Digital Banking Manifesto:
The End of Banks?
Connection Science & Engineering
Massachusetts Institute of Technology
"Banks are trying to be cool and hip and build super cool digital front ends... But it’s like putting lipstick on a pig - ultimately it’s still a pig and the new front end is still running into an awful digital back end."
- Mark Mullen, Chief Executive Atom, Durham, UK
We are entering a new era of innovation that will reshape consumers’ relationships with their banks. In order to understand how banking will evolve in the digital age, it is important to understand its basic premise. While reasonable people can disagree about nuances, at heart, the art of banking is one of skillful record keeping in the double-entry general ledger. At micro level, banks can be thought of as dividend producing machines seeking deposits and issuing loans. At macro level, they are creators of credit money. The main determinants of their quality and reliability are the amount of capital and the level of liquidity (essentially central bank money) they keep. In general, a bank would like to maintain the right levels of both – if it has too little, it becomes fragile, if it has too much, it becomes unprofitable and hence unable to fulfill its purpose of paying dividends. Some of the loans issued by the bank will be repaid as expected, and some will default. In general, when loans are repaid, the bank’s capital grows and when they default, the capital diminishes. If the bank’s capital falls below a certain fraction of its risk-weighted assets, the bank defaults. Good bankers differ from bad ones by their ability to attract a large pool of reliable borrowers, so that default levels stay close to their expected values. (Some defaults are inevitable and are accounted for by charging interest.) At the same time, good bankers need to attract long-term depositors and serve them well, so that depositors do not suddenly withdraw their deposits. If the latter were to happen, the bank can exhaust its liquid reserves and default through a different route. In principle, if its less liquid assets are sound, the central bank, which is called the lender of last resort for a reason, can come to the rescue and provide additional liquidity.
It is clear from the above description that banking activity is mostly technological and mathematical in nature. Hence, it is well suited to be digitized, yet the prevalence of legacy systems and legacy culture inhibits banks from embracing innovation as much as they should in order to survive and thrive in the digital economy of the 21 century. The root causes of banking malaise should be obvious – old-fashioned banks are far behind the latest technological breakthroughs; they also have a poor handle of the risks on their books. While major industries, including retail, travel, communications, and mass media have undergone revolutionary changes in their business models in the last thirty years or so, banking remained static at its core, living on its past glories and ignoring the winds of changes. Existing banks suffer from numerous drawbacks, because competition among them is relatively weak. Moreover, their customers are generally not happy with the level of customer service they receive, besides, they are exposed to the risk of losing their deposits (above and beyond the regulatory guaranteed minimum) in the case of their bank’s default. Zero or negative deposit rates, which became prevalent in most developed countries in recent years, make keeping money in the bank both risky and unprofitable. Yet, at present, customers do not have viable alternatives.
In addition, there are whole strata of people and SME, especially in developing countries, who are either underbanked or unbanked, due to the fact that traditional banking methods are not flexible enough either to solve the know your customer (KYC) problem for them or to assess their credit worthiness.
Thanks to new developments in data technology and in mobile telecommunications adoption, we see the potential rise of a third wave of innovation in banking. We will outline in this paper the key features, benefits, and strategic imperative of the Digital Bank of the Future (DBF).
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