Israel's Supervisor of Banks earlier this month published its latest changes for the next phase of opening the banking market in the country. In a few weeks, traditional banks will begin sharing the credit card data of the Israeli public with third parties (subject to the customer's consent). Other financial entities, such as the digital bank One-Zero, which recently began a quiet rollout alongside non-bank credit companies, are already looking forward to the move. Dozens of fintech companies are also eagerly awaiting the opening up of the market.
In Israel today these fintech companies are still far from taking a meaningful slice of the profitable financial pie. Many Israeli fintech companies anyway choose to operate outside Israel because of its relatively small market. It is not easy to reach a large customer base, in a centralized world of five major banks, and strict regulations that are slowly being relaxed.
Worldwide, fintech companies are biting into bank profits
In contrast to the situation in Israel, in the US and UK, fintech companies are biting significantly into the profits of large banks. According to international consulting firm McKinsey, fintech companies have captured 3% -5% of banks' revenue and are recording revenue of hundreds of millions of dollars. "These companies have grown from something happening marginally to an 'elephant in the banks' room.' By entering their customers' daily lives and providing a solution for specific financial needs, digital companies have gained millions of customers, and investors are attracted to their growth," McKinsey explained.
McKinsey's 2021 Global Banking Review shows that in the US, about 40% of retail customers use fintech or big tech in banking activity. In Western Europe, the penetration rate of these companies is 30%. The main reasons for this are price and customer experience - easy access, speed of services, and app features.
McKinsey explains that banks that are looking to be leaders in their field at a global level have a limited window of opportunity. They urge bank CEOs to make bold decisions concerning the investment portfolio and business model - both to face new competition from fintech companies and digital banking services and to take advantage of new opportunities in a market, recovering from the Covid-19 crisis. The report further states that about two-thirds of the value generated during an entire economic cycle is generated during the first two years after the crisis. Therefore, there is an even greater urgency to make these required changes.
What will the banks do to take advantage of the rebound from the crisis?
McKinsey Israel managing director David Chinn told "Globes," "The key question around the world is what banks will do to meet the challenges and seize the opportunities created by a world returning from a crisis. The most interesting conclusion from the report is what distinguished the most successful and least successful banks from the 2008 crisis to the current crisis. Those who emerged stronger from the previous crisis opened up an ever-growing gap and took advantage of this to renew the modus operandi to widen the gap even further."
McKinsey cites three trends that helped banks open the gap. The first was digital channels with more connecting points to the customer's daily life and an improved customer experience. The second trend was a sustainable economic model, less targeted at wealthy customers and focused on growth and monetization (utilizing the activity of a digital asset such as a website or profit-making app) through services and commissions. The third trend was agility and flexibility in acquisitions and business partnerships. The report noted JP Morgan completed about 30 acquisitions in 2021 to create business partnerships and increase the scope of its services.
Half of consumers use fintech services
According to Chinn, the Israeli banking market is at a key point, and banks must think strategically about distinguishing themselves, with fintech companies waiting in the wings. "There are some changes that will greatly affect the opportunities in the near future.
"The first is open banking, which also gives tools to non-banks to play on a field that until now was owned solely by the banks, and that is through access to data. The second is account mobility "at a click", which is not revolutionary, but whoever has the better capabilities can recruit customers with greater ease. And the third is that anyone who holds a license to provide banking services can enlist the help of a banking computer services bureau, without building a computer system from scratch, and that is the basis for many companies that want to enter the field," he says.
"When I worked at Credit Suisse in 1999 and built a digital bank, we all spoke about how the Internet and companies operating on the web want to destroy the banking market. They have yet to take the entire market from the banks, but more and more consumers, 40%-50%, are already using fintech services - whether it is through a second account, on PayPal, or by making stock deals with Robinhood.
"So we are at a stage where baby boomers are reaching the end of their lives, and the money is moving to the younger generation that is used to working with other companies in a different way. The banks' classic business - to take advantage of the balance sheet to give loans, current accounts, and bank deposits - is about to capture an increasingly smaller slice of the banks' revenue and stands at 45%, compared to 55% in 2014.
"Moreover, profitability of these areas is 3%-5% because they are capital intensive and laden with regulation and competition. But Chinn explains that in new worlds like payments, direct investing, and investment banks, return on capital is 15% to 20%.
