fintech research papers

Fintech and the Future of Finance

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This report explores the implications of fintech and the digital transformation of financial services for market outcomes on one side, and regulation and supervision, on the other, and how these interact.

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• Policy Summary
• Executive Summaries of All Technical Notes
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Technical Notes

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Fintech, the application of digital technology to financial services, is reshaping the future of finance– a process that the COVID-19 pandemic has accelerated. The ongoing digitization of financial services and money creates opportunities to build more inclusive and efficient financial services and promote economic development. Fintech is transforming the financial sector landscape rapidly and is blurring the boundaries of both financial firms and the financial sector. This  presents a paradigm shift that has various policy implications, including:

• Foster beneficial innovation and competition, while managing the risks.
• Broaden monitoring horizons and re-assess regulatory perimeters as embedding of financial services blurs the boundaries of the financial sector.
• Be mindful of evolving policy tradeoffs as fintech adoption deepens.
• Review regulatory, supervisory, and oversight frameworks to ensure they remain fit for purpose and enable the authorities to foster a safe, efficient, and inclusive financial system.
• Anticipate market structure tendencies and proactively shape them to foster competition and contestability in the financial sector.
• Modernize and open up financial infrastructures to enable competition and contestability.
• Ensure public money remains fit for the digital world amid rapid advances in private money solutions.
• Pursue strong cross-border coordination and sharing of information and best practices, given the supra-national nature of fintech.

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Fintech and the Future of Finance: Market and Policy Implications

Blog series.

• Jul 13, 2023 Digital financial services bridging the SME financing gap
• Apr 19, 2023 Central banks and innovation
• Apr 17, 2023 Innovation in payments: Opportunities and challenges for EMDEs
• Mar 07, 2023 Embracing the promise of Fintech responsibly through regulation and supervision
• Feb 24, 2023 Fintech and financial services: Delivering for development

Global Patterns of Fintech Activity and Enabling Factors

The Fintech Activity note takes stock of available fintech-related data, to document patterns of fintech activity across the world, and to help identify enabling factors.

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• 🠞 Full Technical Note

Global Market Survey: Digital Technology and the Future of Finance Survey

The Fintech Market Participants Survey discusses findings from the survey whose responses span 330 market participants from 109 countries.

Fintech and the Digital Transformation of Financial Services

The Market Structure note draws on the underlying economics of financial services and their industrial organization to examine the implications of digital innovation for market structure and attendant policies.

Regulation and Supervision of Fintech

The Regulation note aims to provide regulators and supervisors in emerging markets and developing economies (EMDEs) with high-level guidance on how to approach the regulating and supervising of fintech.

Consumer Protection Implications of Fintech

The Consumer Protection note provides an overview of new manifestations of consumer risks that are significant and cross-cutting across four key fintech products: digital microcredit, P2PL, investment-based crowdfunding, ...

Innovation in Payments

The Payments note discusses the most significant innovations in payments and their key impacts and implications on users, banks and other payment service providers, regulators, and the overall structure of the payments ...

Fintech and SME Finance: Expanding Responsible Access

The SME note discusses policy and regulatory approaches that can facilitate access to finance for small and medium enterprises (SMEs) through digital financial services.

What Does Digital Money Mean for EMDEs?

The Digital Money note categorizes new digital money proposals including crypto-assets, stablecoins, and central bank digital currencies; assesses the supply and demand factors for their adoption; and lays out particular ...

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• Open access
• Published: 18 June 2021

Financial technology and the future of banking

• Daniel Broby   ORCID: orcid.org/0000-0001-5482-0766 1  

Financial Innovation volume  7 , Article number:  47 ( 2021 ) Cite this article

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This paper presents an analytical framework that describes the business model of banks. It draws on the classical theory of banking and the literature on digital transformation. It provides an explanation for existing trends and, by extending the theory of the banking firm, it illustrates how financial intermediation will be impacted by innovative financial technology applications. It further reviews the options that established banks will have to consider in order to mitigate the threat to their profitability. Deposit taking and lending are considered in the context of the challenge made from shadow banking and the all-digital banks. The paper contributes to an understanding of the future of banking, providing a framework for scholarly empirical investigation. In the discussion, four possible strategies are proposed for market participants, (1) customer retention, (2) customer acquisition, (3) banking as a service and (4) social media payment platforms. It is concluded that, in an increasingly digital world, trust will remain at the core of banking. That said, liquidity transformation will still have an important role to play. The nature of banking and financial services, however, will change dramatically.

Introduction

The bank of the future will have several different manifestations. This paper extends theory to explain the impact of financial technology and the Internet on the nature of banking. It provides an analytical framework for academic investigation, highlighting the trends that are shaping scholarly research into these dynamics. To do this, it re-examines the nature of financial intermediation and transactions. It explains how digital banking will be structurally, as well as physically, different from the banks described in the literature to date. It does this by extending the contribution of Klein ( 1971 ), on the theory of the banking firm. It presents suggested strategies for incumbent, and challenger banks, and how banking as a service and social media payment will reshape the competitive landscape.

The banking industry has been evolving since Banca Monte dei Paschi di Siena opened its doors in 1472. Its leveraged business model has proved very scalable over time, but it is now facing new challenges. Firstly, its book to capital ratios, as documented by Berger et al ( 1995 ), have been consistently falling since 1840. This trend continues as competition has increased. In the past decade, the industry has experienced declines in profitability as measured by return on tangible equity. This is partly the result of falling leverage and fee income and partly due to the net interest margin (connected to traditional lending activity). These trends accelerated following the 2008 financial crisis. At the same time, technology has made banks more competitive. Advances in digital technology are changing the very nature of banking. Banks are now distributing services via mobile technology. A prolonged period of very low interest rates is also having an impact. To sustain their profitability, Brei et al. ( 2020 ) note that many banks have increased their emphasis on fee-generating services.

As Fama ( 1980 ) explains, a bank is an intermediary. The Internet is, however, changing the way financial service providers conduct their role. It is fundamentally changing the nature of the banking. This in turn is changing the nature of banking services, and the way those services are delivered. As a consequence, in order to compete in the changing digital landscape, banks have to adapt. The banks of the future, both incumbents and challengers, need to address liquidity transformation, data, trust, competition, and the digitalization of financial services. Against this backdrop, incumbent banks are focused on reinventing themselves. The challenger banks are, however, starting with a blank canvas. The research questions that these dynamics pose need to be investigated within the context of the theory of banking, hence the need to revise the existing analytical framework.

Banks perform payment and transfer functions for an economy. The Internet can now facilitate and even perform these functions. It is changing the way that transactions are recorded on ledgers and is facilitating both public and private digital currencies. In the past, banks operated in a world of information asymmetry between themselves and their borrowers (clients), but this is changing. This differential gave one bank an advantage over another due to its knowledge about its clients. The digital transformation that financial technology brings reduces this advantage, as this information can be digitally analyzed.

Even the nature of deposits is being transformed. Banks in the future will have to accept deposits and process transactions made in digital form, either Central Bank Digital Currencies (CBDC) or cryptocurrencies. This presents a number of issues: (1) it changes the way financial services will be delivered, (2) it requires a discussion on resilience, security and competition in payments, (3) it provides a building block for better cross border money transfers and (4) it raises the question of private and public issuance of money. Braggion et al ( 2018 ) consider whether these represent a threat to financial stability.

The academic study of banking began with Edgeworth ( 1888 ). He postulated that it is based on probability. In this respect, the nature of the business model depends on the probability that a bank will not be called upon to meet all its liabilities at the same time. This allows banks to lend more than they have in deposits. Because of the resultant mismatch between long term assets and short-term liabilities, a bank’s capital structure is very sensitive to liquidity trade-offs. This is explained by Diamond and Rajan ( 2000 ). They explain that this makes a bank a’relationship lender’. In effect, they suggest a bank is an intermediary that has borrowed from other investors.

Diamond and Rajan ( 2000 ) argue a lender can negotiate repayment obligations and that a bank benefits from its knowledge of the customer. As shall be shown, the new generation of digital challenger banks do not have the same tradeoffs or knowledge of the customer. They operate more like a broker providing a platform for banking services. This suggests that there will be more than one type of bank in the future and several different payment protocols. It also suggests that banks will have to data mine customer information to improve their understanding of a client’s financial needs.

