Nonbanks have eaten into traditional banks’ marketplace. Can the older banks retake lost ground by simply becoming more agile?

Once upon a time, banking was simple: Take deposits, use depositors’ money to make loans, and transfer payments between clients and earn a commission.

All three pillars are now under assault.

Longer-term savings have migrated to wealth managers who promise much better returns over time. An array of innovative fintechs offer alternatives for payments. Home or car buyers are ever more likely to borrow from nonbank originators. Some 70% of residential mortgages in the US, the world’s largest banking market, are processed by nonbanks, according to Brian Graham, partner at the Klaros Group, which advises and invests in financial firms.

Corporate borrowers have been shifting to nonbank lending since the 2008 global financial crisis, the latest hot alternatives being collateralized loan obligations and private credit. The latter has mushroomed to $2.1 trillion globally and is still growing fast. Nonbank financial institutions, or NBFIs, hold two-thirds of financial assets in the most advanced economies, according to the Financial Stability Board (FSB).

In order for the banking sector to regain market share from nonbanks, banks will need to change how they compete for customers. Long-established banks will need to become less cautious and more agile in navigating regulations. One avenue for the banking sector is to start from scratch, as KakaoBank did in South Korea and Nubank in Brazil.

Higher interest rates have given banks some relief over the past few years, increasing their net interest income while hampering competitors—particularly fintech startups dependent on equity financing. The FSB reported that global NBFI assets shrank 5.5% in 2022, the first notable decrease since 2009, while banks’ balance sheets grew by 6.9%.

Long-term trends remain adverse, though. “Banks are losing market share to nonbanks, and the situation is much worse than what the statistics show,” says Miklós Gábor Dietz, lead of McKinsey’s Global Banking Strategy and Innovation team, the global Ecosystems Hub and is the managing partner of Vancouver Office.

Pros and Cons of Government Oversight

Banks are competing with the equivalent of weights tied to their ankles. These, of course, are the extra regulations and capital requirements most countries have piled on since the 2008 crisis. Any new loan needs to be risk-weighted and have capital set aside to offset it, restraints that nonbank lenders can often ignore.

Even as earnings seem to be healthy, banks struggle to earn a return on all that capital, Dietz points out—particularly on corporate lending. “On paper, this is the most profitable business in the world,” he says. “But on average globally, corporate banking is adding no value.”

Banks’ long histories and diverse business lines leave them lagging behind newer, more-focused rivals, as competition increasingly revolves around technology, adds Steven Breeden, American financial services technology lead at Bain & Company. “Banks are struggling with historical complexity traps and breaking through silos,” he says. “There’s a cohort of 10 or so banks globally that really get it on tech transformation.”

Yet banks get one large advantage in exchange for the regulators’ heavy hand: state-guaranteed deposits, a cheaper and (usually) more stable source of funding than nonbank rivals can tap.

History and the capacity for a wide range of transactions also have their pluses. “Banks inject trust into the financial system,” says Sandeep Vishnu, a partner at industry consultant Capco. “They are continuing to lose market share, but any complex transaction requires banks to play a role.”

Increasingly, that role is to “run in the background,” and have deep pockets on call, while more-dynamic actors close the deal directly with borrowers or merchants. Rocket Mortgage or another US originator may find the home-buying customer; the loan will likely be packaged into a mortgage-backed security and bought by a bank. At the corporate level, a private credit or leveraged-loan syndicate will likely secure bank credit lines as an anchor.

That’s risky for the financial system, says Viral Acharya, a professor at New York University’s Stern School of Business who specializes in financial regulation. “The growth of nonbanks is really coming on the back of liquidity from the largest banks,” he explains. “The cynical view is that everyone wants to have a put from the banking system in an emergency.”

Running in the background is not a great strategic position for banks either, McKinsey’s Dietz adds. The customer-facing entity gets a free ride, so to speak, on the bank’s capital base, and reaps consumer data that may be more valuable than the transaction itself.

The classic example in developed markets is the relationship between credit card provider Visa and the numerous banks that underwrite its plastic. Equity investors value Visa at 29 times earnings and 13 times book value, according to Bloomberg. The equivalent numbers for JPMorgan Chase, the world’s most profitable bank, are 12 and 2.3. “Banks haven’t solved their fundamental problem, which is losing customer ownership,” Dietz concludes.

Emerging Markets As An Example

The outlook for traditional banks is not all so bleak, particularly in emerging markets. Nonbank competitors are less developed there, leaving banks in control of 57.9% of financial assets, the FSB reports.

The megatrend of unbanked populations joining the financial system via cellular connection may enhance, not threaten, banks’ dominance. India is the prime example. Narendra Modi’s government requires the mobile payments systems that have mushroomed over the past decade are overwhelmingly linked to banks, Vishnu says. The result: 400 million new bank accounts.

Banking systems in middle-income emerging markets tend to be younger, with less “sticky” customer loyalty than in North America or Western Europe, leading to hotter competition and more innovation that crowds out nonbank startups. “The most innovative banks in the world, aside from India, are in Turkey or Poland,” Dietz asserts. “They are leapfrogging with more digital, more automated services.”

Elsewhere, online-only “digital-attacker banks” are shaking up the landscape, Bain’s Breeden says. The biggest player in this category is probably Nubank, based in Brazil and expanding aggressively into Mexico and Colombia. Founded in 2013, it exploded from 25 million customers in 2020 to more than 100 million earlier this year, focusing on credit cards and personal loans for retail customers.

