5 Major Ways Banks Are Getting Disrupted

Have you ever used Venmo to split a dinner with your friend? Have you paid less than $9.99 in fees for a stock trade recently? That's disruption in action.

In this week's episode of Industry Focus: Financials, host Michael Douglass and Motley Fool contributor Matt Frankel talk about five major ways that technology is disrupting big banks -- peer-to-peer lending, peer-to-peer payments, payment processing, free and reduced stock trades, and robo advisors -- and how the financial industry is changing as a result of them. Find out which companies are shaking things up the most, how big banks are trying to keep up, what the not-too-distant future of finance could look like if these trends continue, and more.

A full transcript follows the video.

This video was recorded on April 2, 2018. 

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, April 2nd, and we're talking financial disruptors. I'm your host, Michael Douglass, and I'm joined by Matt Frankel. 

Now, if you've been listening to Industry Focus: Financials for a while, you've heard our three episodes breaking down the big American banks. And you know, at least at a high level, how they make money. Commercial, or to put it differently, more traditional banks like Wells Fargo and U.S. Bank, make their money primarily by taking in deposits and lending those deposits back out as higher interest loans, pocketing the spread between the two. Investment banks like Goldman and Morgan Stanley make their money in part by advising on mergers and acquisitions and in part on wealth management fees. Universal banks do a little bit of both. Several of these banks also operate brokerages, where they make money every time you make a stock trade or by arbitraging the bid-ask spread, which is the difference between what you're willing to pay for a stock and what someone else is asking for for it. Most also operate credit cards, with payment processors like Visa and MasterCard. And of course, they make money on credit card fees, those from you and from the merchant. 

And now, each of the major ways banks seek to make money is being disrupted. And they are, of course, seeking to figure out how best to respond. So, we decided to dedicate today's episode to talking through five different major areas of disruption in financials, and helping you understand what that all means as investors and as we're thinking about the sector as a whole.

So, with that, I'm going to get off my soapbox and let Matt start talking a little bit. Let's start with lending, specifically peer to peer lending.

Matt Frankel: Sure. The peer to peer lending term is kind of a loose term nowadays. Like Michael said, a lot of the bigger banks have started to copy this business model, so it's not exactly peers loaning to peers anymore. But, at its heart, Prosper was actually the first mover on this. A lot of people think it was Lending Club but Prosper actually got there a little bit earlier. But, Lending Club was definitely the big one that got the banking industry on its toes in terms of peer to peer lending. 

Basically, how it works is, investors like you and I would fund the loans of other people and profit from the interest. Instead of a bank making interest money, you make the interest. Returns were attractive, so a lot of investors jumped on board. Within their first seven or eight years, by 2015, Lending Club had already broken the $10 billion mark in originated loans, which is a lot, especially since at first, the banks thought they weren't going to have to worry about this. 

Since then, a lot of other companies have similar business models. Marcus by Goldman Sachs is one of the newest ones. Goldman is getting into consumer banking a little bit. On the business side, you have companies like Funding Circle, which is a really interesting concept, because business lending is a big pain in the neck, especially in certain industries. For example, long before I was in this line of work, when I was in college, I was in the restaurant business. If you own a restaurant, it's almost impossible to get a bank to lend you money to extend your business. So, peer-to-peer lending sites like Funding Circle had made that more streamlined. Square Capital is another example from Square (SQ 2.32%), where they loan based on how much credit card volume a business does, so they know they're going to get their money back. Just different, more streamlined ways of loaning money to individuals and businesses that make the bank's process a whole lot better and more efficient. And most banks, other than Goldman Sachs, have yet to really catch up to this idea.

Douglass: It's interesting, because you also see some of the smaller banks like Bank of the Internet -- BofI, rather. Most people still call it Bank of the Internet, but it's BofI Holding, technically. They're doing a fair amount of business lending these days, and that's one of the areas they're really trying to expand. But the fact of the matter is, the financial industry as a whole has been a little bit slow to cotton on it and is still very much in catch-up mode. 

And what's really interesting about this to me is, it's really taking an area that's been underserved by banks and is now serving it a lot better, and banks are beginning to recognize that there's a business model there. To some extent, that creates an opportunity for them, but they're also competing with really asset-lite internet start-ups, which frankly don't have nearly as much in terms of costs as they do. So, that's going to be a competitive issue for them long-term.

Frankel: Yeah, definitely. Going hand-in-hand with that is the concept of these peer to peer payments. Two big apps that people use -- I don't know if Michael uses either, but I've used Venmo a few times -- Venmo and Zelle are two big ones. And unlike peer-to-peer lending, banks have actually really started to embrace peer-to-peer payments. Zelle is actually integrated into most big banks. I was looking at their website before we recorded this at their partner list, and I couldn't think of a bank's name in my head that wasn't on their list. Names like Bank of America (BAC -0.21%), Capital One, Wells Fargo, Citi, Chase, all the big ones and most of the smaller mid-size banks are using Zelle. 