The key focus of Diamond and Rajan ( 2000 ), however, was to position a traditional bank is an intermediary. Gurley and Shaw ( 1956 ) describe how the customer relationship means a bank can borrow funds by way of deposits (liabilities) and subsequently use them to lend or invest (assets). In facilitating this mediation, they provide a service whereby they store money and provide a mechanism to transmit money. With improvements in financial technology, however, money can be stored digitally, lenders and investors can source funds directly over the internet, and money transfer can be done digitally.

A review of financial technology and banking literature is provided by Thakor ( 2020 ). He highlights that financial service companies are now being provided by non-deposit taking contenders. This paper addresses one of the four research questions raised by his review, namely how theories of financial intermediation can be modified to accommodate banks, shadow banks, and non-intermediated solutions.

To be a bank, an entity must be authorized to accept retail deposits. A challenger bank is, therefore, still a bank in the traditional sense. It does not, however, have the costs of a branch network. A peer-to-peer lender, meanwhile, does not have a deposit base and therefore acts more like a broker. This leads to the issue that this paper addresses, namely how the banks of the future will conduct their intermediation.

In order to understand what the bank of the future will look like, it is necessary to understand the nature of the aforementioned intermediation, and the way it is changing. In this respect, there are two key types of intermediation. These are (1) quantitative asset transformation and, (2) brokerage. The latter is a common model adopted by challenger banks. Figure  1 depicts how these two types of financial intermediation match savers with borrowers. To avoid nuanced distinction between these two types of intermediation, it is common to classify banks by the services they perform. These can be grouped as either private, investment, or commercial banking. The service sub-groupings include payments, settlements, fund management, trading, treasury management, brokerage, and other agency services.

How banks act as intermediaries between lenders and borrowers. This function call also be conducted by intermediaries as brokers, for example by shadow banks. Disintermediation occurs over the internet where peer-to-peer lenders match savers to lenders

Financial technology has the ability to disintermediate the banking sector. The competitive pressures this results in will shape the banks of the future. The channels that will facilitate this are shown in Fig.  2 , namely the Internet and/or mobile devices. Challengers can participate in this by, (1) directly matching borrows with savers over the Internet and, (2) distributing white labels products. The later enables banking as a service and avoids the aforementioned liquidity mismatch.

The strategic options banks have to match lenders with borrowers. The traditional and challenger banks are in the same space, competing for business. The distributed banks use the traditional and challenger banks to white label banking services. These banks compete with payment platforms on social media. The Internet heralds an era of banking as a service

There are also physical changes that are being made in the delivery of services. Bricks and mortar branches are in decline. Mobile banking, or m-banking as Liu et al ( 2020 ) describe it, is an increasingly important distribution channel. Robotics are increasingly being used to automate customer interaction. As explained by Vishnu et al ( 2017 ), these improve efficiency and the quality of execution. They allow for increased oversight and can be built on legacy systems as well as from a blank canvas. Application programming interfaces (APIs) are bringing the same type of functionality to m-banking. They can be used to authorize third party use of banking data. How banks evolve over time is important because, according to the OECD, the activity in the financial sector represents between 20 and 30 percent of developed countries Gross Domestic Product.

In summary, financial technology has evolved to a level where online banks and banking as a service are challenging incumbents and the nature of banking mediation. Banking is rapidly transforming because of changes in such technology. At the same time, the solving of the double spending problem, whereby digital money can be cryptographically protected, has led to the possibility that paper money will become redundant at some point in the future. A theoretical framework is required to understand this evolving landscape. This is discussed next.

The theory of the banking firm: a revision

In financial theory, as eloquently explained by Fama ( 1980 ), banking provides an accounting system for transactions and a portfolio system for the storage of assets. That will not change for the banks of the future. Fama ( 1980 ) explains that their activities, in an unregulated state, fulfil the Modigliani–Miller ( 1959 ) theorem of the irrelevance of the financing decision. In practice, traditional banks compete for deposits through the interest rate they offer. This makes the transactional element dependent on the resulting debits and credits that they process, essentially making banks into bookkeeping entities fulfilling the intermediation function. Since this is done in response to competitive forces, the general equilibrium is a passive one. As such, the banking business model is vulnerable to disruption, particularly by innovation in financial technology.

A bank is an idiosyncratic corporate entity due to its ability to generate credit by leveraging its balance sheet. That balance sheet has assets on one side and liabilities on the other, like any corporate entity. The assets consist of cash, lending, financial and fixed assets. On the other side of the balance sheet are its liabilities, deposits, and debt. In this respect, a bank’s equity and its liabilities are its source of funds, and its assets are its use of funds. This is explained by Klein ( 1971 ), who notes that a bank’s equity W , borrowed funds and its deposits B is equal to its total funds F . This is the same for incumbents and challengers. This can be depicted algebraically if we let incumbents be represented by Φ and challengers represented by Γ:

Klein ( 1971 ) further explains that a bank’s equity is therefore made up of its share capital and unimpaired reserves. The latter are held by a bank to protect the bank’s deposit clients. This part is also mandated by regulation, so as to protect customers and indeed the entire banking system from systemic failure. These protective measures include other prudential requirements to hold cash reserves or other liquid assets. As shall be shown, banking services can be performed over the Internet without these protections. Banking as a service, as this phenomenon known, is expected to increase in the future. This will change the nature of the protection available to clients. It will change the way banks transform assets, explained next.

A bank’s deposits are said to be a function of the proportion of total funds obtained through the issuance of the ith deposit type and its total funds F , represented by α i . Where deposits, represented by Bs , are made in the form of Bs (i  =  1 *s n) , they generate a rate of interest. It follows that Si Bs  =  B . As such,

Therefor it can be said that,

The importance of Eq. 3 is that the balance sheet can be leveraged by the issuance of loans. It should be noted, however, that not all loans are returned to the bank in whole or part. Non-performing loans reduce the asset side of a bank’s balance sheet and act as a constraint on capital, and therefore new lending. Clearly, this is not the case with banking as a service. In that model, loans are brokered. That said, with the traditional model, an advantage of financial technology is that it facilitates the data mining of clients’ accounts. Lending can therefore be more targeted to borrowers that are more likely to repay, thereby reducing non-performing loans. Pari passu, the incumbent bank of the future will therefore have a higher risk-adjusted return on capital. In practice, however, banking as a service will bring greater competition from challengers and possible further erosion of margins. Alternatively, some banks will proactively engage in partnerships and acquisitions to maintain their customer base and address the competition.

A bank must have reserves to meet the demand of customers demanding their deposits back. The amount of these reserves is a key function of banking regulation. The Basel Committee on Banking Supervision mandates a requirement to hold various tiers of capital, so that banks have sufficient reserves to protect depositors. The Committee also imposes a framework for mitigating excessive liquidity risk and maturity transformation, through a set Liquidity Coverage Ratio and Net Stable Funding Ratio.

Recent revisions of theory, because of financial technology advances, have altered our understanding of banking intermediation. This will impact the competitive landscape and therefor shape the nature of the bank of the future. In this respect, the threat to incumbent banks comes from peer-to-peer Internet lending platforms. These perform the brokerage function of financial intermediation without the use of the aforementioned banking balance sheet. Unlike regulated deposit takers, such lending platforms do not create assets and do not perform risk and asset transformation. That said, they are reliant on investors who do not always behave in a counter cyclical way.

Financial technology in banking is not new. It has been used to facilitate electronic markets since the 1980’s. Thakor ( 2020 ) refers to three waves of application of financial innovation in banking. The advent of institutional futures markets and the changing nature of financial contracts fundamentally changed the role of banks. In response to this, academics extended the concept of a bank into an entity that either fulfills the aforementioned functions of a broker or a qualitative asset transformer. In this respect, they connect the providers and users of capital without changing the nature of the transformation of the various claims to that capital. This transformation can be in the form risk transfer or the application of leverage. The nature of trading of financial assets, however, is changing. Price discovery can now be done over the Internet and that is moving liquidity from central marketplaces (like the stock exchange) to decentralized ones.

