Financial Services can learn from unbundling strategies in aviation

01 September 2017

In order to fully understand the true implications and consequences of the Markets in Financial Instruments Directive (MiFID II), the financial services (FS) sector should look to other areas to learn how best to anticipate looming change and prepare in advance, writes Bryan Adare, Senior Consultant at Brickendon.

MiFID II is due to come into effect in 2018 and will likely have far-reaching and wide-ranging consequences throughout the financial world. Amid ongoing uncertainties and concerns around the true scale of the challenges posed by implementation and compliance, drawing parallels with other sectors and industries is a useful and instructive tool for gaining valuable insights ahead of the looming deadline.

With this in mind, at Brickendon Consulting we wanted to look towards less typical sources of inspiration for the FS sector as it prepares for yet another regulatory overhaul in the form of MiFID II.

Taking to the skies

Earlier this year, British Airways removed complimentary food and drinks from their short-haul European flights. A long-time coming as part of many changes to reduce costs, CEO Alex Cruz decided that removing the complementary service in an environment increasingly dominated by low-cost competitors was the best way to improve profitability and maintain price competitiveness.

The changes were not taken well by BA customers, with both leisure holidaymakers and corporate frequent-fliers up in arms about the loss of the previously complementary service. Airline passengers are however not the only ones subject to so-called unbundling. As part of the new MIFID II legislation, banks are on the verge of unbundling previously free research services.

Similar to BA, banks will soon unbundle previously ‘free’ services

Changes like this are part of a larger trend in the airline industry’s unbundling. Within the industry, it has been pioneered by the low-cost segment as a way to create the lowest ticket price for consumers who just want to get to their destination without any frills. Those who want additional services can pay for what they use. Reducing included services is one of the pillars of the low-cost model, and legacy carriers have been struggling to determine how to price competitively, yet continue to offer the level of service their customers expect. Initially it was led by the removal of simple items like checked-in baggage and exit-row seat selection, but has now evolved to cover almost any service traditionally included in the price of admission, from the on-board food and drink service and seat selection in any part of the cabin; to boarding order and number of carry-on bags. 

Naturally, the changes have had an impact on ticket pricing across the board, with legacy carriers reducing their core route prices year-over-year to compete in a market which is generally driven by the lowest advertised price. While flyers are shy to praise these price reductions, they are quick to complain about the removal of services. From a frequent-flyer perspective the impact can be great: they are losing their Thursday night commuter drink and are unable to charge purchases back to corporate policies. For leisure travellers, the degradation in service quality from the expectations set by BA following years of high-quality on-board service, could be one of the final nails in the coffin that drives holiday makers to cheaper low-cost carriers.

Comparisons with Financial Services

Similarly, the investment and asset management industry is also dealing with unbundling, though this time driven by a completely different force, namely the regulatory requirements of MiFID II. As part of the regulations that take full effect from 3 January 2018, portfolio managers and buy-side professionals are barred from accepting free research insights as this could be viewed as an ‘inducement’ under the terms of the MiFID II regulations. The new legislation imposes stringent conditions on clients’ payments for research and requires the use of a dedicated Research Payment Account (RPA) to allow for a buy-side client to pre-select the quantity of research and focus the coverage as they find applicable.

The implementation of these new rules has not been simple for anyone, with major initiatives being taken to ensure the changes are implemented from all perspectives. Sell-side firms have been sluggish to implement the necessary changes, as they also seek to implement numerous other global regulations which have come into force in the last few years. Going forward, buy-side firms are likely to be reluctant to start paying for a service which used to be complementary.

Fundamentally, sell-side institutions work as a gift economy. They provide research, introductions to CEOs, trade ideas and informal advice in the hope that buy-side institutions will later pay them to execute trades or structure deals. This is not to say that research is entirely free, but the payment mechanism is entirely at the buyer’s discretion. Funds are allocated to research and the buyer chooses after the event how to allocate those funds amongst the organisations that provided the research content. In other words, banks provide the advice and are only paid if the buyer believes it was worthwhile.

Financial Services can learn from unbundling strategies in aviation

MIFID II rules are about to tear up this relationship. Not only will buyers pay in advance for advice without knowing how to value it, but the advice will need to be fully costed and not provided at its current large discount. 

Looking to the future – potential lessons and next steps

There are some professionals who wonder what effect this will have on the core relationship between the buy-side and sell-side, and whether there will be a place for research-oriented institutions going forward. Others are concerned that there will be less incentive to cover smaller entities from a research perspective, which could lead to a significant reduction in liquidity for smaller and less-prestigious listed entities. 

The low-cost airline market uses product unbundling as a way of gaining price advantage in a heavily commoditised market by tapping no-frills customers to fill seats and grow volume. There are some industry insiders who suspect that the financial world could leverage this model. The opportunity is now opening for new entrants who can provide execution services at rock-bottom prices with no-frills, and for research-only firms who can provide top-ranked research at lower cost, without the infrastructure and overhead of execution.

Time will tell for airlines how well unbundling works, with the low-cost model sure to continue for those already in the space. Some legacy US carriers have already back-tracked on their cuts to food and beverage offerings, and British Airways has recently re-introduced complementary seat selection for status holders in their Executive Club even on basic fares. For the investment industry, it appears that the regulations, and costs involved in meeting those, will ensure the new status quo remains for the time being.

