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Digital transformation in banking and finance: The evolution of banking

Along with traditional challenges, such as the high costs of capitalization and operational costs – banks that embrace digitization are facing a new set of threats as the world rapidly evolves.

2023-11-01

Survival of the swiftest: Navigating the tumultuous terrain of rapid market evolution

Brendon Byrne, product leader - flow engineering

It is not the most intellectual of the species that survives; it is not the strongest that survives; but the species that survives is the one that is able best to adapt and adjust to the changing environment in which it finds itself. - Charles Darwin

Fintech is the new paradigm of evolution in banking. Once on the fringes of financial services, fintech has been catapulted to the forefront of the industry. Fintech has forever reshaped the banking industry, introducing profound and unprecedented challenges with its opportunities. Along with traditional challenges – such as the high costs of capitalization and operational costs – banks that embrace digitization are facing a new set of threats as the world rapidly evolves.

The shift began after the 2008 Financial Crisis when the public’s faith was shaken in the motives and governance of traditional banking. The relationship between customers and banks was changed forever and became the fulcrum for a new banking era, creating the motivation and market to introduce alternative players to test the largest and most powerful banks. Legislation, like the UK’s Financial Services Act of 2012, and the 2010 Dodd-Frank Act, was passed in response to the massive banking failure and consequently opened banking standards to set the stage for digital banks, lending institutions and payment transfer services.

Challenger companies that were born in the post-Financial-Crisis era have been the vanguard of the fintech revolution. They have driven the digital transformation of financial services and influenced digital banking trends that are now the norm. They have also ushered in numerous hurdles, some that are familiar to traditional banking and others that are unique to today’s era. Financial institutions, both traditional and tech-first, must balance keeping up with high consumer demands while protecting consumers from risks.

The key drivers in banking’s digital transformation

The banking industry is traditionally slow to change. Nimble competitors who have emerged in the last two decades have forced longtime industry leaders to adapt to the rapid market evolution and rewrite the future of banking. New and influential fintech players in the financial industry broadly fall under the following categories:

  • Neobanks
  • Digital payment systems
  • Digital assets

Neobanks

Unlike traditional banks with physical branches, neobanking is a digital-first financial company that conducts all of its banking services online via desktop or mobile app, harnessing modern technology to increase financial innovation and customer satisfaction. As of 2022, there are almost 400 neobanks worldwide, such as SoFi, Albert, Wealthfront, and Chime. Consumers are drawn to these digital banking services for being tech-forward and having lower costs. The COVID-19 pandemic accelerated their growth. Due in part to shutdowns, online and mobile banking grew by 34%, while ATM and physical banking declined by 12% in 2020. Even older and less tech-savvy demographics were forced to adapt, introducing a wealthier set of customers to neobanks.

Digital payment systems

Digital payments enable users to transfer money or digital currency between accounts via digital payment systems, such as mobile apps and mobile wallets. American Express, Visa, and Mastercard still dominate the payments sector, but they are now joined by companies that didn’t exist twenty-five years ago. Companies like PayPal, Tencent, Stripe, and Ant have experienced meteoric growth and opened up a whole new avenue for consumers to make purchases and transfer funds.

Digital assets

A noteworthy disruptor in the banking industry is digital assets, such as cryptocurrency. The broad definition of digital assets is anything that is digitally stored and uniquely identifiable that holds value. Digital assets recently caused a frenzy, which led to an epic rise and fall in the sector. High-profile collapses, like FTX, have ironically resulted in the emergence of stablecoins and central bank digital currency, which links digital assets back to the very institutions it was trying to separate from. Most central banks of major economies have signaled interest in developing fiat digital currencies within the next decade.

The challenges (and failures) of banking’s digital transformation

Fintech has transformed the way we bank. It is also learning the hard lesson of traditional banking: looking after other people’s money and using it to make profits simultaneously is a very difficult feat to accomplish.

Fintech is also facing uniquely new challenges. The digitization of banking, which allows consumers to become more intimately connected to their finances, also exposes them to more attacks. Traditional banks are tough to physically rob. Because fintech operates in the digital ecosystem, anyone with an internet connection has the means to attempt a cyber bank robbery. The financial services industry is now the number one target of online attacks, eclipsing the healthcare sector cyberattacks in 2022.

