Long-term thematic opportunities in financial innovation

December 14, 2018 16:51
Globally, just 36% of total IT spending of banks is devoted to front office and initiatives that will change the bank. This needs an improvement, observers say. Photo: Reuters

The Hong Kong Monetary Authority (HKMA) in 2017 announced seven initiatives to move Hong Kong into a new era of smart banking. Virtual Banking, Open API and the Faster Payment System are the latest buzzwords that represent an irreversible trend towards innovation in the financial sector. While banks remain best placed to dominate the industry in the future, they need to keep up with the fast-paced digital revolution if they are to withstand disruption. US banks are leading the way, but Asian banks have been slower at increasing their IT spending to meet the challenges of the fintech age.

Technology is at the heart of the structural changes occurring in the global financial sector. Banks have already drastically changed the way they deliver products and services as they strive to meet customers’ ever-changing needs. However, the rise of virtual banks in Hong Kong as well as the HKMA's encouragement of API adoption means that a flood of new financial technology companies is entering the market, offering a wide range of innovative products and services and posing a serious threat to banks.

With established customer bases, licenses and brands, traditional banks should be best positioned to dominate the industry in the future. Nevertheless, their complex structure means they must allocate huge amounts of capital to IT legacy systems and maintenance, often limiting available budget for innovation. In fact, partly due to their legacy-free IT, financial technology companies can now offer services up to 50 percent cheaper than banks. With such fierce competition, banks must take the lead in developing and adopting new technology to enhance customer experience and retention if they are to stand any chance of defending or growing their market share.

Financial innovation adopters have huge growth potential

While banks globally are allocating increasing capital to technology and innovation, on average they spend only 10 percent of their revenues, and 15 percent of their total costs, on IT. Furthermore, just 36 percent of total IT spending is devoted to front office and initiatives that will change the bank, while the rest is spent on back office and regulatory or compliance requirements.

Banks' technology spending and willingness to innovate differs significantly across geographies. According to Morgan Stanley research, the US banking sector has generally been the most willing to adopt new technology, with US large caps leading the way. JPMorgan, for example, has grown its tech budget from US$9.5 billion in 2017 to US$10.8 billion in 2018, and US$5 billion of this year’s budget will be spent on new technological developments. In part, US banks have been supported by US regulation, with regulators generally treating fintech companies in the same way as established financial institutions, thereby enabling banks to compete on an equal playing field and therefore potentially keep up with the pace of the sector’s digital transformation.

In contrast, Asian banks have some of the lowest overall IT spending globally (as a percentage of revenues and costs). However, Asia (excluding Japan) is now spending the most on innovative technology as a proportion of overall IT spend (i.e. non-maintenance IT). As one of the leading financial innovation adopters in Asia, Singapore’s DBS has spent over US$3.5 billion from 2012-2016 on digital investments. In 2017, the bank announced its plans to invest S$20 million over five years to educate its 10,000 Singapore employees on digital banking and emerging technologies.

Over the longer run, this investment in innovation could have a significant impact: according to the Monetary Authority of Singapore, banks could cut their costs by as much as 30 percent if they leverage fintech in areas such as automation of banking functions and artificial intelligence, representing 10 percent to 20 percent of Asian banks' operating income.

Fintech companies as enablers of change

Despite posing some threat to traditional financial services companies, fintech companies can also bring many growth opportunities to the banking sector. Banks are increasingly looking to adopt the services of fintech through partnerships, investments or incubators, with only 7 percent preferring to develop all technological solutions internally. With a record US$58 billion invested in over 875 fintech deals in the first half of 2018, banks know they must embrace change and evolve their businesses or else face significant disruption from new entrants.

In 2018, global banks are spending close to US$300 billion on IT. The overall bank IT spending is projected to grow by 4 percent for the next five years. Innovation in the financial sector has opened new opportunities for investors. These broadly fall into two camps: the technology 'adopters' among the sector’s established banks and financial firms, and fintech firms or 'enablers' of financial innovation, which provide a wide range of services and solutions across the financial technology spectrum. The services being offered are vast. From data analytics to security and mobile payments, fintech companies can sell to banks from a variety of different angles, and most have the potential for significant growth. If banks are willing to keep up with the fast-paced innovation, these fintech companies could be enormously beneficial to the traditional banking sector.

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Fund Manager, Global Equities, Jupiter Asset Management.