Innovation in Banking

Contents

List of Figures

List of Tables

List of Annexes

List of Abbreviations

1 Introduction
1.1 Abstract
1.2 Research Method and Questions
1.3 Boundary and Limitation of the Study

2 Banking
2.1 Definition of Banking
2.2 German Banking System
2.3 Effects of the Financial Crisis
2.4 Retail Banking in Germany
2.5 Challenges in the current Market Environment

3 Financial Technology
3.1 Impact of Digitisation
3.2 Definition of FinTech
3.3 Impact of FinTech
3.4 FinTech Market in Germany
3.5 FinTech Business Models
3.5.1 Digital Payment Business Model
3.5.2 Digital Investment and Savings Business Models
3.5.3 Digital Lending Business Models
3.6 FinTech Business Models versus Traditional Banking Business Models
3.7 Impact of Licenses and Regulation on FinTech Business Models

4 Research Study and Assessment
4.1 Research Study
4.1.1 Objectives
4.1.2 Participants
4.2 Assessment of the Study
4.2.1 FinTech
4.2.2 German Banking Industry
4.2.3 Strategic Alignment and Outlook
4.3 Strategic Options for the German Banking Industry

5 Conclusion
5.1 Summary of Results
5.2 Outlook and Future Research

Reference List

Annex

Imprint

List of Figures

Figure 1: Function of a financial intermediary

Figure 2: Market share of banks in Germany

Figure 3: German Banking Business Model

Figure 4: Income structure of banks

Figure 5: Cost-Income-Ratio (CIR) of German banks

Figure 6: Bank branches in Germany

Figure 7: Interest received and interest paid

Figure 8: VC Investments in FinTech companies

Figure 9: Market volume of FinTech lending services in Germany

Figure 10: Fact sheet: Gini pay

Figure 11: Fact sheet: SumUp

Figure 12: Fact sheet: Vaamo

Figure 13: Fact sheet: Fidor bank

Figure 14: Fact sheet: Lendico

Figure 15: Fact sheet: Kreditech

Figure 16: Business model Vaamo

Figure 17: Business model Lendico (contracted bank)

Figure 18: Business model Lendico (own license)

Figure 19: Business model Kreditech

Figure 20: Overview banking and e-money licenses

Figure 21: Management level of participants

Figure 22: Banking sector of participants

Figure 23: Generation of participants

Figure 24: Expected effects on customer interaction with Digital Natives

Figure 25: FinTech: assessment of understanding

Figure 26: Awareness of FinTech services

Figure 27: Expected impact of FinTech on the financial industry

Figure 28: Potential threat of FinTech services for banks

Figure 29: Other banking segments potentially affected by FinTech

Figure 30: Activities for innovation or investments

Figure 31: More focus on customer needs

Figure 32: Three most critical activities for banks

Figure 33: Effectiveness of cost cutting

List of Tables

Table 1: German retail lending market value

Table 2: German retail savings and investment market value

Table 3: German retail lending market value forecast

List of Annexes

Annex 1: The German Banking System

Annex 2: Top 20 German banks (according to balance sheet)

Annex 3: Largest banks in Europe 2013 (according to balance sheet)

Annex 4: ATMs in Germany (total numbers)

Annex 5: Market share in the retail lending business in Germany 2013

Annex 6: Market share in the savings segment in Germany 2013

Annex 7: Market share of banks in the United Kingdom (UK) in 2014

Annex 8: Worldwide sales in the music industry from 1997 to 2014

Annex 9: Online banking in Germany from 2004 to 2014

Annex 10: Revenues in retail banking in Germany

Annex 11: FinTech companies in Germany 2015

Annex 12: Smartphone and Dongle plug-in

Annex 19: Overview interviews and participants

Annex 20: Company affiliation of participants

Annex 21: Gender of participants

Annex 22: Customer confidence in banks with respect to financial investment

List of Abbreviations

illustration not visible in this excerpt

1 Introduction

1.1 Abstract

The impact of the financial crisis was a challenge for international and German banks and a test for the robustness of their business models. The consequences were stricter financial regulations introduced by Basel III and banks were forced to reduce proprietary trading and to refocus on traditional core banking business. Today supervisory authorities require sufficient and appropriate risk management systems to ensure financial stability and thus the internal operational complexity has increased and generates additional costs. In the aftermath of the financial crisis some banks are still struggling to regain competitiveness in combination with diminishing margins. In particular those banks are challenged with high dependency from interest income by deposit-financed retail banking business.