Alongside these trends, in considering what the bank of the future will look like, it is necessary to understand the unregulated lending market that competes with traditional banks. In this part of the lending market, there has been a rise in shadow banks. The literature on these entities is covered by Adrian and Ashcraft ( 2016 ). Shadow banks have taken substantial market share from the traditional banks. They fulfil the brokerage function of banks, but regulators have only partial oversight of their risk transformation or leverage. The rise of shadow banks has been facilitated by financial technology and the originate to distribute model documented by Bord and Santos ( 2012 ). They use alternative trading systems that function as electronic communication networks. These facilitate dark pools of liquidity whereby buyers and sellers of bonds and securities trade off-exchange. Since the credit crisis of 2008, total broker dealer assets have diverged from banking assets. This illustrates the changed lending environment.

In the disintermediated market, banking as a service providers must rely on their equity and what access to funding they can attract from their online network. Without this they are unable to drive lending growth. To explain this, let I represent the online network. Extending Klein ( 1971 ), further let Ψ represent banking as a service and their total funds by F . This state is depicted as,

Theoretically, it can be shown that,

Shadow banks, and those disintermediators who bypass the banking system, have an advantage in a world where technology is ubiquitous. This becomes more apparent when costs are considered. Buchak et al. ( 2018 ) point out that shadow banks finance their originations almost entirely through securitization and what they term the originate to distribute business model. Diversifying risk in this way is good for individual banks, as banking risks can be transferred away from traditional banking balance sheets to institutional balance sheets. That said, the rise of securitization has introduced systemic risk into the banking sector.

Thus, we can see that the nature of banking capital is changing and at the same time technology is replacing labor. Let A denote the number of transactions per account at a period in time, and C denote the total cost per account per time period of providing the services of the payment mechanism. Klein ( 1971 ) points out that, if capital and labor are assumed to be part of the traditional banking model, it can be observed that,

It can therefore be observed that the total service charge per account at a period in time, represented by S, has a linear and proportional relationship to bank account activity. This is another variable that financial technology can impact. According to Klein ( 1971 ) this can be summed up in the following way,

where d is the basic bank decision variable, the service charge per transaction. Once again, in an automated and digital environment, financial technology greatly reduces d for the challenger banks. Swankie and Broby ( 2019 ) examine the impact of Artificial Intelligence on the evaluation of banking risk and conclude that it improves such variables.

Meanwhile, the traditional banking model can be expressed as a product of the number of accounts, M , and the average size of an account, N . This suggests a banks implicit yield is it rate of interest on deposits adjusted by its operating loss in each time period. This yield is generated by payment and loan services. Let R 1 depict this. These can be expressed as a fraction of total demand deposits. This is depicted by Klein ( 1971 ), if one assumes activity per account is constant, as,

As a result, whether a bank is structured with traditional labor overheads or built digitally, is extremely relevant to its profitability. The capital and labor of tradition banks, depicted as Φ i , is greater than online networks, depicted as I i . As such, the later have an advantage. This can be shown as,

What Klein (1972) failed to highlight is that the banking inherently involves leverage. Diamond and Dybving (1983) show that leverage makes bank susceptible to run on their liquidity. The literature divides these between adverse shock events, as explained by Bernanke et al ( 1996 ) or moral hazard events as explained by Demirgu¨¸c-Kunt and Detragiache ( 2002 ). This leverage builds on the balance sheet mismatch of short-term assets with long term liabilities. As such, capital and liquidity are intrinsically linked to viability and solvency.

The way capital and liquidity are managed is through credit and default management. This is done at a bank level and a supervisory level. The Basel Committee on Banking Supervision applies capital and leverage ratios, and central banks manage interest rates and other counter-cyclical measures. The various iterations of the prudential regulation of banks have moved the microeconomic theory of banking from the modeling of risk to the modeling of imperfect information. As mentioned, shadow and disintermediated services do not fall under this form or prudential regulation.

The relationship between leverage and insolvency risk crucially depends on the degree of banks total funds F and their liability structure L . In this respect, the liability structure of traditional banks is also greater than online networks which do not have the same level of available funds, depicted as,

Diamond and Dybvig ( 1983 ) observe that this liability structure is intimately tied to a traditional bank’s assets. In this respect, a bank’s ability to finance its lending at low cost and its ability to achieve repayment are key to its avoidance of insolvency. Online networks and/or brokers do not have to finance their lending, simply source it. Similarly, as brokers they do not face capital loss in the event of a default. This disintermediates the bank through the use of a peer-to-peer environment. These lenders and borrowers are introduced in digital way over the internet. Regulators have taken notice and the digital broker advantage might not last forever. As a result, the future may well see greater cooperation between these competing parties. This also because banks have valuable operational experience compared to new entrants.

It should also be observed that bank lending is either secured or unsecured. Interest on an unsecured loan is typically higher than the interest on a secured loan. In this respect, incumbent banks have an advantage as their closeness to the customer allows them to better understand the security of the assets. Berger et al ( 2005 ) further differentiate lending into transaction lending, relationship lending and credit scoring.

The evolution of the business model in a digital world

As has been demonstrated, the bank of the future in its various manifestations will be a consequence of the evolution of the current banking business model. There has been considerable scholarly investigation into the uniqueness of this business model, but less so on its changing nature. Song and Thakor ( 2010 ) are helpful in this respect and suggest that there are three aspects to this evolution, namely competition, complementary and co-evolution. Although liquidity transformation is evolving, it remains central to a bank’s role.

All the dynamics mentioned are relevant to the economy. There is considerable evidence, as outlined by Levine ( 2001 ), that market liberalization has a causal impact on economic growth. The impact of technology on productivity should prove positive and enhance the functioning of the domestic financial system. Indeed, market liberalization has already reshaped banking by increasing competition. New fee based ancillary financial services have become widespread, as has the proprietorial use of balance sheets. Risk has been securitized and even packaged into trade-able products.

Challenger banks are developing in a complementary way with the incumbents. The latter have an advantage over new entrants because they have information on their customers. The liquidity insurance model, proposed by Diamond and Dybvig ( 1983 ), explains how such banks have informational advantages over exchange markets. That said, financial technology changes these dynamics. It if facilitating the processing of financial data by third parties, explained in greater detail in the section on Open Banking.

At the same time, financial technology is facilitating banking as a service. This is where financial services are delivered by a broker over the Internet without resort to the balance sheet. This includes roboadvisory asset management, peer to peer lending, and crowd funding. Its growth will be facilitated by Open Banking as it becomes more geographically adopted. Figure  3 illustrates how these business models are disintermediating the traditional banking role and matching burrowers and savers.

The traditional view of banks ecosystem between savers and borrowers, atop the Internet which is matching savers and borrowers directly in a peer-to-peer way. The Klein ( 1971 ) theory of the banking firm does not incorporate the mirrored dynamics, and as such needs to be extended to reflect the digital innovation that impacts both borrowers and severs in a peer-to-peer environment

Meanwhile, the banking sector is co-evolving alongside a shadow banking phenomenon. Lenders and borrowers are interacting, but outside of the banking sector. This is a concern for central banks and banking regulators, as the lending is taking place in an unregulated environment. Shadow banking has grown because of financial technology, market liberalization and excess liquidity in the asset management ecosystem. Pozsar and Singh ( 2011 ) detail the non-bank/bank intersection of shadow banking. They point out that shadow banking results in reverse maturity transformation. Incumbent banks have blurred the distinction between their use of traditional (M2) liabilities and market-based shadow banking (non-M2) liabilities. This impacts the inter-generational transfers that enable a bank to achieve interest rate smoothing.

Securitization has transformed the risk in the banking sector, transferring it to asset management institutions. These include structured investment vehicles, securities lenders, asset backed commercial paper investors, credit focused hedge and money market funds. This in turn has led to greater systemic risk, the result of the nature of the non-traded liabilities of securitized pooling arrangements. This increased risk manifested itself in the 2008 credit crisis.

Commercial pressures are also shaping the banking industry. The drive for cost efficiency has made incumbent banks address their personally costs. Bank branches have been closed as technology has evolved. Branches make it easier to withdraw or transfer deposits and challenger banks are not as easily able to attract new deposits. The banking sector is therefore looking for new point of customer contact, such as supermarkets, post offices and social media platforms. These structural issues are occurring at the same time as the retail high street is also evolving. Banks have had an aggressive roll out of automated telling machines and a reduction in branches and headcount. Online digital transactions have now become the norm in most developed countries.

