Gonzo banks versus 'technologically bankrupt' incumbents

The global banking system came close to collapse in 2008 because institutions had too little in capital reserves to bridge the gap when imprudent lending turned sour.

Now a new build-up of debt threatens the long-term viability of the world's banks. But this is a different kind of debt, not financial in nature, but technical. For years, banks have put off technology upgrades and turned to quick fixes to postpone the day when ageing systems must finally be replaced.

Piling up technical debt is analogous to never repaying credit card debt, according to Ward Cunningham, the agile software pioneer who first conceived the notion of technical debt. Just as credit card debt has its uses, it sometimes makes sense to cut corners on a software project to make faster progress. But if you never go back to refactor those workarounds, then over time the software becomes more and more expensive to maintain and operate. The same is true of failing to implement functional upgrades as they become available from software providers — the cost and complexity of getting back on track just keeps on rising.

You end up paying more and more just to stand still, while the need to service those debts from your current income limits your flexibility to embrace new opportunities. A sudden crisis often proves the final straw, when the debt becomes unsustainable.

'Technologically bankrupt'

Incumbent banks in the UK have now reached such a crisis point in their technical debt, according to the young CEO of a challenger bank. Just as it's become imperative for them to refactor their IT systems for the digital age, they've been forced to retrench, Monzo's Tom Blomfield told the Press Association last week:

I think many of the big incumbents right now will die. They have not kept up to date and they are technologically bankrupt. That will catch up.

With Brexit and the spectre of negative interest rates they have retrenched. I have heard that many of these digitization projects have been cut. It's just back to being inward-looking and focusing on staying solvent.

Hard on the heels of renaming his bank because of a trademark dispute — Monzo originally launched as Mondo and unveiled its new name two weeks ago — Blomfield's rhetoric is of course self-serving. Monzo only just got its banking license from the regulator and needs all the publicity it can get. Badmouthing the incumbents as hopelessly behind the times plays well with Monzo's target demographic.

But the jibe hits home — the incumbents do have hopelessly outdated internal systems that have been accumulating technical debt for decades, while most of their efforts at digital transformation are skin-deep at best. HSBC, whose CIO Darryl West spoke about its progress last week at a conference in Shanghai, sums this up perfectly. With the bank's board committed to finding $5 billion in operational savings, digitization has to cut deep into wasteful internal processes, says West:

We’re going to restructure the cost base of the bank by digitising everything. We are on a mission to take every customer interaction and every process of the bank and digitize the whole thing. There will be no paper.

Yet you won't hear much about investment in replacing core systems with a new generation of digital technology. All the focus remains at the customer interface, with gimmicks such allowing new customers to verify their identity using selfies taken on their smartphone — part of a move towards replacing passwords with biometrics when accessing accounts.

Blomfield argues that even initiatives like these are superficial and often starved of funding when the going gets tough:

Each of the banks has an innovation team or a digital lab, but they are kind of for show. When things get a bit rocky or serious, they get their funding cut and they go back to getting the basics right.

Paying down the debt

What the incumbents have going for them, however, are huge reserves of what you might call inertia capital. They have what challengers like Monzo yearn for — hordes of customers for whom changing their bank is simply too much hassle, along with a brand that, while often tarnished in terms of customer experience, is still imbued with trust and familiarity. That buys them time.

The challengers may have the technology edge, but it will take them years to build up the market and brand presence to truly challenge the incumbents. The incumbents will either use their inertia capital to pay down their technical debt — or, more likely, they'll buy up the successful challengers once they've reached sufficient scale.

This is a pattern that's familiar from other industries — the IT industry in its short history has seen several waves of innovation during which incumbents have either been replaced by challengers, bought them up or somehow transitioned from one generation to the next. As a regulated industry, banking has more barriers that innovative newcomers have to overcome — but in the UK the regulators seem keen to level the playing field. Blomfield even suggests relaxing some of the regulation for smaller players:

What would really help is if you could start a new bank and cap it at 50,000 customers and £10 million ($13m) worth of deposits. Once you have reached that cap you have shown you have overcome the biggest problem, which is acquiring customers.

Then you can go through the next hurdle, where you have a big bank license with much more governance in place and risk management. So allowing lots of small banks to flourish to get the one or two real gems is a much better approach than putting you through a two-year wringer.

That probably won't fly, given that regulators may feel the downside of consumers and small businesses experiencing a bank failure probably outweighs the advantages of encouraging more innovation. Existing regulations still haven't prevented a healthy crop of challenger banks emerging.

My take

The innovative banks in this new generation are delivering much more immediate, responsive customer service at lower cost because they don't suffer the legacy technical debt (and process debt) of the incumbents — also because these new ventures can pick off specific services to offer rather than offering the full range that an incumbent must provide. Inspired by Monzo's new name, I'm tempted to call them gonzo banks — because they're to the point, they challenge convention and they engage much more individually (although the GonzoBanker blog predates my usage).

Gonzo banking is one part of the threat to the dominance of incumbents. But the biggest threat comes from inside, from their own accumulated technical and process debt that has built up over decades of making do rather than going back and refactoring from time to time. As external pressures grow, that technical and process debt looks increasingly unsustainable. It becomes bankruptcy when an organization can no longer refactor fast enough in response to changing business conditions to maintain its market presence. Incumbent banks may be closer to that point than we (or they) realize.