What this allows people could do is send money to whoever they want without going to the ATM, writing a check, pay wire transfer fees. Anyone who's done that knows they're not cheap. And this gets really useful for situations like if you want to split a check at dinner with somebody. I'm sure most listeners have already used one of these two and they know this. Not me so much. No one splits my check. I have a family, so I pay the entire bill now. But, I could see where I would have a very, very, big for an app like Venmo 10 years ago. But, this is an area where the banks have really embraced the disruption.

Douglass: Yeah, it's interesting. For the record, I use Venmo, and I've certainly seen, Bank of America, where I do some of my banking, has done a lot of promotion of their peer-to-peer transfers, which is, as you noted, powered by Zelle. It's kind of the banking industry's response to primarily Venmo's disruption. And it's interesting, because this is another area where fees are very much heading toward zero. And that's definitely going to be, long-term, an issue for banks. Because historically, as you noted, they made their money from wire transfer fees and all these different fees, check writing fees and check cashing fees and all this stuff. If peer to peer payments end up taking over and doing everything, that stream is going to dry up for them. 

And I'll just finish with a personal anecdote. When my wife and I were heading to closing on our house, I really did not want to carry a cashier's check for our down payment, so I did a wire transfer. And my bank was like, "It's $27." Of course, you're spending a lot of money on a house, so $27 doesn't matter, but I was like, "Come on, really?" I was so annoyed about that. [laughs] 

Frankel: Not only that, wire transfers are often not instantaneous.

Douglass: Oh, yeah. I think they promised it within two business days, so I had planned ahead, but I was still checking my email constantly making sure, has it gone through, has it gone through, am I going to be able to close? Anyone who's bought a house knows there's a lot of stress, particularly in that last day, particularly if you're carrying the check, I think, but also if you're doing a wire transfer. And yeah, that's a pretty major area where a lot of banks make a lot of money that long-term looks like it's going to dry up.

Frankel: Yeah, that makes perfect sense.

Douglass: Let's also continue talking about payments, but a different part of payments -- payment processing. This has been an area where historically, your bank partnered with a Visa or MasterCard and you are making money every time somebody uses a credit card from the merchant, and, of course, theoretically, also if they don't pay off the credit card bill from the consumer. But, on the merchant side, this payment processing, this is an area that's really not just changing, but in a lot of ways democratizing. PayPal and Square have really made this a lot easier, particularly for small businesses, in ways that the big banks and credit card companies hadn't really until they really stepped on the stage.

Frankel: Yeah. The prohibitive factor in the past has not necessarily been the processing fees, the 2-3% that goes to Visa and MasterCard and AmEx, but the hardware costs. Somebody who, say, has a small booth at a craft market, isn't going to buy a credit card payment system that costs $3,000. What Square has done is give you a little tiny reader that goes into your phone that costs next to nothing, relatively, that allows anybody to accept credit cards. My wife and I go to a big farmers market/ craft market downtown once a week, and I can't remember the last time I bought something there where the vendor did not accept cards through Square's platform. And up until a couple of years ago, you had to make a separate trip to stop by an ATM on the way to a market like that. Now that's becoming a thing of the past. It's becoming much rarer that even the smallest business doesn't accept credit cards.

Douglass: Yes. And long-term, what that means is more competition among payment processing means that businesses will have increased choices among how they accept credit cards, and that's going to mean that these payment processors, to some extent, there will be competition. And I think as a result of that, that will be a good thing for consumers. Prices will come down. But it does mean that another area of income will, long-term, probably dry up, at least to some extent. 

Now, you could argue that they'll make it back on volume, and to some extent they probably will. You see a lot of really tiny businesses -- craft markets, farmers markets, even small churches sometimes use Square -- are able to do things, therefore the credit card companies are able to pocket a little bit from the transaction fees as a result. But, increased competition is also going to mean that per transaction costs and, as you noted, those hardware costs, are going to continue going down.

Let's also turn to one of the other big areas that banks have made a lot of money historically, and that is things regarding investments and wealth. There's really two areas here, but we'll start with the first one, which is stock trades. This one's very visible, I think, to probably most people listening to this. If you're an investor, you have dealt with paying for a stock trade, whether it's $9.99 or $7.99 or $4.95, most of us has paid some fees. And what you've seen is, because of all of the competition among the online brokers, those fees have continued to come down. You also have folks stepping in and offering free stock trades, Robinhood being a great example.

Frankel: Yeah, definitely. It's interesting to note, the $9.99 online brokers were themselves a disruptor not too long ago.

Douglass: Right, a big one.

Frankel: Yeah, up until about 20 years ago, people would have to physically call a broker, pay a commission of about 1% of the sales price. If you're buying $100,000 worth of stock, that's a big commission. So, these were themselves disruptors not long ago. But yet, now you have companies like Robinhood who are doing it for free. The drawback is, they don't have quite as many features as the ones that charge. 

