As many participants in the VC industry are aware, there is a general pendulum swing in technology and business between two enormous trends: bundling (collecting and combining multiple services into one provider) and unbundling (separating services supplied by one provider into subcomponents).
Typically, services are bundled because it is more convenient to use a single provider for multiple services. Typically, unbundling occurs for efficiency reasons; it is difficult for a single provider to be an expert in providing multiple services.
The Banks’ Core Services
Community and regional banks have operated within the framework of aggregation for the majority of the past century. Banks provide three fundamental services:
- The storage of currency through a deposit account
- By facilitating the interconnection of these deposit accounts, the central bank facilitates the transfer of funds.
- converting funds from deposit accounts into loans in order to lend.
Banks monetize these three services by charging fees to perform tasks associated with money movement and net interest margin (NIM), which is the disparity between the yield on loans and the yield on deposits, for their deposit and lending businesses.
As a result of rules and regulations, banks have quasi-monopolies on all three of the services they offer. Their strongest position may be in their deposit business, as it is virtually impossible to hold cash outside the banking system due to regulations. Sure, you can store currency under your mattress, but banks are the only institutions authorized to hold cash. Like all rivers that flow into the ocean, money always returns to a bank.
The regulation also favors banks on the lending side, although banks are not the only capital providers to the economy; private credit funds also provide this service. (Since the collapse of SVB, I’ve also observed more private credit funds supporting bank lending.) Nevertheless, banks have a distinct advantage in this lending service due to their low cost of capital (via cheap deposits).
On the payment and money-transfer side (another regulated sector), the emergence of various types of payment providers has led to some competition. However, in the background, banks continue to power them due to their monopolies on the custody of currency.
How Technology Is Disaggregating Banking
As in every sector of the economy, technology has progressively promoted competition and leveled the playing field over time. This trend has affected all three of the primary services offered by banks.
• Digital Underwriting
On the lending side, the digital underwriting process has emerged in recent years. Historically, a regional bank may have had a significant advantage in the underwriting process due to its superior knowledge of the borrower and the local economy. However, this informational advantage is diminishing as other lenders gain improved digital access to borrower-quality data.
• Lower Friction
Similarly, technology has reduced friction in money transfers on the payment front. Their cash warehousing service has been the last monopoly stronghold that is still relatively intact. As recent bank failures have demonstrated, however, the banks’ monopoly on currency storage is also beginning to be challenged.
Recent banking stress is merely an accelerant; underlying this are deeper trends that are influencing the bank deposit business. Historically, it has never been simple to transition between banks, but technology has made it possible to increase the speed of interbank money transfers.
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Through the establishment of brokerage accounts, technology has also made it easier to invest in cash-like securities such as money market funds, Treasury bills, repo, and commercial papers.
• Non-exclusive Deposits
In addition, the yield offered by these cash-like securities under the current monetary regime is considerably greater than what can be garnered at a Big Four bank. Currently, the yield at the Big Four institutions is as low as 0.01%, compared to 5.45% on T-Bills, which is up to 500 times higher. The confluence of these trends is now beginning to threaten the banks’ monopoly on the deposit business.
It is essential to observe that cash warehousing, the last bastion of bank monopoly, is also one of the primary drivers of both payments and lending. Consequently, the competition for deposits has also diminished the two other services offered by the bank as well as its overall position.
On the lending side, banks have long capitalized on their deposit monopoly by utilizing cash warehousing as a low-cost funding source to finance loans and redeploy in higher-yield loans.
The fundamental premise is that deposits and loans have essentially the same duration; however, as we have recently observed, the duration of deposits can change drastically and without warning. With deposits losing their tenacity, banks are hampered in their ability to provide their remaining services.
Last but not least,
Technology now enables increased competition across the three primary business units of banks, thereby making room for new entrants. This is why we are currently witnessing the vast disaggregation of banking services.
I believe that this has two major implications. One is that specialized service providers for payment, lending, and cash warehousing will continue to operate via technology, with banks functioning as an interface to connect and bundle these (outsourced) services. On the other hand, we could see the emergence of non-bank players seeking to bundle these distinct services using a bank as their backbone (i.e., a BaaS provider).
The evolution of these banking services is advantageous to the end user, who will have significantly more banking options and access to more customized solutions.
As the field continues to rapidly evolve, this highlights the need for banking executives to take a more proactive approach to assessing end-user requirements and determining how they are met. Undoubtedly, the finance industry and ecosystem have never been more exciting.