Will COVID-19 Transform the Banking Landscape?

Even as the world gradually reopens, traditional banks are facing an uncertain future, rife with vanishing revenues, huge projected credit losses, declining earnings and stiff digital banking competition from financial technology (fintech) companies. Banks must also contend with an expected rise in non-performing assets, and will therefore have to rethink their business models, with an eye on alternative data, advanced analytics and even more online product innovation and service distribution.

The devastating COVID-19 pandemic has, of course, forced millions of people to stay at home. With customers kept away by lockdowns, scores of businesses, including many banks, have been forced to shut their doors and furlough employees. Complicating matters further, those that have managed to stay afloat have had to continue to manage their lease and loan obligations, amid a free-falling economy and limited revenues.

Initial unemployment claims during the pandemic reached at least 25% of the labor force, levels unseen since the Great Depression. The Bureau of Economic Analysis, moreover, reports that personal consumption declined by 13.6% in April, and also predicts that U.S. GDP is likely to contract at least 5% in the first quarter.

The unprecedented COVID-19 financial strife has impacted banks and technology companies alike, but fintechs bring to the market certain advantages that give them an edge during a lockdown - including user-friendly products, fast processing of digital information, attractive data visualization, continuous transaction analysis, easily accessible and clean user interfaces, and simplified customer onboarding. Furthermore, the pace of fintechs' innovation may be faster than what banks, on average, can sustain or emulate.

Banks Must Adapt to a New Digital Reality

A recent McKinsey report estimates that credit losses in the U.S. “may range from $400 billion to $1 trillion between 2020 and 2024,” with a disproportionate amount coming from commercial and industrial (C&I) loans to those most heavily affected by lockdowns. Net interest income, moreover, may decrease by up to $200 billion from its 2019 baseline. Therefore, during the recovery phase, banks will have to manage concurrent battles: adapting to a changing environment while experiencing declines in asset quality and earnings.

This bifurcation in strategic priorities is not new. However, the immensity of the crisis will likely further erode the role of incumbent banks, as the recovery will build on a digitalized business model, where fintechs have an inherent advantage.

As the pandemic spread around the globe in March, banks scrambled to close down their physical distribution networks and increase digital access to products and services, while allowing employees to work from the safety of their homes. What's more, they rapidly shifted to a digital business model. (Indeed, in a separate study, McKinsey found a "10 to 20% rise in digital banking use across Europe" in April.)

The speed of digital transformation in banks has accelerated over the past few months: multi-year digitalization strategic roadmaps were executed in a matter of weeks. If there is a need, there certainly is a way.

Online banking portals became critical as business continued their operations. As bills mounted and revenues collapsed, business faced liquidity crunches and online access to accurate real-time liquidity information became critical - both for banks and their customers.

Both banks and their customers could rely on the combination of digitalized documentation, remotely accessible data, integrated on-boarding tools, and APIs. With digitized customer information accessible without difficulty, banks provided their established customers capital support easily.

But they could not serve all their customers, and acquiring new customers became challenging, because some of their KYC and onboarding processes still require human interaction.

Rescaled Fintechs

Enter fintech. Challenger banks, particularly the digital platform-based banks in Europe, are now in a stronger position to acquire customers.

By design, fintechs operate remotely and distribute their products and services digitally. This has given these technology innovators a leg up during the pandemic. For example, SMEs working remotely can conduct their business using easily-navigable fintech apps on any ubiquitous smartphone.

Fintechs also have an edge because they are subject to less-onerous regulation and have a lower cost base than traditional banks. This advantage has been evident during the pandemic. Businesses are suddenly relying, more than ever, on fintech apps like Stripe and Square to (for processing payments) and Lendio (to apply for SBA/PPP loans), bypassing traditional banks in the process.

What's more, PayPal added 7.4 million new accounts in April, one of the best months in the company's history. The simplicity and direct access of retail-oriented services and banking tools have clearly been embraced, not only by SMEs but also by larger companies.

Consider, for example, if you need to send $1,200 to a colleague to buy personal protection equipment for the office. While the typical bank may be closed, there is a fintech app for that.

Reimagining Financial Services

In our new world, after social distancing is a distant memory, many customers will continue to appreciate their rapidly embraced digital conveniences, whether it is immediate delivery of food and groceries or complex liquidity planning.