In recent years financial technology companies, commonly known as FinTech, gained more importance in the financial industry and challenge banks and established business models. Digitisation is advancing in all industries and the music and media industry has already experienced a painful transformation process and a similar development is expected as well for the financial industry. Depending on how revolutionary the technological innovation is the more intense will be the impact on business models and in consequence fast adaptability is essential. The level of activity within FinTech is enormous at the moment in Germany and over one hundred new companies were launched in 2014. As a consequence digital business models are analysed with respect to core competences and how FinTech generates benefits for customers by improving the value with innovative digital solutions.

Digitisation should not be seen as a threat, but more as a chance for banks for clearing out an ageing business model and to step up the evolutionary ladder and generate new core competences. The banking industry is in a transition phase and that requires new approaches for services and talents and therefore cooperations are a strategy to bring the hoodies to the bank. The concept of the digital bank can tackle many challenges that have been identified in the interviews, but banks should not reinvent the wheel and allocate resources on critical investments like core banking systems that meet the requirements of the twenty-first century. Value innovation is the key to generate new competences and concentrate on benefits for customers and FinTech. Banks have a central economic role and decades of experience, which is a competitive advantage especially with respect to financial regulation, but without adapting digitisation not the winning edge in the long run.

1.2 Research Method and Questions

The study starts with a literature review of the German banking system, its characteristics and difficulties due to the financial crisis plus the effects of the low interest rate environment on traditional banking business models. Insurance companies, investment and other financial service providers have not been considered in the analysis and are not part of the study. Subsequent to this a literature review of the FinTech industry and new digital business models is executed. FinTech is a young industry and thus substantial data is limited. Due to this lack of sufficient literature on FinTech a qualitative approach with semi-structured interviews has been carried out. Sources for literature are the Deutsche Bundesbank, journals and literature available via EBSCO and Statista.de for relevant data as well as publications by research units of banks or consulting firms are integrated to some extend as well.

Intention of the interviews was to validate findings of the literature research and to extend the assessment with insight in banks’ undertakings and strategies to face the approaching FinTech challenge. In question one the change in customer behaviour and how this might affect customer interaction is addressed as well as what is meant by the term FinTech to achieve a consistent definition. Question two deals with FinTech service offerings and the impact on the financial industry with a focus on retail banking. Questions three and four concentrate on banking and actions that are taken to address FinTech. Question five aims at the criticality of measures of banks that relate to FinTech and examines cost cutting as potential approach.

Twenty-three interviews were conducted in June and July 2015 to cover all business sectors of universal banks in Germany with a focus on retail banking and to achieve representative results by selecting a high level of seniority with respect to participants. The interviews were done if possible on site or by phone. The purpose of the research was explained in detail at the beginning of each interview and strict confidentiality regarding personal and company details was guaranteed. Semi-structured interviews allow improvising and give room to elaborate on additional information depending on the openness of interviewees. Some participants revealed personal opinions, concerns and reflected critically about developments in the financial industry. All interviews followed a protocol, were simultaneously noted and transcribed in a self-developed database the same day. The gathered data was rich in detail and additional information was clustered, evaluated separately and steadily validated throughout the study.

1.3 Boundary and Limitation of the Study

The study started with a literature review, but the FinTech sector is a relatively young industry and thus substantial and representative data and literature is limited. Main sources for literature are the mentioned sources in the previous chapter. Publications by research units of banks or consulting firms are used in parts as well, but considered to some extend biased. Some required data was not available, especially regarding digital business models or FinTech and in that case experience and approximate values had to be based on educated estimations and on the author’s long-term banking experience in Germany and the United Kingdom.

A qualitative approach with semi-structured interviews had been carried out to generate more data and information for the study. One of the main intentions was to achieve a sample that reflects the German banking industry with a focus on retail banking, but it was also critical to achieve a high level of seniority and experience to get a reliable assessment of the topic. Due to this conflict commercial banks are disproportionately represented compared due to savings unions or credit cooperations. Besides the proportion of participants of the Generation X is dominating with 57% in the study and this demographic imbalance could not be avoided, but is considered less critical. Distortions in the sample could not be avoided, but the deviation to the corresponding population should be insignificantly due to the high level of seniority and experience of participants.