The financing of banks is also evolving. Traditional banks have tended to fund illiquid assets with short term and unstable liquid liabilities. This is one of the key contributors to the rise to the credit crisis of 2008. The provision of liquidity as a last resort is central to the asset transformation process. In this respect, the banking sector experienced a shock in 2008 in what is termed the credit crisis. The aforementioned liquidity mismatch resulted in the system not being able to absorb all the risks associated with subprime lending. Central banks had to resort to quantitative easing as a result of the failure of overnight funding mechanisms. The image of the entire banking sector was tarnished, and the banks of the future will have to address this.

The future must learn from the mistakes of the past. The structural weakness of the banking business model cannot be solved. That said, the latest Basel rules introduce further risk mitigation, improved leverage ratios and increased levels of capital reserve. Another lesson of the credit crisis was that there should be greater emphasis on risk culture, governance, and oversight. The independence and performance of the board, the experience and the skill set of senior management are now a greater focus of regulators. Internal controls and data analysis are increasingly more robust and efficient, with a greater focus on a banks stable funding ratio.

Meanwhile, the very nature of money is changing. A digital wallet for crypto-currencies fulfills much the same storage and transmission functions of a bank; and crypto-currencies are increasing being used for payment. Meanwhile, in Sweden, stores have the right to refuse cash and the majority of transactions are card based. This move to credit and debit cards, and the solving of the double spending problem, whereby digital money can be crypto-graphically protected, has led to the possibility that paper money could be replaced at some point in the future. Whether this might be by replacement by a CBDC, or decentralized digital offering, is of secondary importance to the requirement of banks to adapt. Whether accommodating crytpo-currencies or CBDC’s, Kou et al. ( 2021 ) recommend that banks keep focused on alternative payment and money transferring technologies.

Central banks also have to adapt. To limit disintermediation, they have to ensure that the economic design of their sponsored digital currencies focus on access for banks, interest payment relative to bank policy rate, banking holding limits and convertibility with bank deposits. All these developments have implications for banks, particularly in respect of funding, the secure storage of deposits and how digital currency interacts with traditional fiat money.

Open banking

Against the backdrop of all these trends and changes, a new dynamic is shaping the future of the banking sector. This is termed Open Banking, already briefly mentioned. This new way of handling banking data protocols introduces a secure way to give financial service companies consensual access to a bank’s customer financial information. Figure  4 illustrates how this works. Although a fairly simple concept, the implications are important for the banking industry. Essentially, a bank customer gives a regulated API permission to securely access his/her banking website. That is then used by a banking as a service entity to make direct payments and/or download financial data in order to provide a solution. It heralds an era of customer centric banking.

How Open Banking operates. The customer generates data by using his bank account. A third party provider is authorized to access that data through an API request. The bank confirms digitally that the customer has authorized the exchange of data and then fulfills the request

Open Banking was a response to the documented inertia around individual’s willingness to change bank accounts. Following the Retail Banking Review in the UK, this was addressed by lawmakers through the European Union’s Payment Services Directive II. The legislation was designed to make it easier to change banks by allowing customers to delegate authority to transfer their financial data to other parties. As a result of this, a whole host of data centric applications were conceived. Open banking adds further momentum to reshaping the future of banking.

Open Banking has a number of quite revolutionary implications. It was started so customers could change banks easily, but it resulted in some secondary considerations which are going to change the future of banking itself. It gives a clear view of bank financing. It allows aggregation of finances in one place. It also allows can give access to attractive offerings by allowing price comparisons. Open Banking API’s build a secure online financial marketplace based on data. They also allow access to a larger market in a faster way but the third-party providers for the new entrants. Open Banking allows developers to build single solutions on an API addressing very specific problems, like for example, a cash flow based credit rating.

Romānova et al. ( 2018 ) undertook a questionnaire on the Payment Services Directive II. The results suggest that Open Banking will promote competitiveness, innovation, and new product development. The initiative is associated with low costs and customer satisfaction, but that some concerns about security, privacy and risk are present. These can be mitigated, to some extent, by secure protocols and layered permission access.

Discussion: strategic options

Faced with these disruptive trends, there are four strategic options for market participants to con- sider. There are (1) a defensive customer retention strategy for incumbents, (2) an aggressive customer acquisition strategy for challenger banks (3) a banking as a service strategy for new entrants, and (4) a payments strategy for social media platforms.

Each of these strategies has to be conducted in a competitive marketplace for money demand by potential customers. Figure  5 illustrates where the first three strategies lie on the tradeoff between money demand and interest rates. The payment strategy can’t be modeled based on the supply of money. In the figure, the market settles at a rate L 2 . The incumbent banks have the capacity to meet the largest supply of these loans. The challenger banks have a constrained function but due to a lower cost base can gain excess rent through higher rates of interest. The peer-to-peer bank as a service brokers must settle for the market rate and a constrained supply offering.

The money demand M by lenders on the y axis. Interest rates on the y axis are labeled as r I and r II . The challenger banks are represented by the line labeled Γ. They have a price and technology advantage and so can lend at higher interest rates. The brokers are represented by the line labeled Ω. They are price takers, accepting the interest rate determined by the market. The same is true for the incumbents, represented by the line labeled Φ but they have a greater market share due to their customer relationships. Note that payments strategy for social media platforms is not shown on this figure as it is not affected by interest rates

Figure  5 illustrates that having a niche strategy is not counterproductive. Liu et al ( 2020 ) found that banks performing niche activities exhibit higher profitability and have lower risk. The syndication market now means that a bank making a loan does not have to be the entity that services it. This means banks in the future can better shape their risk profile and manage their lending books accordingly.

An interesting question for central banks is what the future Deposit Supply function will look like. If all three forms: open banking, traditional banking and challenger banks develop together, will the bank of the future have the same Deposit Supply function? The Klein ( 1971 ) general formulation assumes that deposits are increasing functions of implicit and explicit yields. As such, the very nature of central bank directed monetary policy may have to be revisited, as alluded to in the earlier discussion on digital money.

The client retention strategy (incumbents)

The competitive pressures suggest that incumbent banks need to focus on customer retention. Reichheld and Kenny ( 1990 ) found that the best way to do this was to focus on the retention of branch deposit customers. Obviously, another way is to provide a unique digital experience that matches the challengers.

Incumbent banks have a competitive advantage based on the information they have about their customers. Allen ( 1990 ) argues that where risk aversion is observable, information markets are viable. In other words, both bank and customer benefit from this. The strategic issue for them, therefore, becomes the retention of these customers when faced with greater competition.

Open Banking changes the dynamics of the banking information advantage. Borgogno and Colangelo ( 2020 ) suggest that the access to account (XS2A) rule that it introduced will increase competition and reduce information asymmetry. XS2A requires banks to grant access to bank account data to authorized third payment service providers.

The incumbent banks have a high-cost base and legacy IT systems. This makes it harder for them to migrate to a digital world. There are, however, also benefits from financial technology for the incumbents. These include reduced cost and greater efficiency. Financial technology can also now support platforms that allow incumbent banks to sell NPL’s. These platforms do not require the ownership of assets, they act as consolidators. The use of technology to monitor the transactions make the processing cost efficient. The unique selling point of such platforms is their centralized point of contact which results in a reduction in information asymmetry.

Incumbent banks must adapt a number of areas they got to adapt in terms of their liquidity transformation. They have to adapt the way they handle data. They must get customers to trust them in a digital world and the way that they trust them in a bricks and mortar world. It is no coincidence. When you go into a bank branch that is a great big solid building great big facade and so forth that is done deliberately so that you trust that bank with your deposit.

The risk of having rising non-performing loans needs to be managed, so customer retention should be selective. One of the puzzles in banking is why customers are regularly denied credit, rather than simply being charged a higher price for it. This credit rationing is often alleviated by collateral, but finance theory suggests value is based on the discounted sum of future cash flows. As such, it is conceivable that the bank of the future will use financial technology to provide innovative credit allocation solutions. That said, the dual risks of moral hazard and information asymmetries from the adoption of such solutions must be addressed.