In South Korea, online-only KakaoBank has grown from a standing start in 2016 to more than 23 million customers in a nation of just under 52 million. Attacking a highly mature banking market, the bank found a niche as the go-to institution for refinancing mortgages. It’s now eyeing expansion into Thailand in partnership with brick-and-mortar incumbent Siam Commercial Bank.

Unlike many fintechs around the world, Nubank and KakaoBank are also making money. Nubank’s net profit hit $1 billion for 2023, and KakaoBank earned about $267 million.

One more innovative champion hails from the unlikely location of Kazakhstan. Kaspi, one of the biggest e-commerce platforms in the oil-rich ex-Soviet nation of nearly 20 million, used its customer reach to start Kaspi Bank, with dramatic results. “Their return on equity is 90% instead of the 10% that’s standard,” Dietz notes.

Regulation has stymied similar vertical integration in bigger markets. Chinese authorities famously curtailed Ant Financial, sister organization to e-commerce power Alibaba, a few years ago. That has left most lending in the world’s No. 2 economy to very traditional state-owned banks.

Globally, much-anticipated financial services competition from online giants like Amazon, Meta, and Google has largely failed to materialize—largely because they would have to obtain banking licenses in the process. “Big tech has been making some surgical moves, mostly in the realm of payments and digital wallets,” Breeden says. “They are reluctant to set up fully fledged banks from a risk-compliance perspective.”

In the developed world, the banking establishment also has tools to fight back against nonbank competitors, if it can shake off some rust and unleash those tools. The spread of digital payments systems actually represents an opportunity for banks, Capco’s Vishnu says. They can negotiate better fee splits with these new entrants than with incumbent credit card providers like Visa. This would bolster a key income source for banks in the US and Western Europe. “Digital is now disintermediating the credit cards,” he notes.

Setting Up A One-Stop Shop

Banks still retain considerable “customer ownership,” and of course trust, as the holders of deposit guarantees. The banks can possibly build on these factors to expand services instead of retreating.

One obvious area would be shifting more depositors into asset management, selling the convenience of keeping various forms of wealth under one roof. While larger banks are already doing this, they could do it more effectively. “Banks are seeing a lot of stress on net interest and fee income,” Vishnu says. “Capturing some of the wealth management that’s going outside banking could counteract that.”

Though banks in the US have access to the huge money pool, only two of the top-10 US asset managers are banks: JPMorgan Chase and BNY. And they are dwarfed by nonbank giants like BlackRock, Vanguard Group, and Fidelity Investments. European banks are more competitive in this area, accounting for three of the top-five asset managers on the Continent: Credit Agricole, UBS Group, and Deutsche Bank.

Dietz, at McKinsey, sees much broader possibilities for banks that can “organize themselves around customer needs,” creating and dominating new financial services verticals. For instance, one-stop shopping for home acquisition and ownership: combining brokerage, mortgage, and insurance in a single app. Or offering, as financial services firms do, “an adviser who knows everything about you”: wealth management, estate planning, tax and legal services bound together—a service like a private bank for the nonrich.

Breaking out these core functions into separate units would also bring universal banks some of the focus and maneuverability of “pure play” disrupters, while maintaining the strength and breadth of a larger organization, suggests Dietz.

“Unbundling the business and expanding into some nonbank areas are the two things that banks can do to escape the value trap they are in,” he says. “If they do, the opportunity is tremendous.”

One big obstacle to this transformation is psychological. Since 2008, many developed-world banks have hunkered down in a defensive crouch, focused on building buffers to avoid the near-death experiences of that time and complying with the onslaught of new regulation. Going on the offensive into new business lines has seeped out of their DNA. “Banks need to start erring on the side of maximizing their reach [and] not worry so much about losses,” Capco’s Vishnu says.

Another hurdle is technological. To leap to the kind of one-stop shopping Dietz envisions, banks will need software that works as simply and intuitively as that of digital-native pioneers like Uber or Airbnb. “Banks need to step up their game on human-centered design,” says Bain’s Breeden.

Among banks in the developed world, big US institutions look the best prepared for ongoing shifts in the financial landscape. They are ahead of the pack technologically, Breeden observes. “A handful of banks in the US Tier 1 rise above all others in being tech forward,” he affirms.

The top US players can also take advantage of weakness further down in the country’s archipelago of over 4,500 licensed banks, Klaros’ Graham says. Washington regulators contained the fallout when three second-tier banks—Silicon Valley Bank, Signature Bank, and First Republic Bank—abruptly failed last year. But many others continue to struggle with their key weakness: unrecorded losses on bonds bought when interest rates were much lower. Mounting liabilities from commercial real estate loans are compounding the problem.

A large amount of the US banking system’s reserve capital is “impaired,” Graham states. The concealed weakness is not dire enough to trigger a 2008-style wave of insolvencies, adds Graham, but it is enough to spawn an army of “zombie banks” that have reined in lending to conserve capital. Either they will yield clients or they’ll have to be acquired by stronger rivals. “This is an incredibly target-rich environment for banks that can afford to play offense,” Graham says. “They can acquire teams or grow loans.”

Like death and taxes, highly regulated banks holding state-guaranteed deposits are embedded as a fact of life in complex economies. “There is no alternative to banking as an ecosystem,” says Vishnu.

Also, like death and taxes, potential clients and customers increasingly avoid banks to the extent they can. For banks, there is no time to lose in reversing that trend.