Banks as marketplaces
The internet has enabled tech companies to capture enormous value by becoming arbitrators of marketplaces they operate. But the financial industry in India is a different beast.
Our current mental model of online commerce has come to be heavily influenced by large online aggregators like Amazon.
Surely it’s commonplace to read headlines about new industries getting Amzon’ed every other day. In the wake of this reality, it isn’t hard to admit that most of us believe that at least some significant part of the banking business too, like many other consumer facing businesses will ultimately will end up being disrupted by internet aggregators.
In line with this thinking, several Fintech startups in India have raised large amounts of capital in the last few months to build neo-banks. A neo-bank (also referred to as “challenger bank”) is touted as a high-tech bank (“imagine if Amazon were to build a bank”). These Neo-banks, set up in partnership with the existing banks and other financial entities, are expected to disrupt the incumbents with better technology and superior customer experience.
Here’s the FT reporting on the recent BharatPe fund raise of $50Mn:
Since its launch this year, the uptake has been “amazing”, says 37-year-old Mr Grover, who previously worked at American Express and Grofers, an Indian online grocery delivery service. “We want to be seen as the digital bank for the merchant,” he says, “We have applied [to be] a non-banking financial company and we should be getting our license in 2019 or early 2020.”
And here’s the bit on PhonePe from the same article:
PhonePe, the payments app owned by India’s largest ecommerce group Flipkart, is in the process of expanding aggressively with the dream of becoming as ubiquitous as China’s WeChat, an app used for everything from chatting to banking to gaming. “At this point we have 75 mini-apps on the platform,” says Sameer Nigam, PhonePe founder and chief executive, “We aspire to be as much of a daily habit in people’s lives.”
To be clear, neither PhonePe nor BharatPe has set up a new bank or underlying financial entities by itself. Instead, they’re adopting an all-too-well-known-now strategy employed by aggregators across the world of building an intermediary platform that connects the SMEs or individuals with financial products provided by underlying suppliers.
Online aggregator platforms in other industries have been able to extract enormous value by centralizing demand and supply than by merely taking one side or the other, making them very attractive bets for the VC firms.
The premise for VC funding into Fintechs (especially the banking focused ones) is made further attractive by two important realities:
- One, that India is essentially a capital starved market due to multiple [1] reasons[2].
However, with deeper internet and smartphone penetration and potentially lower compliance costs due to new digital public infrastructure, serving informal markets — which makes up the bulk of the market, is expected to become cheaper.
- The second being that over the last few years, banks have been increasingly supplanting their interest incomes with fee based income, which is mostly derived from payment fees, and origination commissions for selling of other financial products like Insurance, Investment plans, etc. The bigger private banks make revenues up to the tune of 45% of their interest income from fee based activities.
This fee based income presents a great opportunity to the online aggregators because the marginal cost of adding a new product line when you have massive distribution is relatively minimal. That is, while you are on Amazon purchasing toothpaste, flight-tickets and Jeffery Archer novels, what’s to stop them from suggesting you to add mutual funds and insurance products to your cart at the time of checkout?
Commoditising supply
People in startups love to talk about network effects in online platforms, a phenomena used to explain how upstarts online have become multi-billion dollar enterprises. Here’s how it goes:
The platforms start by drawing in a large number of initial users by a variety ways like discounting, or improving the user experience or making it more convenient to get the job done.
This draws in the suppliers who in turn draw in more users, and so on, setting forth a chain reaction of sorts that expands the network. All this is easier said than done but it sure is an elegant framework to understand online aggregators.
By capitalizing the deep relationships online aggregators have built with the customers, they are able to dictate the terms to suppliers and distributors in the ecosystem, and are successful in capturing a greater share of margins. This often involves burrowing deeply into the value chain by modularising and commoditising the suppliers altogether. We can see this in action all around us. For example, Amazon has commoditized the suppliers in some categories to an extent where its private label brands are pulling in more revenues than third party suppliers.
What typically affords the aggregators to be able to claw deeper into the value chain set up with the suppliers are low marginal costs and transaction costs to adding new suppliers.
In the case of Amazon, the marginal costs incurred on addition of suppliers isn’t minimal or zero. Currently, it is very likely that Amazon still spends a significant percentage for its revenues with suppliers, and expends substantial monies in transaction costs to on-board new sellers. While the costs may be high right now, they are mostly likely tapering down as more and more sellers use self-serve / low-cost mechanisms to onboard themselves, and network effects creep in to the supplier markets.
Coming back to Neo-banks
One could imagine a similar situation to play out with Neo-banks as well. We can visualize a large Fintech aggregator commoditising the banking or financial layer to give us cheaper loans, higher yielding investment products, and insurance policies with easier claims, and more. Indeed this is supposed to be the promised land for many startups in this space.
However, the likelihood of something of this sort happening doesn’t seem high. The way the financial industry functions, not just in India but across the world, poses some serious challenges to this premise of commoditising supply.
Financial institutions primarily derive their value from regulatory capture. Consider digital payments for example: in terms of the actual work, the cost of moving bits of data around is minimal, and only a small percentage of the interchange fees is captured by the card networks & payment gateways who are actually processing the payments. The bulk of fee goes to the banks who are able to do this mostly because they simply can. This is because the process for getting a banking license in India is hard, expensive and extremely in-transparent. It’s not just hard to get a banking license, it’s just as hard to get the approvals to set up an insurance firm, or an Asset Management Company (AMC) that operate mutual funds, and (arguably) even an NBFC which can finance the loans.
The transaction costs of partnering with banks & other financial entities are just too high for aggregators, unlike in other industries.
Indeed so pervasive is this rent-seeking behavior of financial entities that despite all the capital raises we’ve seen recently, only a handful of the neo-banks have been able to successfully even enter into partnerships with existing banks.
It is one thing to onboard a new private label cloud kitchen, or an electronics accessories brand, or add a new driver on the roads of Bangalore, but it’s completely another thing to partner with new bank or insurance provider.
The strong regulations around banks, insurance companies, NBFCs and other financial institutions have historically been justified by regulators by systemic damages that could be caused to the economy by failure of any of these entities.
Handling the consequences of failures of financial companies when compared to a cloud kitchen shutting down can be trickier, and hence it will always be slower and harder to add new suppliers to the underlying financial layer .
Even if some radical steps are taken to allow for a more transparent and reasonably straightforward way to give licenses to new companies to set up financial entities, it’s hard to see how aggregators will end up in a position where they will be able to achieve network effects on the supply end.
This essentially means that:
- The value that can be captured by an online aggregator will always have to be shared with the underlying banking or investment company it is twinned to.
- Additionally, a rusty underlying supply infrastructure would also mean a serious limitation in terms of kinds of products or user experience levels that can be offered by the Neo-banks. This was apparent recently when the UPI transactions on a number of apps began experiencing high rates of failures when some banks were facing trouble with their tech infrastructure. It’s not hard to imagine how this could end up being a major bottleneck for Neo-banks looking to scale aggressively in the future.
As an analogy, think of what would the streaming platforms like Netflix or Prime Video be like if they were limited to only distributing the programming of existing TV networks and not produce any originals. Surely differences would emerge, as they already have, in the user experience involved in streaming of the shows, but the shows themselves are arguably the main draw for these platforms, not necessarily the user experience offered by them.
Given our natural predilection towards seeking market-based solutions for many of the problems, we’ve sought (at least in theory) to build technology platforms that can create efficient marketplaces. However, in the case of Neo-banks, a better alternative could very well be just a better bank, not bank as a marketplace.
