DIGITAL TRANSFORMATION OF THE BANKING INDUSTRY

Industries across the board are undergoing structural change. This change extends beyond individual firms and spills across industrial sectors. Some industries that have been exposed to the tide of technology-driven structural changes have harnessed technology to reinvent themselves as new industries befitting this evolution in industrial structure. The financial industry traditionally has been far from the vanguard of this change.

The proliferation of the Internet and digital technologies is only accelerating the evolutionary shift across all industries. This stands in stark contrast to the traditional non-modular, vertically integrated structure (where all the products and services are provided through and within one exclusive value chain) that the industry has historically embraced. However, disruptive new market players have visibly forced conservative, existing entities to begin to seek new approaches; at the same time, regulatory authorities have started to embark on establishing a new, more robust system for regulating the financial industry.

The hotel industry offers a prime example of modularization on the demand side. Today, hotels, as well as the entire travel industry, offer consumers the experience of comparison shopping across service, price, and quality. Celent refers to this phenomenon as modular demand.

Modularization on the supply side is perhaps best exemplified by the aviation industry. The aircraft industry intrinsically does not lend itself to being a self-contained business, relying on a variety of actors to make, operate, and commercialize aircraft. Technological innovation, deregulation, and cost pressures transformed the airline industry, spurring it to evolve into a quintessential modular structure on the supply side.

This modularization goes beyond the industry infrastructure that includes airports and ground facilities. All components of the value chain — from in-flight services such as meals and movies to ground services such as boarding and baggage handling, as well as aircraft maintenance, flight plans, management, pilots, and cabin attendants — are now all subject to external procurement. The airline business now hinges on corporate management’s adeptness at forging and managing alliances. At Celent, we refer to this phenomenon as modular supply.

Today’s music industry showcases some of the greatest modular advancements. On the demand side, the industry saw a shift in the listening experience, as consumers moved from CDs to online downloads and streaming. Dramatic technological advancements have enabled music distribution sites and social networking services to tailor recommendations to users, offering songs and videos to suit music preferences and enabling consumers to search for, purchase, and enjoy music in real time.

On the supply side, record labels and their vertically integrated model were initially largely blindsided by innovation because musicians no longer needed to rely exclusively on CD sales or being scouted, signed, recorded, and promoted by record companies. The ensuing change saw a shift to a new model where a diverse range of artists recorded themselves and harnessed social media and trendsetters to promote their colorful charm and generate fans. Both the supply and demand sides of the music industry value chain underwent a dramatic upheaval that shook the industry and spawned a more dynamic and open industry. This resulted in a new life for the music industry that relegated the CD and conventional business practices of music labels to history.

The securities industry can be regarded as the first sector in the financial industry to have embarked down the path of modularization. Mutual funds was the first major area involved in this first step toward modularization. Mutual funds are now mainstream products of banking and wealth management. The banking industry should not overlook the following episodes.

The mutual fund business model can be broken down into two process areas: 1) selecting investments or investment destination (portfolio building), and 2) sales of the created mutual funds. In the former, the products (portfolio) are designed and created (produced), while the latter involves the sales of investment firm securities (mutual fund beneficiary certificates), with sellers undertaking the office processing such as customer transaction reports.

In the closed model era of brokers and mutual fund firms, the norm until the 1960s, mutual fund firms would outsource sales to securities companies (full service brokers). This resulted in mutually beneficial consignment-based relationships between the investment trust companies and securities firms that endured for a long time with a fixed fee structure (investment sales commissions paid from the customer to the securities company) and securities trading fees (paid by the mutual fund company to securities company). These sales formats have since diversified.

No-load funds entered the market starting in the 1970s, spurred on by the liberalization of commissions for the brokering of securities, sluggish demand in the stock market, and the emergence of discount brokers that did not offer investment advice. This era was characterized solely by diversification of sales methods, and was entirely absent changes to the closed model that covered planning, manufacturing, and sales.