There are a number of uncertain variables with respect to FinTech and the banking industry in Germany. Financial regulation and in specific the BaFin has not commented extensively how FinTech is perceived and thus regulatory implications remain vague. The research available and the interviews conducted allow the conclusion that BaFin has a more conservative attitude towards FinTech and digital business models. This assumption is based as well on meetings with FinTech founders and their experience with the BaFin in Germany. In comparison the Financial Conduct Authority (FCA) is more favourable and open towards FinTech as shown by the number of licensed FinTech companies and the significant higher business volume in the United Kingdom (UK). Data on the impact of FinTech on the German banking industry is rare and thus reference values or benchmarks from other countries had to be used. In consequence many assumptions are based on indications as concrete data or information was not accessible or available.

2 Banking

2.1 Definition of Banking

In general the areas of activity of banks can be classified in commercial banking and investment banking. In simplified terms commercial banks are financial intermediaries that hold deposits of their customers and conduct maturity and risk transformation to offer lending services and in result generate new business. The difference between the interest that is paid for deposits and charges for credits or loans, the interest margin or credit spread, is the earning for the bank and depends on the risk of the specific transaction and the customer rating (Hartmann-Wendels, Pfingsten, & Weber, 2007). Lending involves consumer and corporate credits, as well as real estate and project financing. Besides the traditional core deposit-financed lending business commercial banks offer a broader range of products and services like payment services, current account services or investment advice.

Investment banks act as financial intermediaries on the capital market and deliver services in securities or more general in financial instruments and engage in proprietary trading. Services related to financial instruments include the issuance of bonds, negotiable loan securities or other debt and equity issues (Tolkmitt, 2007). In simplified terms banks are defined as financial intermediaries and the below scheme shows the source and use of funds. This scheme will be used in the further assessments and to explain banking business models.

illustration not visible in this excerpt

Figure 1: Function of a financial intermediary

Source: Own illustration modified from Hartmann-Wendels et al. (2007, p. 12)

This study concentrates on retail banking services like payments, savings, current account management, investment (consultancy in investment products like stocks or ETFs), lending (consumer and small enterprises loans) and mortgage lending. Characterized by the broad range of services these banks are defined as universal banks and beside the before mentioned insurance or other advisory services are offered as well (Ostendorf, 2013), but these are not traditional banking services and will not be considered in the following. The advantages and disadvantages of a universal banking system versus a separate banking system have been discussed over decades (Benston, 1994) and discussions are more current than ever in the aftermath of the Financial Crisis in 2008 and 2009 (Ayadi, Arbak & de Groen, 2011).

2.2 German Banking System

The German system is a universal banking system and in principle banks are authorized to offer all banking, financial and payment services. For historical reasons some banks have been formed with limited areas of activity and therefore the banking system can be divided into universal banks and specialist banks. Universal banks conduct all banking operations, whereas specialist banks normally focus on individual segments (Hartmann-Wendels et al., 2007). The Single Supervisory Mechanism (SSM), the European Banking Authority (EBA) and the German Central Bank (BuBa) along with the Federal Financial Supervisory Authority (BaFin) build the institutional regulatory environment. The German Banking Act (Kreditwesengesetz -KWG) constitutes the legal basis for banking business and is supplemented by further regulations like the BaFin Circular 10/2012 (BA) Minimum Requirements for Risk Management (MaRisk). Universal banks are characterised by the fact that all services and operations described in Section 1 KWG are offered to and performed or offered for customers. Savings and lending business have a high significance reflecting the function of the financial intermediary (Tolkmitt, 2007). The notably higher volume of interest earning related businesses (figure 4: income structure of banks) in the profit and loss accounts compared to commission dependent financial investment services business is additional indicator for the importance of that business segment (annex 1: German Banking System).

Universal banks are differentiated between three categories, commercial banks, public sector banks (Landesbanken and savings banks) and credit cooperatives and their regional institutions (Genossenschaftsbanken). The BuBa includes big banks, regional banks, other credit banks and branches of foreign banks in the segment of commercial banks. Specialist banks are distinguished in six categories, mortgage banks (Realkreditinstitute), building associations (Bausparkassen), direct banks (Direktbanken), investment companies (Kapital-verwaltungsgesellschaften), securities depositories (Depotbanken) and banks with special assignments or projects (Deutsche Bundesbank, 2015). An overview of the largest 20 banks in Germany according to their balance sheet and a similar overview for Europe can be found in the annex (see: annex 2 and annex 3).

