Sizing Up the Nonbank Threat

“The world needs banking but it doesn’t necessarily need bankers.”u2013 Microsoft Founder Bill Gates

Does the average consumer really need a traditional bank nowadays? Bill Gates didn’t think so when he made that statement back in the 1990s as Microsoft Inc. was pushing into the home banking market with its Money software program, and he’s even more right today.

A brokerage firm or mutual fund company can manage your IRA. You can get a home loan from a mortgage company or credit union. An airline company would be happy to give you a rewards credit card. Technology giant Apple Inc. can provide you with a digital wallet that will enable you to pay for some of your purchases with an iPhone. And a growing number of online banks can give you a debit card, which you can use to make purchases on your smartphone.

If you’re a traditional banker, it’s time to recognize (if you don’t already) that a growing number of consumers-many of them young, well educated and upwardly mobile-can get along just fine without you.

Traditional banks are by no means obsolete or unimportant. They still dominate the financial services market in the United States, including the credit card and home mortgage markets. The great majority of Americans still have their checking accounts and debit cards with a traditional bank, and it’s not at all uncommon to find bank branches on opposite street corners everywhere-from Manhattan, New York, to Manhattan Beach, California. Banks are also the primary lenders to companies and commercial real estate concerns, and when they turn off the loan spigot, the economy suffers.

If traditional banks still enjoy a commanding share of the financial services market, that’s not to say they aren’t being attacked by a growing number of hungry competitors from outside the industry. Peer-to-peer lenders, like San Francisco-based Lenders Club, are beginning to gain traction as an alternative to banks in both the commercial and consumer loan space. In the retail sector, well-funded technology companies like Google, Amazon and a host of others are swimming around like sharks looking to tear off chunks of revenue, particularly in the $300 billion a year payments business. These disruptors, as many consultants call them, are generally more nimble and quicker to bring new products to market. They have a better understanding of technology and have built their business models around it, and are better at innovating than most traditional banks. They also have a deeper understanding of the millennial generation-who are now beginning to enter the economy in force-than most traditional banks, many of which are still being run by baby boomers.

“Banks are general retailers,” says Hank Israel, a managing director at the consulting firm Novantas Inc. “Competitors are going after pieces of their business and that’s hard to defend against.”

A perfect case in point is Simple, a five-year-old online bank that was started by Chief Executive Officer Josh Reich and Chief Financial Officer Shamir Karkal. Reich is from Australia and Karkal from India, and when they first came to the United States they were very dissatisfied with the service quality of the banks here. Karkal, who spoke to Bank Director magazine for this story, says he felt he always had to be on the alert for mistakes in his monthly account statements and it didn’t seem that his bank had his best interests in mind.

Simple, which was acquired in February of this year by Spanish banking giant Banco Bilbao Vizcaya Argentaria (BBVA), has been able to generate approximately 120,000 customer accounts since its opening in July of 2009. Karkal says the alternative bank’s success should be a warning to more traditional institutions. “All of our customers come from the larger banks,” he says. “And they are leaving them and coming to us in increasing numbers.”

Certainly, these new disruptors could pose a significant threat to traditional banks that are slow to adapt to the changes taking place in the financial services marketplace today, although the full impact of those changes could take several years to play out. “I don’t think Bank of America is going to go away because of some nonbank start up,” says Jacob Jegher, research director at the research firm Celent. And yet it would be foolish for any bank CEO or director to operate with a false sense of security that their institution won’t need to adapt. The market share losses to new entrants like Simple might be a “drop in the bucket now,” Karkal says, “but eventually it will make a difference to them. Banks of today will have to evolve or they will become obsolete.”

Or at the very least, even more unnecessary.

Being attacked by aggressive competitors from outside the industry is certainly not a new phenomenon for traditional banks. American Express Co. and Discover Financial Services have been among the largest credit card issuers for years. Likewise, the major car manufacturers have been tough competitors in the auto lending business through their captive finance subsidiaries. Even Microsoft was perceived as a potential threat when it introduced its now discontinued Money personal financial management software in 1991. If banks allowed Money users to access their bank accounts through the software, Microsoft would end up owning the relationship and not the bank, or so the thinking went at the time.

