Unbundling the Financial Services Industry
The infusion of technology into financial services created 2 diverse options: bundled (or packaged) programs in which a single provider delivers multiple services OR unbundled offers in which multiple providers offer single-function services.
Financial institutions as incumbent industry leaders rely on bundling critical services as the backbone of all transaction activity. Through regulation and licensing, banks are the only entities that can hold cash on behalf of others (in accounts), move cash between accounts, and offer loans based on funds held. This theme of bundling touches on how modern financial services are deployed as many infrastructure players focus on a single slice of a banking program.
Based on increased technology, current rate environment, and recent industry events, financial institutions may be losing market leadership in key competencies. This unbundling of traditional banking operations is also impacting how the new generation of financial platforms and products are being deployed. Here’s a breakdown of legacy bank operations, what’s changing now, and when this transition gains momentum.
core bank functions FROM financial institutions
Financial services has operated under a bundled model since its origin (over a century ago).
Regional banks and credit unions manage critical functions in the banking system governed by regulators, and outside of the scope for non-chartered entities. This is specific to 3 fundamental competencies:
Custody of cash in deposit accounts (within the banking system);
Lending activity based of the funds (‘custodied’ or held) in deposit accounts;
Controlling money movement between accounts (in conjunction with the central bank);
For each activity, financial institutions earn some type of fee — either on the transaction (such as in allowing money movement) or through interest margin (via charging more in loan interest than what’s paid out in deposit interest).
To be part of the banking system, banks are required to apply for charters & licensing from government agencies. Once approved, there are periodic audit and reporting requirements from these agencies in order for financial institutions to remain in good standing and maintain licensing. The process (both lengthy & expensive) has no guarantee of approval. Multiple fintechs between 2014 - 2019 made efforts to gain their own bank charters by applying — Varo was one of the few to be successful, but many gave up about a year or so into the process.
Cash ends up in a bank account at some point — wages are paid directly into accounts OR paychecks are deposited monthly. Even individuals paid in cash eventually make deposits for future spend or payments. Non-banks that provide money orders, prepaid cards, or other monetary instruments still use banks to hold cash. Custody of funds is the most critical of the three activities as it delivers the capability to lend and attract higher deposit balances (via a competitive interest rate / APY).
Lending is the most regulated activity with numerous state & federal guidelines. Even though non-bank entities can also become licensed lenders, these companies do not have access to the amount of cheap capital that financial institutions do (based on customer deposit balances). The difference in cost of capital is a huge differentiator for banks.
There are more players (as payment vendors) when it comes to money movement. However, final processing and settlement is still tied to an underlying bank that can custody the cash and access the central bank.
HOW TECHNOLOGY IS CHANGING EACH core COMPETENCY
In 2023, all three functions are being upended due to technology and economic conditions in the US. From bank deposits to payments, and loan underwriting — financial institutions must strategically focus on which activities matter most for their particular clients and business operations.
Deposit Flux in balances & rates
There’s a large gap between what mega banks (such as JPMorgan Chase, Bank of America, Wells Fargo) pay customers on deposit interest (less than 0.1% APY) and the yield on T-Bills (above 5% APY). The Fed is committed to maintaining the Fed Funds Rate at current levels, which puts pressure on all banks to pay more interest to clients.
Mid-size banks and credit unions heavily compete on rates for customer deposits that sit at larger banks. Within this smaller tier of financial institutions, funds can move back & forth between banks throughout the year as clients look for the best rates and promotional offers.
With the collapse of a few regional banks back in March, large deposit balances earning higher yields doesn’t seem to be as secure for some customers. Deposit outflows went back to larger banks (who had a stronger market position) or alternative channels, such as brokerages that provide money market accounts, T-bills, and other cash-equivalent securities.
This rapid money movement (compared to past years) reduces the ability for banks to leverage longstanding deposits for future loans. With increased competition (on rates) and fluctuation in balances, the overall position for banks has weakened due to lack of ‘stickiness’ with deposits. Regulators are putting additional pressure on financial institutions to maintain sufficient cash reserves in order to avoid future deposit runs.
Technology has increased the speed of payments and money movement — showing how quickly a bank run can take place (most recently within 72 hours).
MINIMAL Friction in PAYMENTS
Non-bank players have been hyper-focused on moving money quickly throughout the banking system, especially when it comes to instant, real-time payments. It’s only until last month that the government is catching up and implementing its own payment rail for 24/7 settlement & processing, FedNow.
Removing friction with money movement means deposit balances at banks are constantly at-risk of leaving. In the past, one large wire transfer can empty out an account overnight — this request can now be accommodated same-day, within minutes.
