There is another critical link in the supply chain: regulators. It is easy to overlook since it isn’t a primary component of the typical customer relationship where money is exchanged for a good or service. Without the charter or license, however, a company can’t access many of the payment systems or deliver services to customers that are essential to creating most financial products.
Regulators limit the supply of charters and licenses. They do this to ensure a high bar that protects customers as well as the safety and soundness of the overall system. There is another reason they limit the number of charters. Granting the license to operate is only the first part of the process; they also need to provide oversight to ensure the objective of protecting customers is being met.
They do this by auditing compliance with the regulations, laws, guidance, and often precedence. Testing compliance with all of these things is laborious and time-consuming. Ensuring the objectives are being met is even harder. As a result, regulators tend to issue few charters and to limit activities to things that they have systems for monitoring, and the impact is well characterized. With no alternatives, regulators have a tremendous amount of bargaining power. It may literally require the rewriting of laws and then even longer to propagate those changes.
This constraint on regulatory supply had a tremendous impact on the other forces. First, it lowered the threat of new entrants. Any company that wanted to compete with a bank would first need to receive a charter. That process takes time and money. Companies that are approved for a charter tend to fit into the box of what the regulators already have experience with and know how to regulate. The process of getting a charter makes the applicant look and operate like banks that are already approved.
This leads to the second effect: regulation lowers the threat of substitutes. Even the waves of well-funded fintech startups with digitally native tools and interfaces haven’t disrupted traditional bank accounts because, for the most part, the improvements are cosmetic. Regulation-tempered innovation inhibits fundamental changes to most banking products. With high switching costs, the bargaining power of customers is reduced. We see high open rates for alternatives, but relatively few, if any, are winning the full customer relationship.
Sum up the reduced threat of new entrants or substitute products while maintaining low bargaining power of customers and the rivalry amongst existing competitors is low. All this because of relative monopoly from the critical supplier (regulators) that is primarily interested in maintaining a known system rather than promoting innovation which may break the system or the regulator.
Two things are changing the dampening effect of the near-monopolistic bargaining power of the regulatory supplier:
In 2008, despite being in the worst financial crisis we’d seen since the Great Depression, a few things began to change. Regulators in the US allowed banks to increase partnerships where the partner leveraged the bank’s charter and regulatory relationship to launch new products. The banks were, in effect, acting as a proxy for regulators since they would be held accountable for the activities of the partner using their charter. Early entrants like Perkstreet, Simple and Moven are all gone, but the model has given rise to new entrants. Some new entrants are startups like Chime or Greenlight on the banking side. Others are existing companies moving into the space like the Apple Card produced in partnership with Goldman Sachs. Substitutes are also on the rise. Consumers are using Amazon Pay to purchase on other sites and small businesses are borrowing from their payment processor Square.
The “new” suppliers with “new” products are changing the competitive dynamics, creating new products, and allowing new entrants.
More Production Capacity
The changing dynamics of their customers are driving change with the regulatory suppliers. Technological advances are addressing two regulatory challenges. Advanced analytics, both machine learning and the sexier artificial intelligence, allow regulators to model the potential impact of new products and services with greater accuracy. The same analytics can monitor the impact and update the model. Increasing the cycle time of doing new things without significantly increasing risk is a dramatic improvement from the current system of testing policies and procedures designed to protect against something that happened in the past.
Feeding the analytical engines are increased digitization and automation generated by RegTech. RegTech (short for regulation technology) is the close cousin of fintech, and both feed off of each other. RegTech reduces manual steps and allows more inputs resulting in a richer view of the situation with less effort. Replacing humans with software allows greater consistency and agility. Changing a few lines of code or variables can be done rapidly and propagated versus retraining and rolling out a human-based system.
The promise of RegTech is to solve the tension between the new/unknown and the potential for harm/risk — and to loosen the chokehold the bargaining power of the regulatory supplier has on the remaining forces. With a greater capacity for security, innovation, and perhaps sweeping changes to how banking products fundamentally operate, RegTech may usher in a new era of competition around more customer-centric (rather than regulatory-centric) financial products and services.