So if traditional banks have always been subjected to competition from outside the industry, how is today’s threat any different than what we’ve seen before? One critical factor has been the incredible growth of the Internet since the 1980s, including the strong popularity of online commerce and social media. Most Americans are now entirely comfortable doing things in virtual space, whether it’s buying a new television, paying their bills or posting photos of their children on Facebook. From a competitive business perspective, the Internet has become the great leveler because it allows technology companies to essentially replicate in virtual space what traditional companies-including banks-have always done in actual space, but at much less cost. This has effectively lowered the barriers of entry to the financial services marketplace, and companies that have been at the forefront of this trend include Google, Amazon and Apple, all of which have developed enormous customer databases. Moving into financial services is a logical strategy for these organizations, especially if it strengthens their core business.

The competitive threat posed by these disruptors is very dynamic, with important new developments seeming to occur on a weekly basis. Although alternative lenders like the Lending Club are making their presence felt in the business and consumer loan markets, much of the activity is in two areas-payments and the core banking relationship itself, where relatively new startups like Simple are looking to attract new customers at the expense of traditional banks.

Google, Amazon and Apple are all offering some version of a digital wallet that over time could make them very significant players in the payments space. Google offers a mobile phone application with tap-to-pay functionality, and also a debit card that can be used at merchants that don’t have Near-Field Communications (NFC) capability, a mobile technology that enables smartphones to be used as a payment device. Amazon is performing a beta test on its own NFC-enabled wallet application, and while its functionality is currently less than Google’s, it could over time leverage the company’s position as one of the most successful online retailers in the country.

Apple recently launched a competing payments application called-appropriately enough-Apple Pay, when it launched its new iPhone 6 and iPhone 6 Plus smartphones. Six large U.S. card issuers, including JPMorgan Chase & Co. and Bank of America Corp., have already agreed to pay Apple a small per-transaction fee to be included in the program, no doubt mindful that Apple reportedly had over 800 million iTunes account holders in late 2013, most of whom have credit cards on file. Last but not least, PayPal, which got its big lift when it was acquired by eBay Inc. in 2002, and eventually became the payment mechanism of choice for eBay auctions, has introduced a wallet application of its own that leverages its large and growing international payments network.

The industry also is being pressured by a new crop of alternative providers that have set their sights on the core retail banking relationship. Since 2011, American Express has teamed up with Wal-Mart Stores Inc. to offer a prepaid card product called Bluebird that can be used in the same way as a debit card linked to a checking account, and provides a reported one million customers with a retail banking capability that does not come from a traditional bank. Wal-Mart recently teamed up with Green Dot Corp. to offer checking accounts. And Green Dot has used its mobile banking platform to start GoBank, which offers an online checking account with a debit card and free access to a network of 40,000 automated teller machines, online bill pay, mobile deposit and a person-to-person (P2P) payments capability. T-Mobile US Inc., which most consumers know as a cell phone company, launched its Mobile Money Program in January. T-Mobile’s 47 million wireless subscribers may participate in the program for free, and receive a prepaid debit card, mobile application for their smartphone, mobile bill pay, mobile deposit and access to a network of 42,000 ATMs nationwide.

The widespread popularity of smartphones and the growing comfort level that consumers have with performing a variety of transactions with their mobile devices has traditional banks scrambling to build out their own mobile channels. When CEO Jay Sidhu formed the predecessor to Customers Bancorp in 2009, he built a mobile capability into the bank’s distribution strategy from the beginning. Mobile is coming on so strong, however, that Sidhu is essentially hedging his bets by setting up a mobile-only bank subsidiary that he hopes to launch in the fourth quarter of this year. BankMobile’s targeted customer segments will include millennials who live on their smartphones and, says Sidhu, are “fed up at being charged fees.” The new unit will offer a checking account, bill pay, line of credit and access to a network of 55,000 ATMs. Customers who keep a minimum balance of $5,000 won’t pay any fees. “It’s all the things that millennials and other consumers want,” he says.

Meanwhile, Simple offers its customers a debit card linked to an online checking account, mobile deposit, bill pay, a budgeting and savings application and access to a network of 55,000 ATMs. When Simple’s co-founders first came to the United States, “We were startled by how antiquated banking was here,” Karkal says. “Rather than acting as your partner, your bank was your adversary in terms of managing your money. Our core operating principal is we don’t profit from customer confusion.” The bank’s primary customer segment is young professionals in their twenties and thirties. As a group, Simple’s customers tend to be more educated than the general population and many of them are on their second job after college. “These are people who want to manage their finances but don’t know how,” says Karkal. “That is the core we speak to.”