Customer retention is especially important as bank competition is intensifying, as is the digitalization of financial services. Customer retention requires innovation, and that innovation has been moving at a very fast rate. Until now, banks have traditionally been hesitant about technology. More recently, mergers and acquisitions have increased quite substantially, initiated by a need to address actual or perceived weaknesses in financial technology.

The client acquisition strategy (challengers)

As intermediaries, the challenger banks are the same as incumbent banks, but designed from the outset to be digital. This gives them a cost and efficiency advantage. Anagnostopoulos ( 2018 ) suggests that the difference between challenger and traditional banks is that the former address its customers problems more directly. The challenge for such banks is customer acquisition.

Open Banking is a major advantage to challenger banks as it facilitates the changing of accounts. There is widespread dissatisfaction with many incumbent banks. Open Banking makes it easier to change accounts and also easier to get a transaction history on the client.

Customer acquisition can be improved by building trust in a brand. Historically, a bank was physically built in a very robust manner, hence the heavy architecture and grand banking halls. This was done deliberately to engender a sense of confidence in the deposit taking institution. Pure internet banks are not able to do this. As such, they must employ different strategies to convey stability. To do this, some communicate their sustainability credentials, whilst others use generational values-based advertising. Customer acquisition in a banking context is traditionally done by offering more attractive rates of interest. This is illustrated in Fig.  5 by the intersect of traditional banks with the market rate of interest, depicted where the line Γ crosses L 2 . As a result of the relationship with banking yield, teaser rates and introductory rates are common. A customer acquisition strategy has risks, as consumers with good credit can game different challenger banks by frequently changing accounts.

Most customer acquisition, however, is done based on superior service offering. The functionality of challenger banking accounts is often superior to incumbents, largely because the latter are built on legacy databases that have inter-operability issues. Having an open platform of services is a popular customer acquisition technique. The unrestricted provision of third-party products is viewed more favorably than a restricted range of products.

The banking as a service strategy (new entrants)

Banking from a customer’s perspective is the provision of a service. Customers don’t care about the maturity transformation of banking balance sheets. Banking as a service can be performed without recourse to these balance sheets. Banking products are brokered, mostly by new entrants, to individuals as services that can be subscribed to or paid on a fee basis.

There are a number banking as a service solutions including pre-paid and credit cards, lending and leasing. The banking as a service brokers are effectively those that are aggregating services from others using open banking to enable banking as a service.

The rise of banking as a service needs to be understood as these compete directly with traditional banks. As explained, some of these do this through peer-to-peer lending over the internet, others by matching borrows and sellers, conducting mediation as a loan broker. Such entities do not transform assets and do not have banking licenses. They do not have a branch network and often don not have access to deposits. This means that they have no insurance protection and can be subject to interest rate controls.

The new genre of financial technology, banking as a service provider, conduct financial services transformation without access to central bank liquidity. In a distributed digital asset world, the assets are stored on a distributed ledger rather than a traditional banking ledger. Financial technology has automated credit evaluation, savings, investments, insurance, trading, banking payments and risk management. These banking as a service offering are only as secure as the technology on which they are built.

The social media payment strategy (disintermediators and disruptors)

An intermediation bank is a conceptual idea, one created solely on a social networking site. Social media has developed a market for online goods and services. Williams ( 2018 ) estimates that there are 2.46 billion social media users. These all make and receive payments of some kind. They demand security and functionality. Importantly, they have often more clients than most banks. As such, a strategy to monetize the payments infrastructure makes sense.

All social media platforms are rich repositories of data. Such platforms are used to buy and sell things and that requires payments. Some platforms are considering evolving their own digital payment, cutting out the banks as middlemen. These include Facebook’s Diem (formerly Libra), a digital currency, and similar developments at some of the biggest technology companies. The risk with social media payment platform is that there is systemic counter-party protection. Regulators need to address this. One way to do this would be to extend payment service insurance to such platforms.

Social media as a platform moves the payment relationship from a transaction to a customer experience. The ability to use consumer desires in combination with financial data has the potential to deliver a number of new revenue opportunities. These will compete directly with the banks of the future. This will have implications for (1) the money supply, (2) the market share of traditional banks and, (3) the services that payment providers offer.

Further research

Several recommendations for research derive from both the impact of disintermediation and the four proposed strategies that will shape banking in the future. The recommendations and suggestions are based on the mentioned papers and the conclusions drawn from them.

As discussed, the nature of intermediation is changing, and this has implications for the pricing of risk. The role of interest rates in banking will have to be further reviewed. In a decentralized world based on crypto currencies the central banks do not have the same control over the money supply, This suggest the quantity theory of money and the liquidity preference theory need to be revisited. As explained, the Internet reduces much of the friction costs of intermediation. Researchers should ask how this will impact maturity transformation. It is also fair to ask whether at some point in the future there will just be one big bank. This question has already been addressed in the literature but the Internet facilities the possibility. Diamond ( 1984 ) and Ramakrishnan and Thakor ( 1984 ) suggested the answer was due to diversification and its impact on reducing monitoring costs.

Attention should be given by academics to the changing nature of banking risk. How should regulators, for example, address the moral hazard posed by challenger banks with weak balance sheets? What about deposit insurance? Should it be priced to include unregulated entities? Also, what criteria do borrowers use to choose non-banking intermediaries? The changing risk environment also poses two interesting practical questions. What will an online bank run look like, and how can it be averted? How can you establish trust in digital services?

There are also research questions related to the nature of competition. What, for example, will be the nature of cross border competition in a decentralized world? Is the credit rationing that generates competition a static or dynamic phenomena online? What is the value of combining consumer utility with banking services?

Financial intermediaries, like banks, thrive in a world of deficits and surpluses supported by information asymmetries and disconnectedness. The connectivity of the internet changes this dynamic. In this respect, the view of Schumpeter ( 1911 ) on the role of financial intermediaries needs revisiting. Lenders and borrows can be connected peer to peer via the internet.

All the dynamics mentioned change the nature of moral hazard. This needs further investigation. There has been much scholarly research on the intrinsic riskiness of the mismatch between banking assets and liabilities. This mismatch not only results in potential insolvency for a single bank but potentially for the whole system. There has, for example, been much debate on the whether a bank can be too big to fail. As a result of the riskiness of the banking model, the banks of the future will be just a liable to fail as the banks of the past.

This paper presented a revision of the theory of banking in a digital world. In this respect, it built on the work of Klein ( 1971 ). It provided an overview of the changing nature of banking intermediation, a result of the Internet and new digital business models. It presented the traditional academic view of banking and how it is evolving. It showed how this is adapted to explain digital driven disintermediation.

It was shown that the banking industry is facing several documented challenges. Risk is being taken of balance sheet, securitized, and brokered. Financial technology is digitalizing service delivery. At the same time, the very nature of intermediation is being changed due to digital currency. It is argued that the bank of the future not only has to face these competitive issues, but that technology will enhance the delivery of banking services and reduce the cost of their delivery.

The paper further presented the importance of the Open Banking revolution and how that facilitates banking as a service. Open Banking is increasing client churn and driving banking as a service. That in turn is changing the way products are delivered.

Four strategies were proposed to navigate the evolving competitive landscape. These are for incumbents to address customer retention; for challengers to peruse a low-cost digital experience; for niche players to provide banking as a service; and for social media platforms to develop payment platforms. In all these scenarios, the banks of the future will have to have digital strategies for both payments and service delivery.

It was shown that both incumbents and challengers are dependent on capital availability and borrowers credit concerns. Nothing has changed in that respect. The risks remain credit and default risk. What is clear, however, is the bank has become intrinsically linked with technology. The Internet is changing the nature of mediation. It is allowing peer to peer matching of borrowers and savers. It is facilitating new payment protocols and digital currencies. Banks need to evolve and adapt to accommodate these. Most of these questions are empirical in nature. The aim of this paper, however, was to demonstrate that an understanding of the banking model is a prerequisite to understanding how to address these and how to develop hypotheses connected with them.

In conclusion, financial technology is changing the future of banking and the way banks intermediate. It is facilitating digital money and the online transmission of financial assets. It is making banks more customer enteric and more competitive. Scholarly investigation into banking has to adapt. That said, whatever the future, trust will remain at the core of banking. Similarly, deposits and lending will continue to attract regulatory oversight.

