There is an old paradox of banking being one of the most regulated sectors, yet probably the most distrusted business area. The financial industry has undergone significant changes since the 2009 financial crisis but seems to have been revolutionised by the onset of digital banking. A healthier competition was needed, and the regulatory environment facilitated the transformation.
Digital banking, spanning from simple online banking to artificial intelligence, started as a cost-saving measure for traditional banks and became the critical service to the new challenger banks. The market was dominated by a small number of large banks, whose survival determined the health of the whole financial industry and contributed to the label of ‘Systematically Important Financial Institutions’. The regulators, including bodies such as the Prudential Regulatory Authority, Financial Conduct Authority and the European Commission, have committed to decreasing the barriers to entry for new banks, creating a healthy competition.
The conventional route of setting up a bank requires obtaining a banking license. To be successful you have to be able to have sufficient capital reserves based on the risk assessment of your institution, liquidity levels, satisfactory governance structure. In other words, there are many robust and costly hurdles to get over in the first place. In 2011, the Electronic Money Regulations (implementing the second Electronic Money Directive) created an alternative journey for newcomers who cannot afford the cost of pursuing a full banking charter. Under this regulation, the initial capital requirement was reduced to a uniform sum of €350,000, and additional 2% of the average electronic money held the institution. Significantly reducing the initial capital requirements comes at the expense of services that an e-money institution can offer, which are practically limited to providing digital accounts with a restricted possibility of withdrawals. Providing this service at minimum cost in combination with outstanding customer service is what satisfies the needs of the market. This strategy has brought the fintech Revolut over 4 million users within only four years of existence.
The reduction in the capital requirements has been key for the thriving of the new ‘near banks’ as its calculation is based on a risk assessment related to their operations. The bigger and more established the bank, the lower the perceived risk of failure and ultimately, the lower the minimum capital prerequisite. A new bank in digital space will face many risks simply because of its ‘age’ and the nature of their online activities which will make the capital requirements significantly higher but, under the new regulations, not necessarily unmanageable.
There are two further significant laws that have contributed to changes in the sector. The Capital Requirements Regulation orders banks to hold enough capital to be able to stay solvent in the case of a financial crisis. Practically, this is an attempt to prevent any government buyouts, which in 2009 were needed for several large banks in the UK, including Lloyds, Barclays and Royal Bank of Scotland.
The Capital Requirements Directive provides additional guidance on the calculation of capital requirements reflecting the banking Basel III standards and, more notably, it introduces the idea of the European Economic Area passports. The establishment of this new concept contributes to the success of new entrants, as it allows banks licensed in one of the 27 states to provide such services in other member countries without additional authorisation. The German fintech N26 has leveraged this opportunity and entered more than 17 additional countries after obtaining a banking license from the German Financial Authorities.
One of the most recent regulatory developments is the implementation of the second Payment Services Directive. It aims to level the playing field for all payment providers and encourage innovation, which will help to protect customers in the online domain. In consequence, there is a new obligation for banks to be more transparent than ever and share information relating to consenting customers’ payment accounts. The largest banks have to implement this at the very core of their corporate governance and operations, including the way their banking software is built. This means that there is an opportunity for fintechs to get a head start by increasing their learning curve through studying the existing trends in banking.
There are apparent risks inherent to digital banking that cannot be neglected. Data protection and the risk of online fraud is ever present despite the newly initiated collaboration between banks. Such risks are one of the reasons why it would be disproportionate to decrease the requirements for small banks even lower, despite the assumption that the failure of a challenger bank poses a lesser risk to the financial system than the failure of a big bank. It is also the reason why legacy banks still have the edge over new digital banks. The root of the banking industry lies in trust, and customers do not seem to be ready to give their life-long earnings to an online bank which does not exist in the tangible world. Challenger bank accounts are extremely popular, but so far as secondary accounts only.
Although the role of the new entrants is mostly supplementary, there is no doubt about their skyrocketing popularity. The potential is enormous and with the European Union being committed to the creation of an EU Digital Single Market and embracing innovation, there is a lot to look forward to in terms of their performance as well as regulatory novelties.