As for the low-cost airline model, both corporate road-warriors and leisure holiday makers seem to be continuing to flirt with low-cost carriers. However, many customers now buy their meals before boarding the plane, believing they can get a better price or better quality product. Whether the buy-side implement a similar strategy of shopping around and if they do, what will this do to the trade execution costs that the sell-side is able to charge, remains to be seen. Whatever the outcome, it is definitely an area to watch and one where many lessons are still to be learnt.

Related: Wait and see mode risks successful implementatioMiFID II.


The business and operating models of digital-only banks

04 April 2019

In recent years, several digital-only banks have successfully managed to nestle themselves in the banking landscape, with their popularity continuing to increase. Looking at it from the customer’s point-of-view, there is little difference between these FinTech unicorns; looking at the bigger picture, however, reveals significant variation in their business models. Matyas Fekete, a consultant at KAE, explores some of the main similarities and differences in digi-bank business and operating models. 

What about the profit?

Unlike in the UK, in most of continental Europe, bank accounts and corresponding banking services are historically paid-for services. The fact that digital banks offer most of their services free of charge has undoubtedly helped them build a large customer base. On the other hand, despite comparatively low set-up and minimised operational costs compared to that of traditional banks, and given the lack of revenue stemming from the typically no-fee model, profitability has proved difficult to achieve. Monzo, for instance, recorded a net loss of £30+ per customer in its most recent financial year. 

In the start-up world, it is customary to focus on expansion rather than profit – see the case of Uber, for instance. Still, while profitability might not be their number one priority in their early stages of development, it must be a long-term goal of any business. With their ever-growing customer base, digital banks are increasingly under pressure to turn their business from loss- to profit-making. 

Credit where credit is due

Digital banks pride themselves on their fair (often meaning “free”) proposition and have so far stayed clear of offering loans (including credit cards & overdrafts), traditionally amongst the most lucrative products for traditional providers. Though somewhat reluctantly, newcomers are also realising that offering lending products is one of the most straightforward ways to offset losses made on their free, often high-cost services (e.g. overseas ATM withdrawals). Monzo, N26 and Starling have recently started offering credit products to their customers, with their loan offering expected to be extended to a wide range of services, from mortgages to overdrafts. Correspondingly, creating a lending portfolio can also pave the way for launching an interest-paying savings offering – a proposition seen as a basic banking product that is yet to feature in most digital banks’ portfolios. 

The business and operating models of digital-only banks

The premium customer

While most digital banks offer most of their products for free, some have extended their offering by paid-for premium services in order to create a revenue stream. As these premium features – including different types of insurance, unlimited free transfers/withdrawals, faster payment settlement or concierge services – are often offered in a subscription format, customers are typically prompted to pay for the full package rather than just the desired service(s), providing a significant revenue stream for the bank. Revolut, for instance, was amongst the first digital banks in Europe to break even earlier this year, a feat largely due to revenue from its premium subscription.

SMEs like digital too

Traditional banks typically service small and medium sized businesses under their retail rather than corporate banking arm. Having their product offering tested with consumers, and consequently gaining a reasonable customer base, digital banks have also identified SMEs as an ideal segment to extend their target audience to. The five FinTechs profiled have already gone, or plan to go, down this path by following up their consumer solution with a business account. While both propositions are typically built on similar features, some providers charge businesses a monthly subscription (e.g. Revolut), while others apply additional fees to specific services (e.g. TransferWise), banking on the expectation that businesses are more likely to be willing to pay for banking – something they are already used to doing. 

The marketplace model

While most digital banks offer a wide range of banking services, some of these tend to come from partnering with third-party providers. For instance, Starling Bank’s only proprietary product is its current account, which serves as a basis for the provision of ancillary services, ranging from loans to insurance, to investment opportunities. Instead of developing these services in-house, Starling enables a select group of partnering financial service providers access to its platform in exchange for a fee. In effect, Starling is using its customer base to create a market for its partners, charging a commission for each acquired customer. 

In such cases of digital banks applying this marketplace model, the majority of their income often comes from partners rather than customers. Naturally, only banks with a large enough customer base can be successful in this set-up, underlining the current intensity of competition amongst digital banks.

Banking as a Service

While customer-centricity is heralded amongst the main USPs of digital banks, some are looking beyond offering consumer-facing services to diversify their revenue streams. Starling, which is among the few digital banks built on its own proprietary platform, has recently leapt into the Banking as a Service (BaaS) industry, making its technology available to other start-ups looking to launch a digital bank. Naturally, this raises the question whether the two offerings could threaten each other’s success. Generally, as long as such partners operate in different markets, the two business lines should be able to thrive alongside each other. Further along the line, however, such partners could easily end up expanding their banking solution into the same market(s) as they aim for global success, and by doing so, becoming direct competitors. 

Different approach, same result?

It is fair to say that consumers in Europe looking to bank with a digital-only provider would have a difficult time finding relative advantages/disadvantages amongst the leading players in the industry. Still, despite the limited surface-level variety, exploring the business models of leading digital banks reveals different approaches to the challenge of making money. Alongside the more straightforward method of offering paid-for premium features/subscriptions, some are banking on the value that access to their customer base offers to third-parties, while others outsource their technology to neobanks wanting to focus on the Fin rather than the Tech. With competition amongst digital banks heating up, it will be interesting to see which business model(s) prove to be the winning formula in the long term.