Big banks, regional banks, other credit banks and branches of foreign banks are defined as commercial banks. In Germany four institutions are referred to as big banks, the Deutsche Bank AG, Commerzbank AG, HypoVereinsbank AG and Postbank AG. Commercial banks are private sector institutions and operate mainly as public limited companies and the business activities are profit oriented (Deutsche Bundesbank, 2015). Commercial banks operate nationally and internationally and are active in the securities business and investment banking beside the traditional deposit-financed lending business. The branch network is concentrated on urban areas. Initially regional banks were defined as private sector institutions, but partially the business activities and volumes are similar to big banks. As an example HypoVereinsbank AG was originally assigned as a regional bank. Branches of foreign banks are also amenable to the KWG as according to Section 53 paragraph 1 KWG these are foreign institutions established in a country which is not a member of the European Union that offer banking and financial investment services in Germany (Hartmann-Wendels et al., 2007).

illustration not visible in this excerpt

Figure 2: Market share of banks in Germany

Source: Deutsche Bundesbank (2014a)

Savings banks and Landesbanken are public sector owned and were originally mandated to provide banking services for the population and local enterprises, but the business model of several Landesbanken has become more similar to that of big banks in the last decades. In general savings banks and credit cooperatives are regionally focussed and conduct retail banking. Their branch network is widespread across Germany and often savings banks or credit cooperatives are the only bank in rural areas (Deutsche Bundesbank, 2015; Tolkmitt, 2007). Banking business models can be categorised in three dimensions. One dimension is the earnings structure as business models can be distinguished in terms of their profitability and risk profile. Furthermore banks have different legal forms, which is the next dimension. In Germany banks can be private commercial institutions, public sector institutions and institutes in the cooperative sector. The third dimension is the asset and liability structure as this is directly linked with the business activities, furthermore the funding sources are also used to categorise that dimension (Ayadi & de Groen, 2014).

illustration not visible in this excerpt

Figure 3: German Banking Business Model^[1]

Source: Own illustration modified from Ayadi & de Groen (2014, p. 5)

2.3 Effects of the Financial Crisis

The financial crisis was a challenge for the robustness of banks business models. Banks with a business model focussed on deposit-financed lending have not been hit as hard as other banks that had expanded their business activities and focussed on investment banking activities. Due to this the majority of savings banks and credit cooperatives, as well as most regional focussed commercial banks, have overcome the financial crisis almost entirely unharmed. By contrast big banks and Landesbanken have been seriously affected by the financial crisis. One reason is that during the 1990s big banks and Landesbanken expanded their financial market exposures and interbank transactions significantly and increased also their investment banking activities. Earnings from trading and commission out of the investment business as well as profits from proprietary trading became considerably important, but resulted also in higher income volatility and higher risks (Deutsche Bundesbank, 2015; Rötheli 2010). Until the financial crisis, big banks had a much better profitability than most other banks in Germany, especially compared to Landesbanken. But, the expanded income structure went hand in hand with the earnings volatility in trading business, which resulted in an increased vulnerability to crises. Thus poor profitability was generally attributable to losses in trading throughout the financial crisis (Altunbas, Manganelli & Marques-Ibanez, 2011). In combination with shaking faith in banks assets due to the subprime collapse and accompanied by deteriorating credit ratings, the interbank market that is used to provide liquidity dried out and banks were not able to get the required funding (Crotty, 2009). Huge bank bailout packages were necessary to provide the crucial liquidity to stabilise the banking industry (Hüfner 2010).

illustration not visible in this excerpt

Figure 4: Income structure of banks^[2]

Source: Deutsche Bundesbank (2015, p. 56)

In result the transformation of business models, in particular those banks that used unsecured market based funding and expanded their investment banking activities ended abrupt with the financial crisis. The wave of financial market deregulation starting in 1994 turned into a series of regulatory initiatives to achieve a better financial stability and to secure that in the future banks would have the necessary capital strength to absorb losses in 2010 with the publication of Basel III. The recent reforms to banking regulation have forced banks to reduce proprietary trading and to refocus on traditional core business operations funded with deposits and even to be prepared for a going concern. Supervisory authorities and regulators concentrated also on internal control and risk management mechanisms, especially risk steering and assessment (Altunbas et al., 2011; Deutsche Bundesbank 2015). Without questioning the need of regulatory initiatives to enhance the risk management of banks, at the same time these measures increase the operational complexity due to new processes and organisational changes (Ayadi et al., 2011). The illustration below shows the increase of costs in relation to income, but the increase starting in 2010 cannot be exclusively attributed to the implementation of regulatory measures, as the current low interest rate environment reduces the income as well. However, it can be seen as an indicator^[3] and the peak in 2008 may be understood as increased costs due to depreciations as a direct effect of the financial crisis.

illustration not visible in this excerpt

Figure 5: Cost-Income-Ratio (CIR) of German banks

Source: Deutsche Bank Research (2014a)

2.4 Retail Banking in Germany

In the preceding chapters the definition of banking, the banking system in Germany including the diverse categories of banks and the impact of the financial crisis has been explained. Retail banking is characterised by banking and payment products and services of the daily life and in general business models show a higher degree of standardisation and less complexity than in corporate or investment banking (Ayadi & de Groen, 2014; Laven, 2014).