"Traditional activity has no growth in profitability"
Chinn notes that these changes do not always lead to fintech companies winning in the competition in new areas of operation. "For example, banks are hardly seen in the 'buy now pay later' field, and the profitability goes elsewhere. Banks will probably retain their share of traditional activity. Still, capital markets give this activity value as a public service (like water bills or property tax payments) instead of a growing business. In other words, this field may be safe and long-term, but without growth in profitability."
How do you see the entry of digital banks, when estimates are that in Israel 90% of transactions are carried out digitally anyhow?
"I'm not sure it's 90%. If you look at our data, just a little over half of the customers, 55%, are digitally active, and between a quarter to a third of the banks' big product sales are made digitally. "As for the impact of digital banks, first of all, the standout thing is that almost all of them have a very easy account opening experience. So many people are opening secondary accounts in digital banks. My children, for example, live in the UK, and they have a traditional account. Still, all of them have opened an account in Monzo (a British digital bank that began as an application for controlling expenses). They are slowly transferring their activity there. Since they are still young, they do not need complicated banking services.
"The digital banks are pressing traditional banks to improve their service experience and apps. Almost all countries permit opening of secondary accounts, and many of them offer benefits for a particular market segment. For example, money transfers abroad, which is a very expensive bank service. This is how digital banks began to gain customers and it affected the quality and cost of a very low competition service. It will be very interesting to see what will happen in Israel in this field".
Returns on banks' capital is decreasing
These insights come following the Covid crisis, which has led to a significant drop in the return on capital of the world's leading banks. In North America, returns of the veteran banks has fallen from 12% in 2019 to 8% in 2020, in Europe from 6% to 3%, and on a globally, return on capital fell from 8% in 2011 to 6% in 2020.
According to McKinsey, by 2025, the banking industry will generate a return of 7% to 12% - a reasonable forecast, but not particularly attractive (consistent with the average return in the past decade - 7%-8%.) To this, it is important to add another finding of the report - the return on capital of 51% of the banks is lower than their expenditure on capital. This finding obscures and cools future forecasts.
In Israel, banks during the first three quarters of 2021 reported a return of 15% on capital. IBI investment house expects that in 2022 the return will be 12%-13%.
"The Israeli economy benefits from growth in the consumer index," Chinn explains. "In the world, if the bank interest rate rises, for about every 1% it rises the return on capital rises between 1%-1.5%. Unlike many countries, Israel has index-linked loans, which I assume stems from our history of high inflation. So, when the index rises, it increases the banks' profits without the Bank of Israel raising the interest rate.
"Secondly, the reserves set aside by the banks for credit losses (in case the borrowers are unable to meet the loans) have been repaid in part to a much greater extent than we expected. If this continues, the banks will profit for a year or two from the release of the reserves. "They rightly are not releasing all the reserves now because even at the beginning of the year, the pandemic situation was still uncertain," he explains.
In this context, McKinsey estimated that in 2020, banks around the world would set aside reserves for credit losses amounting to $1.5 trillion. Total deposits eventually stood at $1.3 trillion, still an incredible number. It was $400 billion higher than in 2009, following the subprime crisis.
"In addition to these two points, the Israeli economy is growing at a steeper rate as the population grows and high-tech booms, so it enjoys a higher growth rate than in Europe, and even better than in the US, which is good for the banking system."
"There may be a situation where everyone is mediocre in everything"
McKinsey's summary urges the banks' CEOs to make bold decisions concerning their investment portfolio and activity model. Until recently, the model was 'universal banking' - a strong bank that does everything. But when everyone behaves in the same way, it is liable to create a situation in which everyone is mediocre in everything.
"I do not think that there is one bank in the world that is big enough to do everything. The ability of banks to hire the highest level of technology specialists will always be limited. However, their competitors have access to almost unlimited money in the capital market, so they have the ability to 'buy customers,' which a classic bank does not have.
"Therefore, the expectations from the banks when competition intensifies are to make decisions about where they want to compete, and some of the portfolio decisions will be to give up some of the activity in the portfolio.
"And we already see, for example, banks selling overseas operations to raise capital for their core operations, or banks entering more into specific areas. In other words, the trend is to channel capital from one business to another, where you feel you can earn more," notes Chinn.
Published by Globes, Israel business news - en.globes.co.il - on February 21, 2022.
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