Talking point
The digital structural change in the financial sector

November 24, 2014

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The forces driving digital structural change are complex, and “predatory competition” is certainly an inadequate description of all the effects it is having on established sectors and structures in their entirety. That is why other aspects are making a fundamental contribution to the change. These include the exponentially rising volume of data, the penetration of web-based devices, popular familiarity with the internet, network effects and economies of scale, broadband expansion, the potential for automation and standardisation, the readiness to adapt and the flexibility of established providers, changes in demand and consumption patterns as well as stricter regulatory measures.

Global digitalisation is also altering the structure of existing business sectors, i.e. traditional market structures are crumbling, sector boundaries are shifting and new market entrants are appearing. Virtual marketplaces are being formed with new business models, revenue and cost structures. Sector boundaries that hitherto existed are thereby increasingly being whittled away, because new cross-sector competition conditions are emerging. This is not making macroeconomic sector analysis any easier of course.

However, in principle there are lots of sectors experiencing the same fate. Competitors are forced out of the market by the use of new (internet) technologies and changing demand and consumption behaviour. In the current digital transformation process a decisive role is being played especially by algorithm-based analytical methods, digital business models, virtual value creation processes as well as digital products and services. Demographic change is also ensuring that the share of the population that is internet-savvy is constantly rising.

Regardless of the chicken-and-egg debate of whether consumer needs or the early-to-market offering of internet technologies were the trigger for digital change, there are nevertheless roughly five phases of (digital) structural change that can be identified as a recurring pattern:

Phase 1: Technological progress and adoption

Technological progress generates new internet-based consumption, media usage and communications requirements among consumers. Consumers adopt the new technologies and integrate them into their daily lives. In the financial sector traditional payment arrangements, for example, are being expanded to include modern internet technologies and algorithm-based analytical processes.

 

 

Phase 2: Market entry and changed competitive environment

Internet firms from outside the sector along with tech-driven start-ups and niche suppliers are changing the competitive environment with their digital business models, products and complementary services. Modern internet technologies are replacing longstanding (analogue) processes or parts of these processes, which means that personal experience is partly being supplemented or replaced by intelligent algorithm-based software solutions.

 

 

Phase 3: Winners and losers

Traditional business models often feel the squeeze as a result, because individual process stages are subjected to stiff competition. The consequences are reflected in declining sales and profits. The established revenue sources of traditional firms can only be compensated for inadequately by other business areas. New players are, by contrast, registering initial successes and generating profits.

 

 

 

Phase 4: Stiffer competition and forced market exits

Market share of the incumbents shrinks; new players can grow their market share; dog-eat-dog competition becomes more intense.  Painful adjustment processes and cost-intensive reforms (for example via digitalisation strategies) are initiated by the incumbents.

 

 

Phase 5: Market consolidation and strategic alliances

Market consolidation occurs and some firms disappear from the market. New, mainly non-financial players enter the market, establish themselves and boost their profits. In addition, strategic alliances emerge that deliver added impetus to the market and technological developments and drive additional innovations.

 

 

And this brings us back to where we started

These five phases of digital structural change in the financial sector can be observed occurring at different junctures in various sectors and are even repeated within a sector or in more and more parts of the value chain according to certain time cycles. The outcome is a cycle. Depending on how trailblazing the technological progress is and which strategies are deployed by the incumbents the individual phases do of course have differing degrees of impact.

 

 

All the same, “change is the only constant” (Heraclitus, c. 520 BC - 460 BC), i.e. in principle we find ourselves permanently experiencing structural change, but not every innovation is capable of bringing about a paradigm shift. A large proportion of innovations occur between trailblazing events. They are no less valuable, but they are more incremental in nature and are embellished or marginally improved versions of existing products, services and processes. This is also the case in the financial sector. The new competitors are not really reinventing the banking business. However, they do know how to make good use of modern data analysis methods and numerous (especially personal) data sets to individualise certain financial services digitally in such a way that they can be of greater benefit to internet-savvy customers in particular.

So the business ideas behind them are often not new, but they are based on digital value creation processes. In addition, the new players speak the language of the internet. “Convenience” and “one-stop shop” are the key ideas of our time. The economics behind this is relatively simple: firstly, digital value creation processes can be managed much more cost efficiently, and secondly, wider (customer) reach is achieved faster thanks to economies of scale and network effects. In dynamic markets with shorter product life cycles these are valuable competitive advantages that ensure a company's survival.

There are future opportunities above all for those firms that swiftly succeed in embedding their internal and external processes, services and products as flexibly as possible into a digital company infrastructure (IT architecture) in order to be able to quickly anticipate new technologies or engage in timely uncomplicated collaboration with relevant market players. Also, the players that will be successful are those who can convince clients credibly that in particular their (personal) data will neither be sold to third parties nor used for other non-business purposes. This not only opens up the prospect of survival, but depending on the strategy also of lucrative growth opportunities.

 

 

More on Fintech...

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How crowdinvesting works

 

 

 

 

Graphs: Oliver Ullmann, Deutsche Bank Research.
Source: Dapp, T. (2014).Fintech–The digital (r)evolution in the financial sector: Algorithm-based banking with the human touch. Deutsche Bank Research. Frankfurt am Main.

 

 

 

This commentary was originally published in German on November 20 and translated on November 20.

 

 

 

 

 

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