Standardisation is a result of to the technological evolution and the high costs of maintaining branch networks. Consequently several banks have shifted parts of their service offering to self-service devices or online banking units. Especially big banks have reduced their branch network significantly due to high fixed running costs. In 2003 banks had 49,711 branches in total and branches have been reduced to 38,255 within ten years, a decline of 23%. The basic idea was to downsize cost intensive services like cash withdrawals at bank counters (annex 4: ATMs in Germany) and by standardising such services to shift the service offering of branches to consultation-intensive services and products with a higher margin (Deutsche Bundesbank, 2013; Leist & Winter, 2002; Köhler & Lang, 2008).

illustration not visible in this excerpt

Figure 6: Bank branches in Germany

Source: Deutsche Bundesbank (2014b)

Parallel to this development direct banks expanded their service offerings, which ultimately resulted in better rates for the customers. The persistently low interest rates accompanied by increased price sensitivity and decreasing loyalty of customers has accelerated this development. Lower switching costs and also an improved market transparency through comparison sites have further increased those effects. As a consequence, the retail banking remains in a difficult situation due to a tougher competition, stricter market regulations and the need to find the balance between profitability and a sustainable business model (Deutsche Bundesbank, 2013; MarketLine 2015a). In the last years the retail banking lending market in Germany has grown slowly and this is likely to continue. In 2014 the lending market had an outstanding debts of 1,217.4bn EUR and in result a compound growth rate (CAGR) of 1.3% as measured by 2010. In the UK the retail lending market had a CAGR of 4.4% in the same period and a 23% higher market value. The German lending market is the second largest in Europe followed by France and the mortgage lending accounts with 85.7% as the largest segment (MarketLine, 2015a) (see: annex 5).

illustration not visible in this excerpt

Table 1: German retail lending market value

Source: Own illustration modified from MarketLine (2015a, p. 8)

The retail savings and investment market increased with a CAGR of 2.0% and had a market value of 2,813.6bn EUR in 2014. The German market is with a market share of 19.1% the largest in Europe followed by the UK. The savings segment leads with 67.0% of the market (MarketLine, 2015b) (see: annex 6).

illustration not visible in this excerpt

Table 2: German retail savings and investment market value

Source: Own illustration modified from MarketLine (2015b, p. 8)

2.5 Challenges in the current Market Environment

Especially big banks and Landesbanken were hit hard by the financial crisis and many of them re-adjusted their business model more towards traditional banking products and services. However some banks are still struggling to regain competitiveness, which is a serious issue as the capability to generate satisfactory income is key for a sustainable business model (Ayadi et al., 2011). The illustration below shows insistently, how the low interest rate environment has diminished the interest margin over the last years and has also reduced the profitability and in consequence fosters competition in the segment (Deutsche Bundesbank, 2013). Consequently especially banks that depend to a large extend from interest income by deposit-financed lending like savings banks and credit cooperatives are challenged. Big banks and Landesbanken in Germany are expanding their activities to the lending business as well and thus banks try to take countermeasures by increasing the lending volumes and maturity transformation (Deutsche Bundesbank, 2015).

illustration not visible in this excerpt

Figure 7: Interest received and interest paid^[4]

Source: Deutsche Bundesbank (2013, p. 16)

As shown in the previous chapter the retail banking lending market has been growing slowly in recent years and market growth is forecasted also moderately with an expected CAGR of 1.0% between 2014 and 2019, which will further intensify the competition in this segment (MarketLine, 2015a). In such a market environment organic growth can only be achieved by offering better rates than competitors, with negative effects on the profitability. Another option is to accept more risk in the portfolio of the bank, which is also difficult as the level of risk within the portfolio increases capital requirements. A better service offering than competitors would also be an option. But banks struggle to differentiate themselves as their recent activities are still more focussed internally on stabilising the organisation, ensuring a sufficient capitalisation and recover from the effects of the financial crisis (Hüfner, 2010). In Germany retail banking is a highly fragmented market (see: annex 5 and annex 6), compared to the UK where the four largest banks combine 75% of the market share (annex 7: Market share of banks in the UK in 2014).