Availability of data and materials

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Fintechs: A new paradigm of growth

Over the past decade, technological progress and innovation have catapulted the fintech sector from the fringes to the forefront of financial services. And the growth has been fast and furious, buoyed by the robust growth of the banking sector, rapid digitization, changing customer preferences, and increasing support of investors and regulators. During this decade, fintechs have profoundly reshaped certain areas of financial services with their innovative, differentiated, and customer-centric value propositions, collaborative business models, and cross-skilled and agile teams.

As of July 2023, publicly traded fintechs represented a market capitalization of $550 billion, a two-times increase versus 2019. 1 F-Prime Fintech Index. In addition, as of the same period, there were more than 272 fintech unicorns, with a combined valuation of $936 billion, a sevenfold increase from 39 firms valued at $1 billion or more five years ago. 2 Dealroom.co; McKinsey analysis.

In 2022, a market correction triggered a slowdown in this explosive growth momentum. The impact continues to be felt today. Funding and deal activity have declined across the board, and there are fewer IPOs and SPAC (special purpose acquisition company) listings, as well as a decline in new unicorn creation. The macro environment also remains challenging and uncertain. In such a scenario, fintechs are entering a new era of value creation. The last era was all about firms being experimental—taking risks and pursuing growth at all costs. In the new era, a challenged funding environment means fintechs can no longer afford to sprint. To remain competitive, they must run at a slower and steadier pace.

About the authors

This report is a collaborative effort by Lindsay Anan, Diego Castellanos Isaza, Fernando Figueiredo, Max Flötotto , André Jerenz, Alexis Krivkovich , Marie-Claude Nadeau , Tunde Olanrewaju , Zaccaria Orlando, and Alessia Vassallo, representing views from McKinsey’s Financial Services Practice.

In this report, we examine how fintechs can continue to grow in strength and relevance for customers, the overall financial ecosystem, and the world economy, even in disruptive times. Based on research and interviews with more than 100 founders, fintech and banking executives, investors, and senior ecosystem stakeholders, we have identified key themes shaping the future of fintechs. To help fintechs capitalize on these themes, we also provide a framework for sustainable growth, based on an analysis of the strategies used by long-established public companies that have weathered previous economic cycles.

Fintech growth then and now

The fintech industry raised record capital in the second half of the last decade. Venture capital (VC) funding grew from $19.4 billion in 2015 to $33.3 billion in 2020, a 17 percent year-over-year increase (see sidebar “What are fintechs?”). Deal activity increased in tandem, with the number of deals growing 1.2 times over this period.

What are fintechs?

We define fintech players as start-ups and growth companies that rely primarily on technology to conduct fundamental functions provided by financial services, thereby affecting how users store, save, borrow, invest, move, pay, and protect money. For the analysis of this report, we included the following fintech sectors: daily banking; lending; wealth management; payments; investment banking and capital markets; small and medium-size enterprise (SME) and corporate services; operations; and infrastructure (including embedded finance, and banking as a service). The analysis excluded cryptocurrency, decentralized finance, and insurtech.

The industry fared even better in 2021, thriving on the backs of the pandemic-triggered acceleration in digitization and a financial system awash with liquidity. Funding increased by 177 percent year over year to $92.3 billion, and the number of deals grew by 19 percent.

The funding surge proved to be a one-off event. Funding levels in 2022 returned to long-term trend levels as inflated growth expectations from the 2021 extraordinary results were reanchored to business-as-usual levels, and as deteriorating macroeconomic conditions and geopolitical shocks destabilized the business environment. The correction caused fintech valuations to plummet. Many private firms faced down rounds, and publicly traded fintechs lost billions of dollars in market capitalization. VC funding was hit hard globally and across sectors, dropping to $459.6 billion in 2022 from $683.1 billion in 2021. Fintech funding faced a 40 percent year-over-year funding decline, down from $92 billion to $55 billion. Yet, when analyzed over a five-year period, fintech funding as a proportion of total VC funding remained fairly stable at 12 percent, registering only a 0.5 percentage point decline in 2022.

Looking ahead, the fintech industry continues to face a challenging future, but there are several opportunities yet to be unlocked. Investors are adapting to a new financial paradigm with higher interest rates and inflation, which has altered their assessment of risk and reward. At the same time, the once-in-a-generation technology revolution under way is generating more value creation opportunities. Our research shows that revenues in the fintech industry are expected to grow almost three times faster than those in the traditional banking sector between 2022 and 2028. Compared with the 6 percent annual revenue growth for traditional banking, fintechs could post annual revenue growth of 15 percent over the next five years.

McKinsey’s research shows that revenues in the fintech industry are expected to grow almost three times faster than those in the traditional banking sector between 2023 and 2028.

These trends are also coinciding with—and in many ways catalyzing—the maturation of the fintech industry. Based on our research and interviews, three themes will shape the next chapter of fintech growth. First, fintechs will continue to benefit from the radical transformation of the banking industry, rapid digital adoption, and e-commerce growth around the world, particularly in developing economies. Second, despite short-term pressures, fintechs still have room to achieve further growth in an expanding financial-services ecosystem. And finally, not all fintechs are being hit equally hard during the market correction: fintechs in certain verticals and at particular stages of growth are more resilient than their peers.

Radical transformation of the banking industry

Banking is facing a future marked by fundamental restructuring. As our colleagues wrote recently, banks and nonbanks are competing to fulfill distinct customer needs in five cross-industry arenas in this new era: everyday banking, investment advisory, complex financing, mass wholesale intermediation, and banking as a service (BaaS). 3 Balázs Czímer, Miklós Dietz, Valéria László, and Joydeep Sengupta, “ The future of banks: A $20 trillion breakup opportunity ,” McKinsey Quarterly , December 20, 2022.

At the same time, macro tailwinds are powering the growth of fintechs and the broader financial-services ecosystem. Digital adoption is no longer a question but a reality: around 73 percent of the world’s interactions with banks now take place through digital channels.

Moreover, retail consumers globally now have the same level of satisfaction and trust in fintechs as they have with incumbent banks. 4 McKinsey Retail Banking Consumer Survey, 2021. In fact, 41 percent of retail consumers surveyed by McKinsey in 2021 said they planned to increase their fintech product exposure. The demand—and need—for fintech products is higher across developing economies. In 2022, for example, Africa had almost 800 million mobile accounts, almost half of the whole world’s total. 5 The state of the industry report on mobile money , GSM Association, April 2023.

B2B firms’ demand for fintech solutions also is growing. In 2022, 35 percent of the small and medium-size enterprises (SMEs) in the United States considered using fintechs for lending, better pricing, and integration with their existing platforms. And in Asia, 20 percent of SMEs leveraged fintechs for payments and lending. 6 McKinsey 2022 US SMB Banking Survey, 2022 (n = 955).

To capitalize on this demand, fintechs will need to keep up with fast-evolving regulations and ensure they have adequate resources and capacity to comply. Some European Union member states, such as Ireland, are bringing buy-now-pay-later providers under the scope of financial regulation. 7 Miroslav Đurić and Verena Ritter-Döring, “Regulation of buy-now-pay-later in the EU: New regime on the horizon,” Law Business Research, February 8, 2023. Meanwhile, the US Consumer Financial Protection Bureau aims to issue a proposed rule around open banking this year that would require financial institutions to share consumer data upon consumers’ requests. 8 Farouk Ferchichi, “The US is one step closer to making open banking a reality,” Finextra, January 19, 2023. This would make it necessary for fintechs to ensure they have the available resources and capacity to respond to these requests.

A nascent industry in an expanding ecosystem

The banking industry generated more than $6.5 trillion in revenues in 2022, with year-over-year growth in volume and revenue margins. 9 “ McKinsey’s Global Banking Annual Review ,” McKinsey, December 1, 2022. Given the fintech market dynamics, this suggests there is still plenty of room for further growth in both public and private markets.

In 2022, fintechs accounted for 5 percent (or $150 billion to $205 billion) of the global banking sector’s net revenue, 10 Net revenue equals revenue after risk minus direct costs. according to our analysis. We estimate this share could increase to more than $400 billion by 2028, 11 Estimate based on historical growth at regional level and expert inputs from regional leaders in the banking industry (for example, forecast of roughly 80 percent 2021–22 revenue increase in Latin America). representing a 15 percent annual growth rate of fintech revenue between 2022 and 2028, three times the overall banking industry’s growth rate of roughly 6 percent (Exhibit 1).

