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    Virtual Banking: A Guide to Innovation and Partnering
    Virtual Banking: A Guide to Innovation and Partnering
    Virtual Banking: A Guide to Innovation and Partnering
    Ebook424 pages4 hours

    Virtual Banking: A Guide to Innovation and Partnering

    By Dan Schatt and Renaud Laplanche

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    About this ebook

    Technology is permanently transforming the banking industry, and digital payments are the key

    Electronic Payments, Mobile Commerce, and Virtual Banking: A Guide to Innovation, Partnering, and Regulation takes a hands-on approach to competing in the modern banking environment. Former PayPal Head of Financial Innovation Dan Schatt explores the reasons behind the massive consumer migration away from traditional banks, and provides clear, actionable guidance on beating new banking models at their own game. Digital payment is the hottest topic in banking today, and is set to define the future of the industry.

    Consumers are rapidly abandoning traditional banks in favor of institutions that are lower-cost and more consumer-centric. Between the pace of financial regulatory reform and the cloud computing revolution, the old banking model is on the fast track to extinction. Electronic Payments, Mobile Commerce, and Virtual Banking provides the information banks need to compete in this new environment, and details the integral implementation actions that will allow them to thrive. The book discusses real-world innovations from banks, non-banks, and up and comers, and the heavy competition from the new outsource bank model. Topics include:

    • The changing POS landscape and the need for digital wallet partnerships
    • Shifting gears to greenfield market opportunities versus non-profitable markets
    • Digital channel best practices for superior customer experience
    • When to outsource, and what capabilities to truly own

    Case studies including PayPal, Google, Square, Facebook, Twitter, and more illustrate acceleration of innovation through banking partnerships, as well as the mechanics behind banking's biggest, scariest threats. The trick to surviving the paradigm shift is to embody innovation while providing a superior customer proposition. Electronic Payments, Mobile Commerce, and Virtual Banking: A Guide to Innovation, Partnering, and Regulation provides the inside track on managing the shift and dominating the new marketplace.

    LanguageEnglish
    PublisherWiley
    Release dateJul 29, 2014
    ISBN9781118742549

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      Book preview

      Virtual Banking - Dan Schatt

      Introduction:

      Innovating Through Scarcity

      More money is rarely the answer to innovation. The best innovations actually come from a world of scarce resources.

      —John Donahoe, CEO, eBay1

      A few years ago, I had the privilege to be one of the early members of PayPal X, a division of PayPal owned by eBay Inc. PayPal X was a radical idea at the time—a complete shift in business and operating models, which put developers and partners at the center of everything PayPal did. It was an acknowledgment that despite the significant number of talented people working at PayPal, far more talent, business insight, and innovation existed outside PayPal’s walls than from within. That’s a tough realization for any company to grasp—the fact that the best ideas, business, product, marketing, and engineering talent will always live outside the walls of any particular company, regardless of how successful it is with its core business. It requires a lot of courage to invite outside talent to compete with your company’s ideas and products, and that was certainly true for PayPal. It meant that other companies might have a better idea of how to serve their customers with your company’s assets. It requires a very strong, forward-looking CEO to allow that creative destruction to take place—a company might disintermediate itself to some degree, but the trade-off is that it stays relevant and has its fingers on the pulse of where an industry may be headed.

      Most financial services companies are not wrestling with this challenge. Hiring a chief innovation officer or forming an innovations group isn’t sufficient because significant industry innovation and disruption happens outside the walls of a company. Just consider the average mortality of large, multinational firms—roughly 40 years, versus the 75+ years that humans live.2 We live in a world of scarcity—there never seems to be enough talent, time, or resources for innovation beyond a core business. Ask any senior executive at a bank how many of their information technology (IT) and operations professionals are dedicated to risk and compliance initiatives, and chances are high that you’ll hear that anywhere from 70 to 90 percent of their resources are tied up to ensure they are meeting regulatory and risk requirements, despite the fact that U.S. banks will spend close to $42 billion on technology.3 They’ll spend another 25 percent of their compliance budgets on new overseas regulation.4

      Even at places like PayPal, which has a reputation for industry innovation and disruption, it’s never easy to free up product and engineering resources to focus on new initiatives. In today’s world, the only way to harness a critical mass of talent and stay relevant to consumer preferences and expectations is to open up and partner.