illustration not visible in this excerpt

Table 3: German retail lending market value forecast

Source: Own illustration modified from Marketline (2015a, p. 11)

Thus retail banking in Germany is characterised by an intensive competition in combination with substantially increased market regulations and in result further pressure on margins. Kim and Mauborgne (2005) have defined such a market as a red ocean, as increasing the market share can only be achieved by fighting rivals and shrinking profits. In such an environment companies can only succeed by creating a value innovation as else it is unlikely to generate profitable growth in the future. The creation of such an unchallenged market space is also defined as blue ocean and this is contrary to Schumpeter’s theory of creative destruction by unseating incumbents fast and devastating. According to Schumpeter innovation happens endogenously by entrepreneurial creativity, but empirical studies have revealed that in established industries such change is very slow and a high degree of regulation encourages neither (Deakins & Freel, 2003; Grant, 2005). The question remains how to create such a blue ocean within the banking industry in Germany and if this is even possible.

3 Financial Technology

3.1 Impact of Digitisation

Digitisation is gaining ground and thus work as well as private space is getting more and more digitised, starting with smartphones and tablets to connected cars and other devices. But interconnection goes beyond technical dimensions, as it progressively transforms processes, industrial and commercial structures. Digitisation triggers structural and economic change driven by technology and offers business opportunities and benefits for customers, but challenges also traditional business models (Leist & Winter, 2002).

The Internet bundles vast quantities of data and information and makes it supported by data-driven technology in combination with virtual organisations permanently available and accessible to all business models along the value chain and each consumer around the globe. Over the last twenty years the impact of digitisation and in result structural change can be easily studied in the music industry, as traditional business models have been revolutionised (Walker, 2014). This revolution can be traced back to the invention of the mp3 standard in 1987, a technology to compress music into a digital format. However, the disruption of the music industry started with online peer-to-peer technologies like Napster. Napster enabled an online exchange of compressed music files in mp3 format without using physical storage mediums like Compact Discs (CD) and as well without a substantial worsening in quality. A sharp slump in traditional physical media sales due to this technological development challenged the music industry and in consequence the established business model had to be adjusted to limit these losses (Dewan & Ramaprasad, 2014). Furthermore new products and services were introduced and have generated new innovative business models. As an example Apple has been a manufacturer of computers focussing on integrated software solutions, but launched with iTunes a digital business model and adjusted its traditional business model to a platform that operates now in many segments (Osterwalder & Pigneur, 2010).

In recent years the decrease in physical music sales could be decelerated by digital music sales (annex 8: worldwide sales in the music industry), but new competitors like the music streaming service Spotify are ready to challenge digital sales by offering their service (Dewan & Ramaprasad, 2014; Leung, 2015). The whole system of music consumption, production and distribution has transformed radically and this process is definitely not finished yet. The music industry is one example, but in general there are numerous industries that may come under pressure due to digitisation. Media and publishing industry has experienced a painful transformation process as well due to the expansion of Internet technologies. Furthermore as explained before, digital structural change can be witnessed occurring even repeated within a sector and depending on how revolutionary the technological innovation and progress is the more intense will be the impact on the business model. Technological change is constantly accelerating as well as the adaption rate of innovations. Within nineteen years the personal computer could reach 50% ownership whereas mp3 players needed three years to achieve the equivalent diffusion rate. The Internet was the trigger that accelerated the rapidity of technological diffusion and social networking and media plus viral messaging intensify this further on. Therefore the Generation Y or Digital Natives will pose a challenge for many industries as they have been grown up with advanced and smart technologies and adopt new technologies easily, resulting in new consumer behaviours and demands (Rothaermerl, 2013).

Thus fast adaptability appears to be more and more important, when business models are challenged by technology-driven concepts. Digital structural change is a complex process and impacts established industries, structures and business models in its entirety (Teece, 2010). Necessary requirements for digital structural change are familiarity and availability of online services, broadband expansion, saturation of smart technology and devices, potential for technology-driven standardisation, changes in demand and consumption behaviour as well as the degree of market regulation (Deutsche Bank Research, 2014b). In the digitisation process a major effect can be attributed to modern analysis techniques, digital value creation procedures and in result digital products, services and increased user friendliness. In recent years technology-based firms are entering increasingly the financial industry and challenge banks and traditional business models. FinTech is advancing and acts as a catalyst to the digitisation. In general activities concentrate on a limited area, as this specialisation is a huge benefit to use resources efficiently in manageable structures (Deutsche Bank Research, 2015).

