This article first appeared in Personal Wealth, The Edge Malaysia Weekly on October 22, 2018 - October 28, 2018

Financial services companies that do not drastically improve their digital footprints and online user experience will cede control of their distribution channels to global technology firms, Moody’s Investors Service said in a recent report.

Its late-September report, “Threat of big tech disruption is real”, proposes two scenarios in which this could occur. The central scenario sees financial incumbents losing control of a portion of their distribution channels to global tech giants’ superior product aggregation abilities.

In the alternate scenario, global tech giants will have gained the expertise to manufacture certain financial products and services of their own. Therefore, in addition to controlling even more of the distribution, tech giants will now be competing directly with financial incumbents.

“We think that they (global tech giants) will start with the simplest products that are core to their business, such as payments,” senior analyst and lead author of the report Stephen Tu tells Personal Wealth in an interview.

In the central scenario, financial incumbents will end up ceding control of customer relationships to tech giants, as the latter expand into distribution of retail financial services. “Customer relationships touch every product out there, so it is an important factor in the ability to sell and make a profit off of any financial product or service. We believe that the largest threat is to the retail customer relationships,” Tu adds.

The report’s central scenario says that while big tech firms will continue to expand in the distribution and inclusion of financial services in their ecosystems, they will nonetheless largely stay clear of the direct manufacture of certain financial products. This is especially true of lending and deposits, given the high regulatory burden on financial institutions and the presence of well-established incumbents.

This is likely to lead to partnerships between big tech firms and financial incumbents. These partnerships can help financial incumbents be more responsive to the new environment.

Through these partnerships, however, financial incumbents will eventually cede a level of control over distribution, which is a credit negative, the report said. Although the tech partner can provide a large, attractive customer base for the financial incumbent, it will be the tech partner that retains a large percentage of the customer’s mindshare, while simultaneously gaining trust and credibility.

Tech giants have a key advantage in product aggregation, that is, displaying all kinds of products and services on an “online shelf” a la Amazon and Alibaba, Tu says. “Just like any supplier to a supermarket, they typically have to pay for the shelf space. So, one way for tech giants to monetise the aggregation of financial products and services would be to charge financial incumbents a fee for displaying their products online.”

In the long run, Tu says this will see tech giants selling financial products under their own brand name. “Customers will see the tech company as the product provider, even if the actual manufacturing of the product is done by the financial incumbent. When this happens, you’ll see for example, an ‘Apple’ insurance product, or a ‘Facebook’ financial product.”

The resulting higher price transparency and decreased customer interaction — once these relationships are “owned” by global tech giants — could result in margin pressure for financial incumbents, the report says. In response, incumbents will either have to develop new and effective digital platforms, or focus on market niches. “For example, the United Services Automobile Association (USAA) primarily insures US veterans. Meanwhile, Bancorp Bank primarily acts as a banking services provider to fintech companies,” says Tu.

In an effort to stave off this scenario, financial incumbents have invested heavily in technology and transformation in recent years. “Over the last several years, incumbents have primarily focused on building digital financial ecosystems or market niches where they believe they can maintain a strong value proposition for the consumer. They have rapidly accelerated their digitalisation efforts in a number of different ways,” the report found.

These efforts range from spearheading in-house technology transformation initiatives, running tech incubators, and forging partnerships with tech companies to strategic investments.

Most of the technology investments undertaken in retail financial services have been defensive, that is, to counteract threats to decreasing revenue. Technology investments also represent an opportunity to reduce costs, as well as to increase revenues in retail banking, asset management and, to a lesser extent, retail brokerage.

Nevertheless, the greatest uncertainty in the report’s central scenario is whether most financial incumbents can successfully evolve before big tech firms gain control of the customer relationship. “Although we expect financial institutions with greater resources and comprehensive, executable digital strategies to do well in the new digital age, the ever-increasing speed of change enabled by new technology is clearly a threat. This threat is most significant for smaller firms that are late adopters and continue to underinvest,” the report found.

Even so, Tu adds that financial incumbents still enjoy a clear scale and trust advantage. Incumbents such as JP Morgan and asset management giant Fidelity have strong user interfaces, he says. “Overall, however, we believe that technology companies are able to provide a better user experience, particularly in digital formats which we see becoming more dominant (in the retail financial services space).”

The alternate scenario
In the alternate scenario, big tech firms go on to compete directly with financial incumbents. Despite large technology investments, financial incumbents will not only lose control of distribution, but tech giants will also directly manufacture certain financial products as a means to better control user experience and retain more profit.

“We think that in this scenario, tech giants will control an even larger share of distribution (than in the central scenario), and a portion of the manufacturing of these financial services will also be done by the tech companies themselves,” Tu says.

The report adds that this scenario assumes digital ecosystem providers would gain increasing levels of customer trust and adopt prudent business processes, such as “know your client” and anti-money laundering processes.

Under this alternate scenario, it is also assumed that regulators do not block tech firms from making inroads into the financial sector, such as when US regulators blocked Ant Financial’s proposed purchase of MoneyGram International Inc.

Medium and small financial companies, and non-specialised firms in particular, will be challenged to maintain their competitive advantage amid the large investments required to keep pace with tech giants and the larger financial incumbents. “More farsighted financial companies will likely merge with the financial incumbents while their franchises still command strong valuations,” the report concluded.

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