Do We Need Challenger Banks? Do We Need Banks?


Bill Gates said that we need banking, but not banks. What does this mean?

The International Monetary Fund (IMF) recently published their view on “What is Really New in Fintech?”. This highlighted the potential for new players to deploy new tools to collect and analyse data on customers in order to, for example, determine creditworthiness. They point out that what they call “the real challengers” exploit non-financial data and further, that research shows that such data as the type of browser and hardware used to access the internet, the history of online searches and purchases are often superior to traditional credit assessment methods. Not a substitute for traditional methods, note, but superior to traditional methods.

This is why platforms such as Amazon, Facebook and Alibaba (the techfins) incorporate more and more financial services into their ecosystems, to collect more and more data, enabling the rise of what the IMF terms “specialised providers” that compete with banks to deliver the functions that society needs.

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This seems a reasonable analysis but what struck me about it was that there was no suggestion that these specialised providers need to be banks or, in particular, “challenger” banks. Challenger banks have not really transformed the banking sector (I love the banking app on my phone, but I use it to access checking account, savings account, debit card and mortgage products that are exactly the same as they were a generation ago) but what if that doesn’t matter because we are coming to the end of the era of the bank?

What if we don’t really need challenger banks because we don’t really need banks? Or, to put it another way, if we are looking at a strategic consolidation in the manufacturing of financial services as I discussed in a previous column here in Forbes, does it make sense to have horizontal integration in banks or are (for example) payments products and savings products better developed by specialist institutions and then integrated into consumer-facing brands?

Banking Functions

Now, if you think this is me spouting new-age fintech hippy waffle you could not be more wrong. A functional view of banking will show why. When I’m working on strategy with financial organisations, I often find the Bodie and Crane classification (Harvard Business Review, 1996) a useful basis. This gives me a model that sees banks as a bundle of six basic functions: three core transfer functions and three interaction functions. The core functions are transfers in time (credit provisions, savings and loans with maturity transformation), transfers in scale (investments and funding large scale enterprise) and transfers in space (payments). The three interaction functions are informationrisk and incentive.

(That final function is often overlooked, by the way, but it is strategically important to the economy. As my good friend Ron Shevlin pointed out here in Forbes recently, almost all Americans with cryptocurrencies said that they would or might use their bank to buy and sell them. I strongly suspect that there are a substantial fraction of Americans who do not currently hold cryptocurrencies who would if the services was offered by their bank.)

This presents the incentive function of banking in context: that is, the existence of regulated financial institutions in a market means that transactions will take place. Now, this is not to say that speculating on DogeCoin is a good thing to do or not (I have genuinely no idea whether to buy it or not, and any references to specific cryptocurrencies in this article are for entertainment purposes only) but it is to say that transactions are enabled by banks and, as Ron points out, banks need information to set the dial on those incentive functions. But does it need to be bundled together with information and risk management functions? Probably not. Each of those individual functions could be unpacked. There is no obvious reason why this particular bundle is either optimal or invariant.

Now look at the transfer functions and consider payments, as the obvious and current example. I might observe here that not only is there no fundamental economic reason why banks should be the dominant providers of payment services, there is no fundamental economic reason why they provide them at all – see, for example, Radecki, L., Banks’ Payments-Driven Revenues in “Federal Reserve Bank of New York Economic Policy Review”, no.62, p.53-70 (Jul. 1999) – and there are many very good reasons for separating the crucial economic function of running a payment system to support a modern economy and other banking functions that may involve systemic risk. Here’s what Charles Calomiris, Chief Economist and Senior Deputy Comptroller for Economics, Office of the Comptroller of the Currency (OCC) said about this at the CATO Institute conference last November:

It requires some rather complicated and specialised economic modelling assumptions to explain why banks sometimes choose to bundle lending and payments services within one intermediary. Those assumptions do not always hold, which explains why bundling is not always a good idea.

Indeed it is not and perhaps it is time to reassess the financial sector and ask whether it delivers the best services to the rest of the economy. 

Unbundle and Win 

The traditional theory here says that the reason for the bundling is that control over payments provides information that gives banks competitive advantage in risk management for credit and investment decisions: In other words, to make the adjacent transfer functions more efficient. And, indeed, that may well have been the case in the past. But in America, at least, it has not led to the best of outcomes. Calomiris noted that banks’ services remain expensive (and some have become more expensive since the great financial crisis) while more than 60 million Americans are still described an “un-banked” or “under-banked”.

(The Financial Times was less kind recently, asking why the country with Silicon Valley has such “bafflingly archaic” financial services.)

Many jurisdictions have already started to unbundle payments and the provision of credit (in the European Union, for example, there is the regulatory category of Payment Institution) and the US will follow. It is happening anyway: many others can step in to provide credit and the techfins can take away the payments (the low-margin function). Just look at the example of Stripe and it’s new banking-as-a-service that is being used by organisations such as Shopify to embed financial services in their lines of business to see how the unbundling can work to deliver better services.

Big institutions managing transfers in time, space and scale all together and exploiting informational advantages to improve risk management may have been the way to organise the business of banking once, but it simply isn’t true any more. Banks can obtain data from all sorts of sources to help their risk management for lending (just look at the business models around Ant Group in China) while, conversely, a great many other businesses might want to provide lending given the right funding models.

As Bill Gates is credited with saying, society needs banking but it does not need banks. There is simply no reason why the three transfer functions essential to society should be bundled in one kind of institution any longer. One of the outcomes of the fintech revolution will be to unbundle and unlock value as the shock troops of big tech breach the redoubts of consolidated, utility banking.

All of which seems to suggest that we are somewhere around peak challenger already and that we will see more investment in specialist niche financial services players. Not a hard prediction to make from London by the way, with the recent capital injections for (e.g.) Curve and showing the way.


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