But as shown in previous chapters this cannot be solely addressed to FinTech companies as banks started originally to standardise cost intensive services like bank counters by shifting such services to telephone or online banking services (Deutsche Bank, 2013; Köhler & Lang, 2008). You might say that banks encouraged customers to use self-service services and were successful considering nearly tripling online users within 10 years. Online banking increased from 13mn user in 2004 to 37mn user in 2014 in Germany (annex 9: online banking user in Germany). In combination with technological demands and changed consumer expectations of the Generation Y or Digital Natives that are open for technological innovations banks will be challenged additionally and the competition further intensified.

3.2 Definition of FinTech

Before considering FinTech as new competitor, analysing the service offering and the potential impact on the banking industry, it is necessary to understand and define the term. In the literature and on relevant websites a colourful diversity of explanations and definitions can be found regarding FinTech. In the last years FinTech has also been used in connection with any technological innovation in the financial industry including Bitcoins^[5]. FinTech is frequently used to describe innovative business models (Paxmann & Roßbach, 2015) or the transformation from analogue to digital services in the financial industry (Laven, 2014). Very often a direct connection is seen between FinTech and start-ups in a continuous improving technological environment (Deutsche Bank Research, 2015; King, 2013), but Google or Apple offer also FinTech services and can hardly be characterised as start-ups. The question remains and thus considering a simplified approach, the term FinTech is a portmanteau of financial technology and in result characterises a procedure when technology is applied to digitise banking, payment or financial investment services, products or related processes.

In the meantime it is assumed that this definition should be sufficient, but it will be reviewed throughout the study to validate or adjust the definition if necessary.

3.3 Impact of FinTech

Assessing the impact of FinTech on retail banking and validating if the current attention is reasonable is the main purpose of this study. Considering high market valuations of technology firms that dominate financial markets these days and the criticism that these are irrational figures compared to the underlying value uncover another problem that traditional valuation models seem not to fit anymore. Especially new companies that use technology to deliver products or services that were once delivered in a more traditional way until the invention of the Internet technology are difficult to evaluate. Moreover many of these firms have low revenues compared to large operational costs when they come to market and report enormous losses in the start-up phase (Damodaran, 2001). Examples are Amazon, Facebook or more recent UBER and Airbnb. The San Francisco based company UBER closed another funding round over 1bn USD in June 2015 resulting in a valuation exceeding 50bn USD compared to a value of 17bn USD a year before. As a comparison, due to that funding round in combination with expectations that the company will extend its activities beyond the core transportation UBER outpaced FedEX, the logistic company was valued 48bn USD the same day (Financial Times, 2015). Those valuations of technology firms are justified as eligible with the outlook of excessive growth in the future, but if this can be realised needs to be verified over time.

Considering the definition comprised in the previous chapter FinTech companies fall into this category as they use technology to digitise financial services or products. In chapter 2.4 the German savings and investment market was valued with a market value of 2,813.6bn EUR in 2014 (MarketLine, 2015b) and the Boston Consulting Group forecasted for Germany total revenues of 68.3bn EUR in retail banking for 2015 (see: annex 10). But considering Damodaran (2001) the use of traditional valuation methods may be difficult due to negative cash flows in the start-up phase. A multiple analysis would be another possibility by selecting a metric like the EPS and multiply that with a market-determined multiple (Ehrhardt & Brigham, 2014). However this approach is inappropriate due to a very limited accessibility of data and further information.

Beside the market values and revenues for the retail banking in Germany it is meaningful to consider direct investments in FinTech companies by Venture Capital (VC) firms, as the current market share of FinTech is very small and thus negligible (Deutsche Bank Research, 2015; Paxmann & Roßbach, 2015). The figure below illustrates the worldwide increase of VC investments from 520mn USD in 2010 to 2.8bn USD in 2014. That is an increase of 438% within four years. In result there is a reasonable attention considering VC investments, but this has to be seen as an indication and does not reflect that FinTech companies will be successful by having a similar disruptive effect as technology firms in other industries.

illustration not visible in this excerpt

Figure 8: VC Investments in FinTech companies

Source: Creative Construction (2015)