But, what they've done is, like you said, they put a downward pressure on prices. I used TD Ameritrade personally, and they were one of the last holdouts of the $9.99 price point, and they just went down to $6.99. You also have, overstock.com is another one that's about to offer $2.99 stock trades and $1.99 if you're a member of their loyalty club, and with some actual brokerage features, like research reports and investing tools. So, this is a big disruption, and it could force companies like TD Ameritrade and E*Trade to lower their prices even more over the years. And like you said, eventually gravitating toward virtually free stock trades, where you're just going to be paying a small premium for the other features of the platform.

Douglass: And the other piece that I'll throw out there as well is, you're seeing a lot of use of free stock trades to try to get people to join your platform. I've seen plenty of platforms offer, you get 60 days of free trading, or, you get 60 free stock trades in your first year, things like that. I personally use Merrill Edge, which is owned by Bank of America, and because I have a certain amount of assets with Bank of America and things like that, I'm able to get some free trades. 

So, all of that combined is a sign, again, that the very traditional side of the industry, the big banks, and the less traditional but at this point incumbent part of industry, which are the online brokerages that are divorced from the big banks, are all finding ways to respond, and try to retain that market share in the face of what is, frankly, a really compelling value proposition. It's hard to beat free. You can, and of course, what you need and what makes the most sense for you is going to depend based on what your research needs are and how you invest and a lot of other things. But the fact of the matter is, this is going to continue that downward pressure. 

Speaking of downward pressure, let's talk about wealth management. Again, as we highlighted earlier, this is something you see from the investment banks and also the universals. And of course, the commercial banks, in some cases, do some of this, too. But, it's more on the investment bank side. And that's wealth management fees. Wealth management fees have been in a downward trend for a long time, and a lot of that is because of the advent of robo advisors. We've done an episode on robo advisors. That was our November 12th, 2017 Industry Focus. Give it a listen if you want to learn more about them, but we'll give a quick overview here.

Frankel: Robo advisor pretty much puts the investment process on autopilot. It makes decisions with your portfolio, how to allocate assets, how much risk to take on, things like that. But it pretty much does it automatically, so you're not paying a person to do it for you. The industry standard for a wealth manager is still about 1% of assets. It's gotten a little bit lower over the years, it used to be closer to the 2% range. But, 1% of assets. For comparison, Wealthfront and Betterment are two of the big robo advisory firms, and they each charge 0.25% of assets on an ongoing basis. And some of the bigger names, TD Ameritrade, for example, my broker, they just rolled out what's called their Essential Portfolios that charges 0.3% of assets and offer some very low-cost mutual funds to invest in. Schwab has a robo advisory service that's been very successful so far. 

These are particularly resonating among the Millennials that are very anti-fee. Fees weren't very transparent until not that long ago, and Millennials, more than anybody else, they're getting very aware of the fees they pay, and are trying to avoid them, realizing that someone's making a ton of money from their investments, whereas there's a better option where they could be making all that money. And over time, that little difference in fees can really add up. I did an article not too long ago about the difference between even a 0.5% and 1% fee in an IRA long-term, it can add up to about $10,000 of difference in gains. So, this is a big deal for value-conscious investors.

Douglass: Absolutely. Fees are one of the great killers of investment returns, along with, of course, poor investments being the other part of that. But, yeah, when you think about all five of these major trends -- that's peer to peer lending, peer to peer payments, payment processing, free and reduced-price stock trades, and robo advisors -- I think there are some really key takeaways for all of us to consider as we're thinking about how to invest in these trends or how to invest in response to these trends. 

The first is that some of these folks are going to make money. Many, I think like Venmo, for example, will really struggle to, because in most cases, these are all heading toward a cost of zero. You'll make up some of it on volume, for sure. I think particularly for the payment processing, there's a good argument to make on volume there, particularly if you can get your underlying hardware costs down and free it up and create a step-change there of additional demand. But in a lot of cases, this is going to make costs go down. Great for consumers, but on the flip side, that can make it a little bit more difficult for the investing side.

The other thing I'll point out, and this is particularly on the lending side. Watch out, watch very carefully, for anyone who claims to have cracked credit, to really understand, to have a new algorithm to really understand who is a good credit risk and who is a risky credit risk. If that company wasn't around in the financial crisis and does not have a record that you can look at when the credit cycle turns against people, I would be very skeptical of that, because frankly, it's very easy to look over your shoulder and say, "This is how we would have done things." Nobody really predicts these things well beforehand, so it's very important to see how any business does in both a good credit cycle and a bad one, when the economy's doing well and we're in a recession. And I personally have a lot of trouble investing in companies that haven't operated in both areas, although I still do sometimes, and I think that's a good conversation about risk we can have, but it's probably a long conversation.

The final point that I'll make is, banks have historically made their money because of market inefficiencies. So, as these inefficiencies disappear, as these markets become more competitive and more efficient, it'll be increasingly difficult for them to churn out a profit. And I think that's something that anyone investing in financials should be paying a lot of attention to.

Folks, that's it for this week's Financials show. Questions, comments, you can always reach us at [email protected]. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so, don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!