However, change descended on the market in the form of the mutual fund supermarket revolution. With the launch of Mutual Fund OneSource in 1992, Charles Schwab offered multiple funds that customers could purchase without paying a commission, but for which Schwab’s mutual fund management arm collected an annual management fee based on asset balance. Metaphorically speaking, this approach was akin to companies putting mutual funds on the shelves of a supermarket and charging commissions only for the products sold. The interface between mutual fund companies and securities companies opened up, and the creation and sales components were decoupled and functionally modularized.

More change is on the horizon. An era is coming in which the banking industry should orchestrate a shift to a structure that hinges on modular demand to respond to new needs fostered by digital technology and the new demand of the emerging digital generation.

Industry players should be ditching vertically integrated direct sales, or so-called keiretsu, which are tantamount to direct sales routes; instead, they should establish delivery models that are more dynamic and open. Omnichannel initiatives are not only opportunities for firms to launch or shut down these channels, but also to revisit and reconsider their optimal delivery model. Moreover, collaborating with non-financial sector players, including start-ups, opens the door to the possibility of accessing vast and new untapped market frontiers.

Robo-advisor initiatives can be expected to accelerate the speed of advances in modular demand structure. Presumably, coming delivery channels will seek to optimize information and investment expertise, driven by approaches that respond to the needs of investors by providing automated advice and harnessing bankers as human support mechanisms.

In the banking sector, players should strive to become trailblazing purveyors of financial services that leverage digital technology.

There are areas in the banking services value chain where firms should work independently to generate unique, in-house, high-value-added services and products; there are also areas where banks stand to benefit by collaborating with other firms to drive down costs. Also, firms should consider collaborating with other firms to leverage economies of scale and economies of scope, parlaying cost centers into new profit centers, and securing a role in the industry infrastructure.

In actual operation, after deliberating and implementing such initiatives, big-data analytics and the automation of all processes will prove the most important. Here as well, a shift to a modular supply structure will be required, and a critical factor in determining the success of financial institution management will be alliances — namely, how adroitly firms partner with other entities.

In Conclusion

Celent offers the three points below as food for thought and policy prescriptions for modernization in the banking industry.

1. Technology as a driver of growth:

• Look for ways to pioneer new segments through the use of technology without fixating on the segments that have been your bread and butter up to this point.
• For example, robo-advisors can be used not only for mutual fund but also for insurance products sales to retail customers. Bancassurance and alternative distribution channels should also be driven by robo-advisors.

2. Vertical disintegration:

• Prioritize finding the sweet spot for cost and risk and revisit and rethink your processes (such as vertical integration and/or internalization, and the use of horizontal division of labor and/or outsourcing) across the board.
• For example, enhancing the agility of new payment product research and development might be achieved by vertical disintegration of banking business into payment services discovery, development, and marketing organizations.

3. Industry-wide priorities:

• Place top priority on initiatives to raise financial and IT literacy among customers.
• Actively seek to leverage monetary policy and system reform as business opportunities; avoid a passive approach to system reform.
• Rebuild the industry value chain through methods of modularization, specialization, and integration.

Legacy modernization in the banking industry is much more than simply the application of novel technology. Rather, it portends nothing less than a structural overhaul of the banking industry, an opportunity to envisage anew and redefine the industry’s future. There can be no doubt that this transcends the mere establishment of a digital channel; rather it will certainly impact products, services, IT units, and sourcing models, and, in so doing, provide the banking service providers of the future a chance to seriously consider exactly what kind of companies they would like to be and the corporate cultures they would like to foster.

Celent perceives legacy modernization in the banking industry as instigating change at a fundamental level, in both business execution and organizational structure. Moreover, this transformation promises to have legs and vast implications that will play out over the long haul. Legacy modernization is much more than just new technology and it will have sweeping implications.

Related releases:

Legacy Modernization in the Japanese Banking Industry, Part 1

Legacy Modernization in the Japanese Banking Industry, Part 2