      In the case of PayPal, that meant encouraging developers of all sizes to build new products with a PayPal Inside approach. They could create frictionless experiences by integrating them within their own mobile applications. And through the new JavaScript PayPal buttons, developers could add PayPal by copying and pasting five lines of code into their web site, shopping cart, or a QR (quick response) code5—leading to massive improvements and cost reductions in development and integration. Developers could have access to new application programming interfaces (APIs)6 so that companies could accept credit cards while PayPal maintained the liability of handling the compliance aspects of the payment instrument. This was to include applications like peer-to-peer payments that could happen on multiple platforms besides PayPal.com. It allowed for split payments, enabling many recipients to receive funds at once, or payment preapprovals that allowed for automatic transfer of funds based on preset specifications, and even payment aggregation—allowing businesses to reduce the cost of transactions by aggregating payments to one lump sum.

      Opening up a platform, however, is not trivial and not for the faint of heart. Key vetting processes, compliance, and risk capabilities need to be in place. It requires ceding some control of an institution’s customers and brand. It also requires an understanding of what micro trends will become mega trends, and how to evaluate and build trust with the right partners.

      The exercise we went through with PayPal was transformative for us. Too often, the bigger a financial services company gets, the easier it is to resort to an insular build it and they will come mentality, leading to mediocre thinking and products. At PayPal, the platform approach led us to develop a strong business development culture—scouting for companies that could leverage PayPal assets. We partnered with many types of companies—other platform providers, technology companies, kiosk providers, and various commerce enablers. One of the biggest shifts was our approach in partnering closely with the banking world. We realized early on that these partnerships generated win-win outcomes due to the complementary nature of business models and core competencies involved.

      Fast-forward to today, and the financial services industry at large now has an opportunity to take advantage of a plethora of new services built by innovative companies that are recognizing trends faster than any larger company could. It requires a large company mind shift—an understanding that consumers or small businesses may not want to access their bank for a lending product; they may prefer Kabbage, Lending Club, Braintree, or Square to their banks. The only way to stay relevant is to embrace the fact that if you are one of the 14,000+ financial institutions not in the top 10, faced with a scarcity of assets, you can embrace technology to create incredibly relevant and compelling experiences for your customers. This means making it incredibly easy for others to integrate to your channels through a common platform services approach (think Apple App store for banks), or make it incredibly easy to embed a bank’s capabilities within a nonbank application. If you are involved in a strategy, innovations, or business development role with your institution, that will be important if you want to stay ahead of the curve. Stessa Cohen, a banking analyst with research firm Gartner Group recently tweeted her prediction that a full 25 percent of banks will have consumer app stores by 2016.7

      So how are some financial institutions not just surviving but thriving in this environment, even with little to no IT staff? They are taking advantage of a few key shifts in the marketplace—changing consumer behavior (social, mobile, and local trends discussed later in this book), the rise of platform services, and open APIs. These shifts, if combined with good, creative partnering, can go a long way to ensure that any institution can stay relevant and thrive. There are a few other trends and influencers discussed briefly in this introduction that we’ll weave throughout this book.

      The Influence of Cloud on Innovation

      Platform services, as we’ve just discussed, have been a tremendous enabler for anyone looking to innovate in the financial services arena. This has all come about as a result of cloud services: the ability for software to be remotely hosted on servers and delivered through the Internet. This allows for traditional financial institutions to more easily take advantage of others’ software and pair up offerings to create an almost unlimited number of software possibilities delivered through bank and nonbank channels. It has effectively lowered barriers and costs for anyone with a good idea to deliver their software. The cloud cuts across many areas of business but is tremendously valuable in the realm of financial services, where most people now bank online and money increasingly is managed in the form of digital information.

      The Influence of Smartphones

      Much has been written on the smartphone revolution, and we’ll explore some of ways the financial services industry can take advantage of new technologies, partnerships, and business models. To this day, 2.5 billion adults do not have access to the formal banking system, yet through smartphones, that is about to change very quickly.8 Around the world, companies such as PayPal, Square, and iZettle are enabling small businesses that would have otherwise transacted in cash to accept electronic payments. Simple credit card readers that can plug into a consumer’s existing smartphone make all this possible.

      Big Data = Big Driver of Innovation

      Big data is a big buzzword, but it’s a powerful trend and concept that we’ll discuss in more detail throughout the book. It refers to powerful analytics that can analyze massive amounts of information to detect patterns and correlations that most would not spot. It becomes particularly interesting these days given the information that can be unearthed in unconventional ways. Data are increasingly read from mobile phones (location, time, identity, mobile applications) combined with social data (e.g., LinkedIn, Facebook) and wearables (e.g., Nike’s Fuelband, Jawbone Up) that can give businesses and consumers the opportunity to better pair their financial and commercial needs with specific, tailored offerings.

