Your phone isn’t a bank, but it can sometimes feel like one. (Illustration: James Boast)

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What Will Replace Today’s Banks?

The financial world is opening up to the 2.5 billion unbanked people around the world.

Three years ago, the leaders of Janalakshmi Financial Services realized they had a problem. As one of India’s leading microfinance organizations, JFS was not a bank, but they thought that by serving the financial needs of the urban poor, they might eventually become one. They were successfully growing their customer base, but the work was inherently inefficient—their operating costs were eight to ten times higher than traditional banks.

Where many such banks simply decided that serving the “unbanked” poor was unprofitable, JFS instead turned to technology, in search of a new business model. It was looking for ways that “per account costs could be reduced,” says Gayathri Parthasarathy, who leads IBM’s financial services business in India and South Asia. And since partnering with IBM, JFS is on track to reducing its transaction costs by 75 percent.

That’s promising news, because it means that expanding the availability of financial services to the 2.5 billion people who don’t currently have them might actually be sustainable.

Governments and nonprofits have long seen financial inclusion as a tool to speed development and lift people out of poverty. But in the past, they’ve had to “encourage, cajole, and force the banks to embark on [an] inclusion agenda,” says Likhit Wagle, who heads IBM’s banking and financial consulting globally, because it was always a money-losing effort.

“We’ve got to go beyond that,” says Anthony J. Lipp, IBM’s global business strategy leader, “ because someone has to pay for it eventually.”

The keys to making financial inclusion financially sustainable is to first determine what financial tools and services customers actually need, and then to find new, more efficient ways to deliver them, beyond legacy banking systems and business models. For many of these new customers, lack of bank access has already forced them “to develop innovative or nontraditional approaches to financial services, to transfer value, and to access credit, like creating informal lending groups,” says Lipp. So when looking for innovative new business models, it makes sense to start with looking at the organic solutions created by people who are “day by day finding a way to survive, creating alternatives to traditional financial services,” he says.

These alternative models include prepaid cards, non-bank lending, and leveraging existing networks like mobile telephony to transfer value. The ubiquity of smartphones and digital transactions has widened and broadened the competitive playing field of companies that are capable of providing financial services.

The services provided by the newcomers—mobile operators, startups, microlenders like JFS, and even retailers like Walmart—are increasingly popular, even in developed countries. According to the FDIC, more than 50 million American adults who have bank accounts still pay to use financial services from other providers instead. In fact, people who use fewer banking services—including both low income households and millennials—are actually more likely than the general population to both own smartphones, and to use them for financial services like checking account balances. In many cases, people choose these alternatives, like prepaid debit cards, because they’re more convenient than what their own banks offer.

The trend should be worrying for banks, says Jennifer Tescher, president and CEO of the Center for Financial Services Innovation, because it demonstrates that they are not really meeting their customers’ needs. While the banks may be losing some potential revenue right now, the perception that they’re not providing valuable services is much worse in the long run. If customers ditch banks for simple financial services, they won’t have any loyalty when it comes to more complicated—and lucrative—services later.

The good news is that the same technologies that have disrupted banking are also the key to developing new business models. For example, rather than relying on a network of bank branches and ATMs, JFS instead uses a large field staff of employees armed with connected handheld devices who travel to their customers. Instead of providing traditional checking accounts and debit cards, JFS uses prepaid cards that can be loaded with a balance and refilled. That saves money because transactions with prepaid cards don’t have to take an expensive round trip through a traditional core banking system.

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Impact Quotes:
from the IBM Financial Inclusion Team

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In addition, big data is changing the way customers and financial providers think about trust and risk. You can see how this is playing out in the way credit scores are calculated. A decade ago, startups began to see if they could leverage nontraditional data to fill in the gaps for the 64 million Americans who don’t have enough credit history to be given an automatic credit score, according to the credit bureau Experian. At the time, alternative underwriting scoring companies found it to be a tough sell, because banks weren’t really interested in alternatives to FICO scores. But in the wake of the mortgage meltdown, FICO scores no longer seemed sufficient, let alone unassailable. Alternative financial data has now become mainstream, says Tescher.

One example is Experian’s acquisition of RentBureau, a company that analyzed rental payment history as an indicator of credit risk. When Experian merged the RentBureau data into its scoring system, it was able to assign credit scores to 10 million consumers who would have previously been unscorable. With better data, banks can more safely acquire customers. Tescher notes that credit scores are about more than loans; they also function “as a passport to entry” for jobs, rental agreements, and more.

Internationally, the situation is a bit different. Many new banking customers have hardly any paper trail at all, so banks face the more basic challenge of simply verifying that people are who they say they are. India’s Universal Identification project aims to solve the identity problem by collecting biometric information (fingerprints, iris scans, and facial photos) of all 1.4 billion residents. But social networks also provide another way to establish identity—it’s much harder to fake an entire interlinking network of people than a single identity.

Ultimately, however, banks should strive to provide more than just basic lending and transactions to the masses, says Shakti Saran, an associate director of banking and financial services at IBM—other services like micro insurance and micro investment could produce more benefits for customers and more profits for banks. As a way of supporting companies who are looking to offer these new types of service along with their existing services, IBM cloud solutions provides them with underlying infrastructures that support multiple deployment options, including smartphones and digital transactions.

But delivering those products will also require banks to invest in the financial literacy of their customers. “This can be enabled by technology,” says Saran, “but technology is not going to be the sole reason for the success of financial inclusion.”