Emerging markets will fuel much of this revenue growth. Fintech revenues in Africa, Asia–Pacific (excluding China), Latin America, and the Middle East represented 15 percent of fintech’s global revenues last year. We estimate that they will increase to 29 percent in aggregate by 2028. On the other hand, North America, currently accounting for 48 percent of worldwide fintech revenues, is expected to decrease its share to 41 percent by 2028.

While fintech penetration in emerging markets is already the highest in the world, its growth potential is underscored by a few trends. Many of these economies lack access to traditional banking services and have a high share of underbanked population. Fintechs have had some success in addressing these unmet needs. In Brazil, for example, 46 percent of the adult population is said to be using Nubank, a fintech bank in Latin America—double the share two years ago. 12 Oliver Smith, “Nubank turns $141m profit in Q1 as Brazilian market share nears 50%,” AltFi, May 16, 2023.

Moreover, while the market cap of private fintech companies has increased substantially over the past decade, the sector’s penetration of the public market remains small. 13 Michael Gilroy, Chase Packard, and Leslie Wang, Fintech and the pursuit of the prize: Who stands to win over the next decade? , Coatue, October 24, 2022. In the eight years leading up to October 2022, 44 modern fintechs (those that were founded in 1999 or later and went public after 2014) did an IPO, creating a combined market cap of $0.3 trillion. In contrast, during the same period, there were more than 2,500 legacy public financial-services companies (whose average year of founding was 1926) with a combined market cap of $11.1 trillion. 14 Michael Gilroy, Chase Packard, and Leslie Wang, Fintech and the pursuit of the prize: Who stands to win over the next decade? , Coatue, October 24, 2022.

Not all fintech businesses are created (or funded) equal

Last year was turbulent for fintechs, but there were differences in the fundraising performance of firms based on maturity and segments.

Maturity stage

Companies in the growth stage (series C and beyond) showed the highest sensitivity to last year’s funding downturn, with a sharp year-over-year funding decline of 50 percent. Meanwhile, fintechs in the early seed and pre-seed stages were more resilient and increased funding by 26 percent year over year (Exhibit 2). This funding outperformance of firms in the early and pre-seed stages was a consequence of the longer time to maturity, which gives start-ups more time to get through periods of economic uncertainty and recover any losses before an eventual sale.

Funding for B2B fintech segments last year was more resilient than for those in B2C, with smaller funding declines (Exhibit 3). The two B2B verticals that were least affected were (1) BaaS and embedded finance and (2) SME and corporate value-added services. These two verticals recorded year-over-year funding declines of 24 and 26 percent, respectively. In contrast, funding for payments-focused fintechs dropped 50 percent. Even then, payments and lending received the largest shares of total fintech funding.

Funding for B2B segments grew at more than 25 percent annually between 2018 and 2022, driven by an increasing number of businesses adopting off-the-shelf solutions provided by digital-native firms (including payments, open banking, and core banking technology) to address challenges arising from using legacy banking infrastructure—for example, limited flexibility, slower speed, and high costs.

Many businesses continue to rely on legacy banking infrastructure that limits flexibility and speed and can often be more costly. To address these challenges, businesses are benefiting from using off-the-shelf solutions provided by digital natives for services such as payments, open banking, and core banking technology.

For BaaS and embedded finance, demand is led by customer-facing businesses looking to control their users’ end-to-end experience. Meanwhile, SMEs have been underserved by traditional financial-services providers, despite the fact they represent about 90 percent of businesses and more than 50 percent of employment worldwide. 15 “Small and medium enterprises (SMEs) finance,” The World Bank, accessed October 10, 2023. And in developing countries, the finance gap for micro, small, and medium-size enterprises (MSME) is estimated to be approximately $5 trillion, or 1.3 times the current level of MSME lending. 16 “MSME finance gap,” IFC, accessed October 10, 2023. Fintech firms have successfully addressed some of SMEs’ needs worldwide, especially in developing countries.

The path to sustainable growth

The current churn in the markets makes it prudent for fintechs to define their next move carefully. After all, they are operating in a much different environment than in years past. In their hypergrowth stage, fintechs had access to capital that allowed them to be bold in their business strategy. They could make revenue generation their foremost objective; profits were expected to follow.

The narrative has shifted since last year. The time between funding rounds for fintechs increased by more than five months from the first to the fourth quarter of 2022. The average value of funding rounds decreased by 50 percent over the same period. 17 “SVB’s challenges will accelerate valuation down rounds, startup mortality, and layoffs,” CB Information Services, March 15, 2023. These changes are forcing fintechs to find newer ways to extend runways and adjust their operating models to make decreasing amounts of cash last longer.

The days of growth at any cost are behind the industry, for now at least. In a liquidity-constrained environment, fintechs and their investors are emphasizing profitability, not just growth in customer adoption numbers or total revenues. “In the past, the reward went to fintechs that showed growth at all costs, which led to healthy valuations,” said one Africa-based growth equity investor. “Now it is about the sustainability of the business, the addressable market, and profitability.”

In a liquidity-constrained environment, fintechs and their investors are emphasizing profitability, not just growth in customer adoption numbers or total revenues.

So how can fintechs get on a path of sustainable, profitable growth?

In 2019, McKinsey conducted an in-depth study of the growth patterns and performance of the world’s 5,000 largest public companies over the preceding 15 years. The researchers’ analysis identified ten rules for value-creating growth. 18 Chris Bradley, Rebecca Doherty, Nicholas Northcote, and Tido Röder, “ The ten rules of growth ,” McKinsey, August 12, 2022. According to the research, companies that set growth strategies addressing all available pathways to growth were 97 percent more likely to achieve above-peer profitable growth. 19 “ Choosing to grow: The leader’s blueprint ,” McKinsey, July 7, 2022.

This set of rules adopted by public companies that have lived through economic cycles and periods of uncertainty can also be useful for fintechs as they transition to a sustainable growth model. Based on our analysis of these rules and interviews with more than 40 fintech industry leaders, we expect four pathways to deliver the most impact for fintechs.

Cost discipline

When fintechs had access to abundant cash and funding was easy, they placed more emphasis on growing rapidly than on managing costs. Targeted cost savings have become a bigger priority today, as fintechs seek ways to lower expenses and achieve profitability while maintaining customer satisfaction and pursuing customer growth and acquisition. Our research has found that 50 percent of public fintechs (following their IPO) were profitable in 2022. And the key differentiator between profitable and nonprofitable fintechs was cost management, not revenue growth (Exhibit 4). While both categories recorded year-over-year revenue growth of 13 percent, profitable fintechs posted a median 3 percent decrease in costs. Nonprofitable fintechs, in contrast, saw costs rise by 27 percent, which affected their profit margins.

Successful implementation of cost management efforts is the key for fintechs in their next phase of evolution. Several leaders are already making moves: 60 percent of our survey respondents said their firms are significantly managing costs. An executive at an African mobile payments firm said they are now negotiating every cost and making sure the firm is thinking for the long run.

Consider the example of the Indian fintech company Paytm, which specializes in digital payments and financial services. The firm had had a target of achieving breakeven by September 2023 but was able to achieve this six months ahead of schedule. It did so through disciplined cost management, revenue growth across businesses, and a business model with strong operating leverage. 20 “Our discipline in cost management sustains and grows profitability,” Paytm, February 20, 2023.

While fintechs establish a clear focus on costs, they should also consider adjusting how they operate, thereby creating a more agile and flexible organization that can deal with the current environment. Around 80 percent of the interviewed fintechs report that they are currently making changes to their operating models. Of these, 66 percent cite a focus on profitability and a sustainable cost structure as being among their top three reasons. Such adjustments to the operating model are most sustainable when institutions also reinforce the control functions to protect customers and stay on top of regulatory changes.