      Two notable areas worth watching relate to home automation and autos. Imagine getting an instant claim completed if there were a fire or flood in the house or a car accident. Leveraged in the right way, better data can also allow consumers to connect more directly with their banker, as they did 50 years ago. It used to be that your banker could sit down with you, view your history, and help you make your money work harder. That can create a digital dialogue that would have once happened in person. Sean Gilchrist, who led Barclays Digital Group, stated, Interestingly, when you ask consumers if a bank can track your mobile data, and it’s put in the right context, 90 percent of the customers will say yes. We did a test with geolocation through your phone and asked, ‘Would you allow our bank to know where, so that if we spot a suspicious transaction, we can text you instead of call you?’ It is very contextual, and we can build their trust in terms of how we’re transparently using this information and it’s relevant to their needs.9

      Today’s banking systems largely still run on technology and credit assessments built decades ago. Increasingly, we’ll see more companies like Affirm on the landscape. Founded by Max Levchin, who was the founder and CTO of PayPal, Affirm is a service that uses nontraditional data sources such as social data—for example, Twitter, LinkedIn, and Facebook—to create a detailed portrait of someone as they live their life online, and by looking at these data with their permission, it’s possible to assess the ability for someone to be responsible financially in an economy better than traditional credit reports can. As we’ll discuss more in this book, the opportunity to partner with firms that are making credit more efficient can enable the financial services industry as a whole to create new markets and bring more financial inclusiveness into the economy.

      Taking a Cue from Retailing

      Remember Blockbuster? Circuit City? Borders? We can learn a lot about how the banking industry needs to adapt from the retailing industry. We’ll discuss the changing landscape of commerce and how financial institutions fit in later, but it’s worth mentioning here that one of the most important trends in retail is the rise of the omnichannel experience—retailers understand that increasingly consumers are buying through their mobile phone, and their expectations have increased dramatically. Why can’t a retailer instantly check their inventory? Why can’t the correct size and color be delivered from another store? Why can’t I return this item just as easily as I bought it? If retailers can’t satisfy their customers in the age of instant information access and transparency, then Amazon will. It remembers what you bought last time, what you looked at, and what you may need next. Retailers need to be just as sophisticated, and so do financial institutions if they want to stay relevant to their customers. Retailers also realize that if they don’t find new channels to offer their goods or services, they face irrelevance.

      There’s a lot we can learn on how bank services will need to be delivered if financial institutions are to stay relevant. How inconvenient it is to go to a bank to deposit a check when many banks now offer the ability for me to use my mobile phone to take a picture of my check. How about requiring me to go into a branch when I’d love to just do everything on my phone or tablet? The good news is that there has never been a better or easier time to work with the many tech providers to build compelling experiences for customers. We’ll hear from tech providers and offer up tips on how banks and financial technology firms can work together in new and unique ways.

      The Enemy of My Enemy Is My Friend

      The new age of partnering and innovation in the financial services arena is filled with brilliant shades of gray. The media would have you believe that any new up-and-comer in the financial services space is a disrupter to banks. I look at the media reports, and then at the 500+ partnerships we struck at PayPal in my tenure, and I just shake my head. There are really very few pure competitors in the financial services arena. The challenge is to recognize and seize new opportunities of every kind. Any institution a financial services company might view as a disintermediator for banks might just be what’s keeping your financial institution relevant. The biggest risk for financial institutions is to remain static. There is a nonbank alternative product to most everything these days, including peer-to-peer payments, financing, investments, and payment services. What will keep consumers using their financial institutions is the level of service, convenience, and trust.

      Reconciling Innovation and Regulation

      In the financial services industry, it’s hard to discuss innovation without at least mentioning regulation. The two are not mutually exclusive concepts. What’s important to note is that history has showed us that often what’s good for the consumer wins the day and results in changes in the regulatory landscape. When PayPal started, some thought what it was doing was illegal as a nonbank. PayPal was considered by some state regulators as an illegal banking service and was shut off in some states early on until it received appropriate licenses.10 Tesla, the electric car company, was viewed as illegally distributing its cars and bypassing dealer networks, until courts ruled in Tesla’s favor.11 Uber, a mobile taxi service that has taken the market by storm, has faced significant legal challenges, given that taxi companies did not want to let a newcomer in. Travis Kalanick, Uber’s CEO, summed up the challenge of innovation and regulation well: If you put yourself in the position to ask for something that is already legal, you’ll find you’ll never be able to roll out.12

      This isn’t true just in the developed world—consider the mobile payments company M-Pesa, offered in Kenya by Safaricom, owned largely by Vodafone. M-Pesa allowed every Kenyan who had a mobile phone to participate in the formal banking system and use the service to pay individuals or businesses. As Chris Bishko and Pearl Chan of the Omidyar Network discuss, the Central Bank of Kenya took a lean approach to regulation in the interest of consumers, and as a result, M-Pesa thrived. In five years, it now has 23 million customers, representing 74 percent of adults in Kenya. Thirty-one percent of Kenyan gross domestic product (GDP) is now transacted through these mobile money services.13

      While I would argue that it’s important for banks to be regulated because they play such a central role in the economy, the details of how governments ultimately decide to impose capital requirements and encourage more efficient business models to surface is up for significant debate. New entrants can provide quicker and more valuable ways of connecting with the customer and provide enormous benefits, particularly if they can still leverage a bank’s expertise and partnership to navigate the complex maze of compliance and regulatory requirements.