The bank experienced a run of service problems earlier this year, which prompted the company to post a long apology on its website from CEO Reich in August. Reich explained that the company had recently switched from a third-party transaction processor to its own in-house system and that had caused many of the snafus. However, additional service problems were reported in September, which led to some criticism by angry customers in the Twittersphere. These missteps aside, there’s no reason to believe that Simple won’t ultimately be successful, especially now that it has the backing of $800-billion asset BBVA.

The disruptors bring certain advantages to the arena that could make them formidable competitors over time. First, because they have the DNA of a technology company, organizations like Google, Amazon and Simple understand how to connect with people in virtual space much better than most traditional banks, which are still more comfortable managing relationships face to face. “We use technology to build customer relationships,” says Karkal. Google, Amazon and Apple also excel at using data to understand their customers’ buying behavior and anticipate their needs. “Their ability to analyze their data and determine their customers’ preferences is going to be key,” says Kishen Kumar, the India practice head in the diversified financial services division at consulting firm Capgemini. “Banks don’t have that ability.”

The technology companies also tend to be faster and more nimble than most traditional banks. “They don’t have a lot of the legacy systems that banks have,” says Derek Martin, the director of consumer banking strategic services at BOK Financial Corp., a $27-billion asset bank located in Tulsa, Oklahoma. “And if they want to get into [a new area] they don’t have to worry about the revenue impact. They can innovate on the fly with relatively low risk.”

Central to assessing the nonbank threat is to understand the endgame. Alternative banks such as Simple and GoBank most certainly want to steal customers from traditional banks of a particular demographic profile-working professionals with above-average incomes who are comfortable with technology and actually prefer to do their banking remotely. “They’re going after customers who are willing to give up access to a branch,” says Ron Shevlin, a senior analyst at the Aite Group.

Simple clearly sees itself as a bank, albeit one with a markedly different strategy than most traditional banks. But alternative banks like Simple and GoBank will probably never be a significant market share threat to traditional banks because they are going after a distinct subset of the population and not the mass market. Google, Amazon and T-Mobile, on the other hand, are scale players that only swim in the mass market, but do these companies really want to compete with banks across an expanded product line-to in effect become banks themselves? Opinions vary. Sidhu believes that some of the technology companies would like to expand further into banking if not actually become banks in a legal sense, but lack the credit skills and are put off by the industry’s regulatory system. “They don’t want to be regulated by the Federal Reserve,” he says. But Shevlin questions whether the industry’s high startup costs, which include elevated capital requirements, would appeal to any of the technology companies that are pushing into the payments sector. “Why would you want to start a bank and make less money than in your current business?” he asks.

If the technology companies do not want to become banks, what do they want? Israel at Novantas believes that Google and Amazon have more in mind than just revenue from their digital wallets. “They’re in it for the data,” he says. “The more they can drive value for the merchant in closing a deal, their value goes up. If I actively close the sale, I’m able to provide to the merchant a higher value.” Shevlin tends to agree, at least when it comes to Google. “It’s all about driving advertising revenue,” he says. “It’s not so much about profiting from the payment itself.” Online advertising is Google’s largest source of revenue, specifically the ads it places next to its search results, and a payments capability should help the company drive more transactions to its advertisers, which will encourage them to advertise even more. Providing payments capability also enables Google to collect vital data about customer preferences, which also provides greater value to advertisers.

If Google and Amazon aren’t intent upon becoming an alternative bank like Simple, only much bigger, then why is everyone so worried about their push into the online payments space? Lending still accounts for the lion’s share of the industry’s annual revenue, but income associated with debit card usage, including interchange fees and fees from overdraft protection programs, are still an important source of profitability for most traditional banks. Working through a complicated set of calculations, Terence Roche, principal at the consulting firm Cornerstone Advisors Inc., estimates that gross payments from debit cards and overdraft protection programs account for 25 to 30 percent of the banking industry’s net annual income.