The strategic prioritization of banks and fintechs will likely diverge. Banks will have to focus on getting their core business in order: e.g., cutting costs, managing risks and allocating capital efficiently. Moreover, they will also have to keep their eye on their risk books and loan portfolios. As non-performing loans increase, earnings quality is expected to decline.

All one has to do to see the warning signs is to peruse Q1 earnings: the U.S. super regional bank, Comerica Inc., with $76 billion in assets, increased its loan loss reserves from $13 million (one year ago) to $411 million. During the same period, Umpqua Holdings, with $27 billion in assets, reported a $1.8 billion net loss. The situation is similar in Europe.

Alternative Data, Innovative Products and Advanced Risk Analytics

Given the sudden onset of the pandemic and its substantive impact on finance, traditional accounting and financial data may be of limited value in workout and credit processes during the recovery. To better understand customer risk profiles (beyond what is considered the traditional markers of creditworthiness), banks will have to dig deep into their accumulated data and harness the power of alternative data. Herein lies an additional obstacle for credit risk managers: how to differentiate between a company that should get help to navigate the post-COVID recovery and a company that should not.

That is a challenge in itself. However, banks will also have to reassess their cost base and build a leaner organization to counteract the impact of a possible slow recovery and a deep (and likely prolonged) economic downturn. A way to achieve this is to rethink their distribution across sales and service, support functions (including risk management) and back-office operations.

There are, furthermore, opportunities to explore: innovate alternative products can provide new sources of income by extending services around core banking services, countering the negative impact of economic concerns and joblessness.

For example, banks could build extended services around core products - such as liquidity management for small businesses and loan products - that improve credit scores that took a hit during the crisis. Modeling these customized, next-generation products will likely pose a challenge, because they'll need to incorporate relatively recent behavior.

Financial inclusion and equity in access will, moreover, likely emerge as both a concern and an opportunity. There are number of lenders that charge consumers and small business credit at 5%, but some predatory fintechs charge their borrowers interest rates that can hit 400%.

One way that traditional banks can reduce their loan losses is by developing machine-learning algorithms to merge traditional, structured, financial data with alternative, unstructured data collected from internal and external sources.

Banks will also have to reassess their capital management strategies, as credit loss management will have an outsize impact on their future. Advanced analytics are likely to play an increasingly central role in cost reduction, innovation and credit risk management, and therefore can and should underpin capital allocation. Ultimately, this should lead to improved decision making. However, the regulatory model approval processes may hamstring these attempts.

Traditional analytics focus on identifying the greatest impact of customer services, and assess their value to the bank based on long-term customer engagement. However, under the extreme and anomalous circumstances brought about by the pandemic, analytics will need to be more forward-looking and innovative - as customer demand and customer behavior evolve in lockstep with the economic recovery.

Continued investments in digital banking services will require deep pockets. Scarce and expensive bank capital will be spent grudgingly. In the fourth quarter of 2019, investment into fintechs slowed down remarkably, with signs suggesting that venture capital is strategically standing at the sidelines; however, if banks continue to struggle, they may be tempted to open up their purse strings.

Parting Thoughts

As restrictions are slowly lifted and businesses reopen their doors, many will come to the grim realization that they will not recover fast enough, if at all. Facing lower revenues and demand than ever before - while working to accommodate social-distancing guidelines and operating with essentially the same cost base - all businesses will likely need to rethink their incumbent business models.

JP Morgan and Citibank are among the traditional banks that have demonstrated their ability to adapt during the lockdown. They are now major and successful players in the fintech space (both as investors and sponsors), and have shown why it's wrong to discount large banks' technological capabilities and commitment to innovation.

However, there are thousands of banks where digital innovation has not taken root. Indeed, around the globe, hundreds of the medium-to-large banks still rely on legacy tech stacks and corroded risk architectures, with scant digitalization. In the U.S., it is increasingly likely that a large number of antiquated community banks will be gobbled up by their better positioned and financially healthier peers.

That's part of the reason why fintechs - smaller and nimbler, without onerous banking charters - continue gnaw away at the business of traditional banks. Fintechs embrace partnership opportunities (even, at times, with direct competitors) and have quicker-to-market strategies.

Unburdened by loan losses and stringent regulatory requirements, fintechs also have the know-how to effectively deploy digital, habit-forming financial products that customers actually want to use. In the aftermath of COVID-19, this business model should give fintechs a strategic advantage.

Peter Went is a lecturer at Columbia University, where he teaches about disruptive technologies like artificial intelligence and machine learning, and their impact on risk management.