A new world introduces new problems, but the old challenges also remain. Fintech companies must contend with classic financial issues deeply rooted in the banking sector concurrently with new challenges tied to the digital world.

The classic issues

Silicon Valley Bank (SVB), which exclusively invested in fintech companies, experienced traditional banking woes. Its lack of investment diversification and a decrease in portfolio value led to an old-fashioned bank run. Other challenger banks – such as Bank North, Dozens, and Volt – faced similar issues and closed their doors in 2022. In the words of Volt CEO Steve Weston, “I don’t think this is the end of the neo banking experiment, but we were at a very unhelpful time to raise capital. If you want to be a bank and you want to scale up, you are going to need a lot of capital, and if you don’t [raise it], you are not going to be able to grow.”

The new issues

The internet introduced new threats like cyber criminals and digital hackers. All fintech companies and now traditional banks with digital services are susceptible to cyber-attacks. Finance app Revolut reported a $20 million attack in early 2022. Neo banking app Dave was compromised in 2020, and 7.5 million users' data was published to a hacking forum. Mobile banking app N26 was shown to be vulnerable by Vincent Haupert in 2017. Anything online is open to attack, and financial services are in the crosshairs because of direct access to what criminals want the most: money.

The classic issues meet the new issues

The crypto market in its current form is irrevocably damaged after a string of collapsed exchanges, like Mt. Gox, Bitfinex, QuadrigaCX, Cryptopia, and, of course, FTX. Similar to recent neo banking failures, crypto exchanges faced familiar and traditional challenges, but also experienced new challenges.

Mt.Gox was the victim of a hacking theft but was subsequently found manipulating balances and misappropriating funds. Bitfinex was also hacked and revealed for illegally cross-financing to cover trading losses. FTX failed because of a liquidity crisis, which unearthed a misappropriation of funds. The new FTX CEO said it best to the US House Committee: “It was old-fashioned embezzlement.” For FTX, the cherry on top was when a hacker stole $477 million of cryptocurrency from the exchange. FTX ultimately failed because of a lack of traditional banking operational oversight but had to experience a massive digital threat on the way down.

Balancing opportunities and challenges in digital transformation for banking

The financial services industry faces a confluence of seemingly incompatible wants and needs. Does it “go fast” and adapt to the evolving world? Or does it “go slow” and thoroughly calculate all risks before changing?

The “go fast” argument postulates that the industry is primed to transform and needs to meet more demanding customer expectations. Customers have high expectations in the digital era and will quickly adapt to new technologies and trends; therefore, companies must do the same to survive. The “go slow” side counters that it is already challenging to mitigate the risks from lack of observability and governance. Introducing new business models and technologies will only exacerbate an already complicated task.

With great power comes great responsibility, and regulatory agencies recognize the importance of harnessing the potential of cutting-edge technologies while mitigating the associated risks. The modern landscape demands a balance between quickly adapting and thoughtfully regulating. Widespread adoption of new technologies, like artificial intelligence (AI) and machine learning (ML), is inevitable, and regulators must stay on their toes to continue upholding privacy, fairness, and civil rights, especially in unexplored territories.

Governments and regulators are addressing the velocity and pervasiveness of AI and ML by working on new legislation. The Monetary Authority of Singapore published its “Fairness, Ethics, Accountability, and Transparency” principles; the European Union prepared pre-legislation consultation for the imminent “AI Act;” and, most recently, President Joe Biden signed an AI executive order establishing new standards for AI safety and security. The AI executive order will have widespread implications for the banking industry’s use of AI and ML. Though the US is in the early stages of mandating AI, the legislative impact of the EU’s directives foreshadows how the executive order will soon alter the fintech business model.

Technological innovation and openness are key to discovering and monetizing new channels and markets. Speed to market and consumer experience is vital to staying ahead of the pack. As the world changes and develops, these channels and markets will continue to change, but traditional governance and risk mitigation will continue to remain paramount. Banks and fintech companies that marry these seemingly contrasting ambitions in their digital transformation strategy will be ahead of the curve. Creating flexible compliance frameworks to cope with changing best practices, yet specific enough to provide meaningful measures of risk, is the key to navigating the ever-changing landscape and embracing digital transformation.