The Durbin Amendment, which was contained in the Dodd-Frank Act and took effect in July 2011, reduced by approximately half the interchange fee that banks over $10 billion in assets could earn from a debit card transaction, with the benefit going to the retailer. (Banks under $10 billion in assets are exempt from the restriction.) Having already lost such a big chunk of their debit card revenue to retailers, large banks can hardly afford to surrender even more to the likes of Google, Amazon and PayPal. It will take time for the entry of new competitors like Google and Apple into the payments space to make a big dent in the industry’s profitability because merchants will have to adopt the necessary NFC technology to enable tap-to-pay transactions, but the risk is still out there.

Just as important as the revenue is the customer connectedness that a debit card enables. The checking account is still the lynchpin product in the relationship between a bank and its retail customers, but people are writing fewer checks every year as debit card and online bill pay usage continue to rise. It’s not an exaggeration to say that your “bank” is whatever organization has given you a debit or prepaid card linked to a transaction account. Large disruptors like Google and Amazon seem to have little interest at this point in moving beyond their digital wallets and actually making a play for the core banking relationship. But technology companies operate on a shorter strategic timeline than most traditional banks and are constantly adjusting and recalibrating their business models. “They can offer a new product and get it to scale quickly,” says Shevlin. So when it comes to the technology companies’ intentions in the banking space, what is true today might not be true tomorrow.

There are several things that every traditional bank should be thinking about now. Debit card adoption and usage varies widely from bank to bank, so those institutions that haven’t traditionally viewed it as a profit center should take another look at their whole payments strategy. “The conversation is so dominated by lending because lending is the dominate revenue source,” says Cornerstone Senior Director Sam Kilmer. “The payments area has been taken for granted.” Rather than seeing the debit card as an important profit center in its own right, many traditional banks have seen their value from the perspective of funding: The checking account is an important source of funds that can be turned into loans, and the debit card is something that most checking account customers want. “That’s how a lot of banks have looked at payments-a means to an end,” says Kilmer. Instead, Kilmer says that banks would be wise to establish payments as a separate profit center with its own profit and loss statement, and then make a conscious effort to drive up adoption and usage in their retail customer base, comparing their performance with industry averages. “Some banks are very good at getting their card to be top of wallet,” he says.

Traditional banks should also look for new payment products to offer their retail customers. BOK Financial believes that it has a strong debit card program, but is taking a close look at whether to add a P2P capability to its payments arsenal. Options include PayPal and clearXchange, a program owned jointly by JPMorgan Chase, Bank of America, Wells Fargo & Co. and Capital One Financial Corp., which is open for other banks to join. Martin says that BOK has been listening to its retail customers to assess their interest in using a P2P service. So far the demand is not there. “Is it table stakes for consumers to choose your bank to start a relationship?” he asks. “For us, not yet. We’re not at the tipping point.”

Obviously, traditional banks need to continue to develop their online and mobile distribution skills because these have become table stakes in today’s financial services marketplace. They need to watch for consumer preferences very closely, particularly as millennials play a more important role in the economy. And they need to remember that one of their greatest strengths is the relationship they have with their existing customers. At this point, the technology companies like Google and Amazon are highly focused on using their new payments capabilities to drive other parts of their business. They would like a deeper relationship with their customers, too, but not across the full spectrum of financial services. At least not yet. “We’re trying to meet the needs of the customer who wants a broad relationship,” says Martin. That includes millennials who are most open to the idea that traditional banks are no longer necessary. “They’re going to need to buy a a house,” he says. “They’re going to inherit money and need a financial advisor.”

Traditional banks also need to do a better job of analyzing their customer data and do real-time customer segmentation, which is a strength of the technology companies. Or put another way, banks need to do a better job of anticipating their customers’ needs and then facilitating a funding solution, which is essentially what the technology companies are doing with their new payments applications. “Banks are not the greatest innovators,” says Kumar at Capgemini. “They have to come to grips with market reality. [Customer] profiling is very important. What does the customer want? The ability to come up with new products that appeal to specific customer segments is where nonbanks are very effective.”

Traditional banks have time yet to adapt to all the technology-driven changes taking place, and as Novantas’ Hank Israel puts it, “It’s their market to lose.” But lose it they could if they don’t begin to evolve, not so much by being toppled by some future high-tech juggernaut like Google Financial Corp., but by growing less and less necessary as consumers go elsewhere.

Any bank CEO or director who isn’t scared today should be. Take it from Bill Gates: “In this business, by the time you realize you’re in trouble, it’s too late to save yourself. Unless you’re running scared all the time, you’re gone.”