When it comes to small, everyday transfers, customers are using Zelle, PayPal, and Venmo more often than their primary bank. As transaction activity increases on these non-bank platforms, financial institutions are earning less in payment fees and not able to generate net interest margin due to a lack of steady balances.
Combining faster money movement with the ability to open a new account digitally (in minutes) makes it easy for customers to switch away from financial institutions — impacting all 3 functions (deposit balances, payments, lending).
the trend towards Digital Underwriting
A key differentiator for banks was access to customer info — transaction history, balances, monthly deposits, loan payments, etc. These financial details were helpful when it was time to underwrite clients applying for loans (personal, auto, mortgage, home equity, and business). No other companies had so much customer history available as financial institutions.
Technology has now digitized underwriting processes AND retrieved transaction data from multiple banks via APIs (after authorization from customers). Regional banks & credit unions no longer have an advantage in qualifying potential borrowers based on data, and also lack speed in loan review (compared to non-banks).
Combined with less reliable customer deposits for lending, financial institutions are slowly losing their leadership position. Being a licensed entity (which has a costly, lengthy process) is keeping waves of fintechs & non-banks from entering this space.
WHEN WILL THIS TAKE CHANGE TAKE PLACE?
The unbundling of traditional banking is part of a broader trend in the industry — abstracting the delivery of financial services away from banks (in-person) to non-bank entities (digitally). It’s only in the last 15 years that account opening and servicing has transitioned from a bank branch to online. This development has been made possible by the unbundling of multiple banking processes via non-licensed, tech startups.
Despite the innovation from technology, banks will remain a vital part of the financial services industry. Their roles in each core function may not be as active as before — representing more of a utility provider (like an electric or gas company) delivering infrastructure.
Fintechs and other companies (actively using the latest tech) will continue to step up as the main interface with customers — owning account opening, servicing, advising, and planning activities. We already see this with new accounts, transaction requests, and digitized service from established neobanks.
For a full transition to take place in the near-term (next 1-3 years) away from financial institutions, non-banks will need upgrade capabilities in accessing capital for lending, issuing loans, and taking custody of customer funds. These activities involve licenses, auditing, and better compliance controls — areas that many fintechs lack as a strength. Seasoned companies (8+ years in market) with in-house experts should be the first to take this on, but years of working capital will be needed to get new programs off the ground.
In the mid to long-term (4+ years), there will be a continued development of single-function service providers unbundling the dynamic in banking — focused on only payments, holding cash balances, or lending. For these next-gen providers to be successful industry leaders, they must be well-established and have robust partnerships with financial institutions.
WHY KEEPING A BUNDLED PATH CAN STILL MAKE SENSE
Companies able to take on more than one core activity and package a banking program holistically would clearly stand out in a field of single-service vendors. This bundled approach makes the most sense with embedded finance, in which companies from non-banking verticals (e.g. trucking, eCommerce, healthcare, travel, etc.) would offer financial products to their clients.
The majority of today’s Banking-as-a-Service players are vendors that provide fragments of a whole program — KYC / KYB, APIs for account opening, payment processing, card issuance, transaction monitoring, credit reporting, etc. A bundled path can come from a regulated embedded finance provider that built & manages its own stack for user onboarding, compliance, processing, monitoring. Licensing can allow for direct oversight of program approvals, risk policies, and money movement (not custody).
If discussions of a fintech charter granted by regulators in the US would have materialized (back in 2015 - 2017), there’s no doubt that numerous bundled providers would be available today. FinTech as a sector is only in its 2nd decade, which has government leaders hesitant to handover control to new or established startups. If fintechs can make it through the recent demand for increased oversight & controls from regulators (to partner banks), this charter may be looked at again as an option.
the future of banking to balance functions & risk
It’s clear that traditional banking models are no longer as sustainable for financial institutions. A mix of technology, market conditions, and customer sentiment opened pathways for non-banks to unbundle core banking functions — holding cash, moving funds, and lending. A reduction in fixed deposit balances is impacting how banks operate, especially when it comes to generating net interest margin through lending.
The financial services industry can swing between two extremes in the next decade: an unbundled path in which providers offer individual services OR a bundled path with one provider delivering all features & products.
Efficiency and cost make unbundling the attractive option in today’s market, especially for newly launched platforms. Established fintechs and fintech-adjacent enterprises would prefer the convenience of bundling — working with one provider that manages & executes all banking functions.
The argument is that there’s difficulty in being an expert in multiple areas (bundle), but there’s also a challenge in managing multiple single-service vendors (unbundle).
Overall, there’s a place for both paths to succeed across multiple verticals.
Supporting future platforms in financial services will include not only startups, but also mid-size and enterprise companies — with or without their own expertise in banking. As one of these platforms grow from startup to enterprise, they may need to change providers along the way — graduating from unbundling to bundling, or owning core components themselves.
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