3.4 FinTech Market in Germany

FinTech companies are advancing, but the current market share is still very small considering that around 86mn EUR were financed by FinTech lending services compared to 1,217.4bn EUR total market volume in 2014 (Cambridge Judge Business School, 2015; MarketLine, 2015a). According to Impulse (2015) there are currently 263 FinTech companies operating in Germany in all segments (see: annex 11). Based on thematic websites^[6] there were around 40 FinTech companies operative in 2013 and over 100 new firms were launched during 2014. The level of activity within the FinTech scenery is currently quite high and thus total numbers have little analytical value as the segmentation of the FinTech industry is not consistent and firms are repeatedly assigned to segments. Multiple assignments of companies into different segments make sense as banks operate as well in various sectors, but a precise differentiation is difficult considering the inconsistent classification and definition of FinTech. Due to this the market cannot be analysed in total, but will be described instead by using exemplary digital business models.

illustration not visible in this excerpt

Figure 9: Market volume of FinTech lending services in Germany

Source: Own illustration modified from Cambridge Judge Business School (2015)

3.5 FinTech Business Models

Lending, investment advice, savings and payment services appear to be the predominant digital business models (see: annex 11) and consequently the intention is to assess these in detail and to identify and highlight differences to traditional banking business models.

3.5.1 Digital Payment Business Model

Digital and technological innovations like Quick Response (QR), Dongle plug-ins or the Near Field Communication (NFC) technology opened the door for various new concepts in the payment segment. Especially NFC chips are used for e-money payment applications (app) like GoogleWallet as NFC technology enables wireless data transfers within short rage distance. Beside those other innovations were QR-codes to scan data with the phone or virtual currencies. Biometric procedures like the payment by using individual fingerprints have been introduced or can be combined with other methods to provide an even better level of security. Apple Pay combines NFC technology with biometric data starting with the iPhone 6 and users connect with an integrated NFC chip at the point of sale and accept the payment. Required payment information like credit card data is safely stored within the secure unit of the iPhone and the verification is finalised by a fingerprint scan (Deutsche Bank Research, 2014b).

Gini pay is an application that scans the payment data of an invoice and transfers it directly to the payment app and eliminates manual typing. Users of the app have to log on to their bank account with the app and can directly process the payment using an encrypted connection.

illustration not visible in this excerpt

Figure 10: Fact sheet: Gini pay

Source: Own illustration modified from Paxmann & Roßbach (2015, p. 31)

The Gini app scans and digitises the payment data and is a technical bridge to a bank for transferring payments, therefore no license is required but cooperations are crucial. However, it is a good example how the use of technology can ease a manual process for customers.

SumUp is targeting merchants or small businesses by offering an easy payment solution for their customers, the required Dongle plug-in and the app are free of charge (see: annex 12). Technically it is similar to a debit or credit card terminal that is used in stores, but this solution increases the mobility and makes it also attractive for example merchants on farmer markets. Merchants are charged for each transaction but benefit from the circumstance that their cash holdings can be reduced, as the money is directly transferred to the account.

illustration not visible in this excerpt

Figure 11: Fact sheet: SumUp

Source: Own illustration modified from Paxmann & Roßbach (2015, p. 77)

Gini and SumUp have both in common that payments can be processed easier and quicker by reducing manual processes with a connected system on a smartphone or tablet. Additionally less cash is required that reduces and accelerates accounting processes. In the end the payment process is mostly automatized and makes it easier and more convenient for the user.

[...]

---

^[1] Explanations to figure 3: Wholesale banking includes interbank and capital market business. Institutional deposits on a short-term basis are generally used for funding. Investment banking has a strong focus on trading oriented to international markets and the capital market.

^[2] Explanations to figure 4: 1 Net profit on financial operations only recorded since 1993; 2 Interest received includes interest income from deposit-financed lending business, interest income from money market transactions; 3 Pre-tax profit for the financial year; 4 Including funds for general banking risks

^[3] The direct effect of regulatory measures cannot be shown isolated as the exact data is not available and the sample is too broad. Additionally big banks depend stronger on market based funding and in result have to bear higher costs. Nonetheless savings banks and credit cooperatives benefit from deposit funding and due to this the funding effect can be ignored as the sample shows the CIR all German banks (figure 2: market share of banks).

^[4] Explanations to figure 7: 1 Until 98, as a percentage of the average business volume; 2 Yield on debt securities outstanding; 3 Until 98, three months funds money market rate

^[5] Bitcoin is a so-called crypto-currency, in other words a virtual monetary unit. This virtual currency can be exchanged decentralised by anyone globally (Skinner, 2014).

^[6] http://www.fuer-gruender.de/blog/2015/01/2014-fintech/