      Banks and tech companies can leverage each other to ensure that innovation and regulation can be balanced, and while it’s true that compliance does suction off significant product, IT, and operational resources, it’s also true that through creative partnering and some ingenuity, banks and financial tech companies can rise to meet these challenges. One of the more challenging pieces of legislation that banks have had to contend with is the Durbin Amendment, which took effect in 2011. Card-issuing banks have made much of their revenue in recent years from interchange, paid by merchants in exchange for the ability to take credit card and debit card payments. The average interchange fee for debit cards has dropped from 50 cents to 24 cents since the law went into effect, translating into $8 billion a year of losses.14 Aside from charging higher fees on other products, this has challenged the financial services industry to think about making up for this shortfall through new revenue streams or increased volume. The thinking this stimulates can lead to some creative opportunities, often introduced by nonbanks. One such example to be discussed later in this book involves Simple, a virtual bank, which has introduced its card through Braintree, a payment processor recently purchased by PayPal. Through Braintree, Simple cards will automatically be on file for consumers as they sign up for various services hosted by Braintree.15

      There are over 9,000 pages of complex rules in the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 1073 of this act gives just one glimpse into the challenges financial institutions face as they reconcile compliance with business innovation. The rule is intended to give greater transparency to consumers related to the cost of international payments. The Consumer Financial Protection Bureau requires fair and transparent disclosures and when the funds become available. While well intentioned, the law poses serious IT challenges for most financial institutions. Since these transactions generally go through correspondent banks, it is challenging to get this information since no central database exists. In later sections we’ll talk about some of the creative partnering that has come about to address regulations and even thrive as a result. Banks have partnered with PayPal and MoneyGram and have seen tremendously positive results. Even start-ups can work with money transmitters who offer their state licensing portfolio, allowing them to get to market quicker.16

      For those financial tech start-ups that are interested in becoming a part of the latest generation of virtual currencies, such as Bitcoin, the guidance issued by the Financial Crimes Enforcement Network (FINCEN) requires these companies to become licensed money transmitters.17 It is otherwise costly and expensive to obtain close to 50 separate licenses, and as such, partnering can present a significant set of opportunities. Otherwise, not only can it be difficult to obtain licenses, but capital constraints can also challenge early-stage companies seeking money transmitter licenses. While companies have to split revenue and pay compliance fees, it is far more palatable than the alternative.

      In Search of New Payment Revenue Streams

      As we’ve just discussed, in the United States, the Durbin Amendment has knocked down a major source of retail banking revenue—debit card interchange. Other countries have had these regulations in place for several years. Australia has a 12-cent debit card fee18 while the European Union19 and Canada20 are offering debit transactions directly out of a bank account at cost. Considering that 25 to 40 percent of checking accounts at big banks are unprofitable21 and banks aren’t making interchange fees, where can they find new revenue? The answer increasingly is to issue prepaid cards, which aren’t regulated, or work harder to provide more value to consumers on how to save or spend, and identify new partners that can bring consumers a new level of convenience and insight. Later in this book, we’ll discuss how banks like Standard Chartered are bringing the concept of artificial intelligence to their consumers to give them more insight and information into their finances.22

      American Express’s decision to partner with Wal-Mart to offer a light-touch banking product based on a prepaid card, which can introduce new segments into more banking products and services, will be an increasingly common model. Banking products are increasingly becoming things you can pick up at any retailer—a prepaid card hanging up near the cashier can get you a bank account with direct deposit, a credit line, and an automated teller machine (ATM) card. Large retailers are seeing the benefits of this model around the world. Wirecard in Germany offers mobile network operators the ability to offer a banking service, just as M-Pesa in Kenya, a mobile service that is ultimately running on the back of an underlying bank. Bank services increasingly are powering channels that connect with customers in new ways. How can these partner tie-ups help financial institutions make up for revenue shortfalls? We’ll discuss later in the book how opportunities to build digital wallets really give financial institutions an opportunity to rethink how they can leverage their payment infrastructure. What becomes far more valuable today is how all the nonpayment data—offers, coupons, promotions—can potentially be leveraged around the payment and flow through data rails. With the cost of debit processing going lower, partnering with unconventional partners will be

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