tasks (such as reporting and audit requests).
The need for cyber security continues to rise across the financial services industry. Investors have caught on to this growing demand and continue to pour funding into startups in this sector. Banks have accepted that fintechs are powerful enablers and a partnership is the best path forward.
ADDING IT ALL UP
Among these industry challenges, business models and risk management are two common threads that stick out the most.
It's critical in today's climate (more than ever) to work with experienced partners that don't take shortcuts in building products that are sustainable (for growth & compliance). This holds true banks & fintechs partnering to offer embedded finance and other banking services.
For financial institutions, strategy & operations must adapt to the current economic and regulatory environment. This means changes in traditional bank products, adding partnership opportunities, and exploring new channels for revenue. Serving non-US individuals and businesses with US banking products is an emerging path that some banks are finding success with.
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