European banks – don’t fear the Libra

BOAML | For a while, we’ve been asked by clients how “big tech” might compete with the European banks. This question now seems to need an answer. We think the European banks sector faces plenty of challenges, but a head-on challenge from the likes of Amazon and Google etc aren’t among them, in our view.

Tech companies have made significant inroads into emerging market finance. Companies like Ant Financial and M-Pesa are obvious examples of this. Are the giants of tech poised to do something similar across Europe?

We don’t think so. The reasons for our view lie in a mixture of regulation and incumbency. The emerging market businesses which have become finance powerhouses have done so in the main by finding a vacuum and expanding into it. There are far fewer vacuums in the European banking system. In particular, there aren’t many millions of people without access to mainstream finance. Providing financial services to the unbanked has allowed emerging markets tech companies to build large (and socially useful) businesses. We think the same approach in Europe would fall on stony soil, because bank accounts are relatively plentiful.

Libra

Libra seems to us the most obvious example of big tech looking to move into financial services, although it only challenges a small part of the incumbents’ business. So, we talk at some length about Libra and the issues it raises. In our view, Libra is a good example of how difficult it may prove for tech to compete with banks. While Libra may have advantages we believe that the process Facebook is engaged in may prove to be a testing one.

Libra, on first glance, seems a straightforward proposition, although the details are complex. It is a retail-oriented digital currency (we argue it is NOT a cryptocurrency) aiming to make transactions easier both within and across borders. We’ve outlined some of the issues which Libra may need to consider but nothing here seems existential.

The main issue appears to be the regulators. Policy makers and central bankers from around the globe have publicly asserted that Libra must be subject to intensive regulation.

BIS – same activity, same regulation

The BIS (Bank for International Settlements) has recently provided a very helpful review of regulatory attitudes to big tech. This is a highly important part of the note, but we’d highlight two principles which the BIS sets out.

“Same activity, same regulation”- This is pretty clear; it is a variant of “if it looks like a duck and quacks like a duck…”. The key wrinkle here is that as well as extending existing banking rules to technology companies, the BIS suggests that new rules may be needed where technology firms have changed markets enough to take them “outside the scope” of existing regulations.

“Revisiting the competition-financial stability nexus”– This is less pithy, but important. Regulation can be a trade off between competition and financial stability. When making this trade off in future, the BIS argues that regulators should consider technology firms’ strength in data when thinking about competition.

UK regulators

Three UK perspectives have been set out on how to regulate big tech.

Mark Carney

Mr Carney’s recent Mansion House speech also talks about the need to balance rights with regulatory responsibilities with fintech. He talks about Libra. The most novel aspect of the speech, in our view, is his suggestion that non bank institutions could be given access to the Bank of England balance sheet. This is pro competition, in our view, but potentially raises issues around risk management and could be deflationary.

Unlocking digital competition

This is an interesting report looking at competition in the digital economy. It therefore roams much more broadly than banks. The most significant part of this for our purposes is the strong line the report takes about making sure that companies cannot use data to act anti competitively.

Future of finance

This is a think-piece which is in line with our views that banks’ profitability is being squeezed by a combination of fintech competition and interest rate policy. Once again, it talks about the importance of making data more portable.

Yves Mersch seems not to like Libra

Perhaps the most full-on discussion of Libra has come from ECB Board member Yves Mersch. It’s important to note that Mr Mersch is a very senior, mainstream European banking regulator. He stresses some valid questions about stablecoins in general (applied to Libra), asks relevant questions about the multi currency fiat backing of Libra and about how digital currencies impact central bank’s operations. He finishes his speech with the wish that “the people of Europe will not be tempted

to leave behind the safety and soundness of established payment solutions and channels in favour of the beguiling but treacherous promises of Facebook’s siren call”.

Tech debt

“Tech debt” is in essence jargon for the issues which mature companies face due to their mature technology. Larger, older banks tend to have a lot of “legacy” technology. This is because the industry has been a heavy user of technology for several decades. The incumbents have significant positives in terms of reputation, brand, customers and deposits. A price they pay for this is that they tend to have at least some core systems which were originally designed for mainframes.

If you were starting a bank now, you would probably do what many of the digital banks have done and deploy in the cloud in an agile manner. We suspect that the incumbents would like to do this, too, but getting from here to there is difficult, especially when your customers (reasonably) rely on you to have your systems up and running pretty much 24/7. TSB’s troubled IT refresh is an example of the downside risks of replacing banking IT infrastructure. In response to this, the UK’s Treasury Select Committee conducted an enquiry into “IT failures in the Financial Services Sector” which said that “While completely uninterrupted access to banking services is not achievable, prolonged IT failures should not be tolerated. We believe the current level and frequency of disruption and consumer harm is unacceptable.”

We discuss two approaches to tech debt – Nordea’s “big bang” and RBS’ one piece at a time. Importantly, though, whilst incumbents are wrestling with this issue, both newer banks and big tech can operate with modern technology.

What happens?

Facebook’s Libra is the first example we’ve seen of big tech trying to become involved in finance. We’re often asked by clients if we think mainstream European banks are under threat from the tech giants currently roaming the corporate world.

Our view is that they are not.

Why big tech might win out

The case for big tech successfully taking on incumbent banks is a strong one. In essence, they have strong brands, a lot of cash, no tech debt and often a lot of customer data. This appears to be a good place to start.

Why we think it won’t

Libra provides a good example of the difficulties which big tech could face if it decided to try to compete with the mainstream. Money transfer and payments are good places to start, in that they do not force participants to run bank-like balance sheets. Libra may make it to the starting line. However, the process so far has been difficult.

Finance is a regulatory construct…

The key point is that finance is heavily regulated. Although we believe that regulators are sympathetic to innovation, they have tended to be heavily motivated by financial stability and competition. The response to Libra, to us, typifies this approach. There is a lot of in principle support for the idea of cheap, global money transfer. But there is much more support for financial stability, competition and strong controls on data in the regulatory community.

… and deposit taking is heavily regulated

Should a company want to disrupt deposit taking, they could face far stricter regulatory constraints, including capital regulation. It’s worth noting that tech firms’ balance sheets look nothing at all like banks.

We think that big tech would find regulation harder than it would wish to challenge the incumbents and that the rewards would be reduced by the capital buffers needed. Certainly, becoming a bank would entail a dramatic change to the balance sheets of existing technology companies.

So that’s all right, then?

No, it isn’t.

We don’t think that big tech will try to compete with the banking system because it does not want to face the regulatory requirements which this would bring. This seems all the more so given the increasing regulatory focus on how data is used.

We do think that the mainstream banks will continue to see their businesses challenged by new entrants which are able to apply modern technology in a tech debt free way to their business models.