A shift from hypergrowth to sustainable growth would also result in a greater focus on strong unit economics. To do this, fintechs ensure that the profitability view is embedded across the business. For example, assessment of the value of adding new customers would evolve from efficiency-only metrics such as the customer acquisition cost (CAC) to a more holistic approach. In this example, one way to embed profitability into acquisition investment and decision making is to compare the CAC with the projected lifetime value (LTV) of a customer, using the LTV/CAC ratio to assess the marginal return on investment for acquiring every new customer. In Latin America, for example, 68 percent of fintechs self-reported an LTV/CAC greater than five, which indicates a potential for fintechs to increase spending and further fuel growth without sacrificing profitability.

Measured growth

As leaders develop growth strategies, an important question is where growth should come from. Fintechs can grow sustainably by taking three steps: building a strong core, expanding into adjacent industries and geographies, and shrinking to grow. Identifying which steps will be most accretive to growth will depend on the unique circumstances of each fintech; some might find value in pursuing all three steps, while others could choose to focus on one. Regardless of the circumstances, this decision will have greater longer-term consequences in the current environment, compared with the earlier high-funding phase.

Focus on building a strong core as a precursor for expansion

The first step in cracking the growth code involves focusing on the local market and developing a healthy core business. According to our research, companies that focus on their core business and have a strong home market are 1.6 times more likely to generate peer-beating returns. 21 Chris Bradley, Rebecca Doherty, Tido Röder, and Jill Zucker, “ Growth rules: Which matter most? ,” McKinsey, March 6, 2023.

For fintechs, the key will be to relentlessly focus on growth in their core business. As a North American fintech executive told us: “It’s a bit of back to basics. On a core product or offering, 18 to 24 months ago, you would have built additional pieces on it to upsell and cross-sell. Now, we’re looking to double down on the core business and make sure it’s a stable, viable operation.”

To do this, fintechs must tailor their value propositions to their focus markets. Let’s take the example of B2C fintechs. Our recent research (McKinsey’s Retail Banking Consumer Survey and Global Banking Pools ) quantified the potential drivers for growth at B2C fintechs. Cross-selling will likely drive growth for fintechs in emerging economies, while those in developed countries will likely see greater growth from capturing new customers. Around 72 percent of revenue growth for companies in Brazil, for example, is expected to come from cross-selling, in contrast with 25 percent and 30 percent for the United Kingdom and the United States, respectively, with the remaining growth coming from new customers (Exhibit 5). There is arguably less potential for new-customer development in developing economies, given their high fintech penetration.

Across the competitive landscape, as markets are highly heterogenous, a dedicated strategy for each region is recommended. For example, our analysis found that in the United Kingdom and the United States, fintech revenue share is split almost equally between incumbent digital banks and pure fintech players. In contrast, digital incumbents in Germany and pure fintech players in Brazil could dominate banking’s revenue share in their respective markets.

Expand into adjacent segments and geographies

After building a strong core, fintechs can consider expanding into other segments and geographies as a second source of growth. According to our previously published research, companies that do so are 1.2 to 1.3 times more likely to generate sizable returns than peers that focus solely on their core. 22 Chris Bradley, Rebecca Doherty, Tido Röder, and Jill Zucker, “ Growth rules: Which matter most? ,” McKinsey, March 6, 2023.

Today, however, expansion is no longer a must-do strategy. It may be most advantageous for companies that have strong footholds in their core markets and can use some competitive or ownership advantage to expand elsewhere. The key is to pursue measured, value-creating growth. A case in point is OPay, which started as a mobile money platform in Nigeria and has since expanded across financial-services verticals. OPay now offers peer-to-peer payments and merchant and card services.

Shrink to grow

Fintechs are moving from hypergrowth to sustainable growth, but that growth may not necessarily be consistent across all parts of the business. If fintechs divest from underperforming parts of their portfolios and scale back from regions recording limited growth, they can reinvest that capital into high-performing segments—a strategy we call “shrinking to grow.” In our research, companies that use this approach are 1.4 times more likely to outperform their peers.

“In the past, many fintechs expanded geographically, even if it didn’t make much sense,” an executive at a Latin American fintech told us. “Now they will have to focus on their profitable segment and geography and stop expanding where they are not.”

Some fintechs have been deliberate about using a shrink-to-grow strategy, changing track if an expansion strategy did not materialize as expected or the local market had more potential for growth. German robo-adviser Scalable Capital, for example, announced plans to discontinue its Swiss operations as of 2020 to focus on other markets because the implementation of the Financial Services Act in Switzerland would have required the company to manage two regulatory frameworks simultaneously. Meanwhile, Wealthsimple, a Canadian online investment platform, exited from the United Kingdom and the United States in 2021 to concentrate on its local retail market and expand its product portfolio into new financial-services areas. Similarly, in late 2020, San Francisco–based fintech LendingClub shut down its retail peer-to-peer platform called Notes to focus on other products.

Programmatic M&A

Many companies will conclude they can achieve the steps outlined in this report—launching new features, building new capabilities, and pivoting toward new revenue streams and segments—more swiftly through thoughtful acquisitions and partnerships than by relying on pure organic development. Fintech firm Block, for example, completed its acquisition of the buy-now-pay-later platform Afterpay in January 2022 to accelerate its strategic priorities for its seller and cash app ecosystems. 23 “Block, Inc. completes acquisition of Afterpay,” Block, January 31, 2022. Nearly 60 percent of fintech executives in our survey told us they are considering an acquisition in the next 18 months.

Moreover, with IPO and SPAC (special purpose acquisition company) activity slowing considerably since last year, many fintechs that might otherwise go public are turning to private markets for funding. Take the example of the British fintech Zopa, which intended to list by 2022 but eventually decided to put IPO plans on hold in response to challenging market conditions. In the interim, the firm has been raising capital from its shareholders, including $92 million in February. 24 “Zopa raises £75 million,” Zopa Bank Limited, February 1, 2023.

M&A transactions increase significantly during periods of economic uncertainty, when they also tend to deliver higher returns. During the global financial crisis, around 45 percent of banking M&A deals showed positive excess two-year total shareholder returns (TSR) between 2007 and 2009. 25 As of the year of the deal’s announcement. In comparison, less than 30 percent of banking deals posted positive excess two-year TSR between 2010 and 2020. 26 McKinsey Fintech Quarterly Radar, Q1 2023. Across industries, companies actively making acquisitions worth 10 percent or more of their market cap in total had an average TSR of 6.4 percent between January 2007 and January 2008, compared with −3.4 percent for the less active companies. 27 Brian Salsberg, “The case for M&A in a downturn,” Harvard Business Review , May 2020.

However, not all M&As are successful. Many fail to create value due to contrasting values and cultures, mismatched product–market fit, and inflated revenue forecasts in the pursuit of customer engagement and growth at all costs.

Keeping the culture alive

What has made fintechs so disruptive over the years? The answer lies largely in their ability to innovate and differentiate. Since fintechs are not as encumbered by legacy systems and processes, they can be more agile in using emerging technologies to anticipate and solve customer needs. Typically, they also have a customer-centric and collaborative approach to deliver innovation with cross-skilled teams.

Innovations have happened across fintech verticals. Neobanks like Chime and Monzo, designed around a simple and intuitive user experience, have changed assumptions about the role of branches in traditional retail banking. In the United Kingdom, for example, the total number of bank and building society branches fell by 40 percent between 2012 and 2022. 28 Lorna Booth, Statistics on access to cash, bank branches and ATMs , House of Commons, September 1, 2023. Robo-advisers such as Wealthfront and Nutmeg disrupted the traditional wealth management industry by offering low-cost, accessible alternatives to individuals lacking access to personalized financial advice. Funding Circle introduced the peer-to-peer lending concept to the financial sector, bypassing traditional banks (which had owned this relationship) and enabling direct lending between parties.

Incumbents are fast catching up with these innovations by ramping up investments in new technologies. Around 94 percent of banks in a recent survey said they plan to invest more in modern payments technology to support end user demand for better payment capabilities over the next two to three years. Of these, 65 percent said they intend to make significant or moderate levels of investment. 29 “94% of banks eyeing investment in modern payment tech, to keep pace with fintech innovation,” Finastra press release, March 8, 2023. Many incumbents are also partnering with BaaS platforms to overhaul their digital capabilities. Examples include Fifth Third Bank’s acquisition of Rize Money in May 2023 and NatWest Group’s partnership with Vodeno Group in October 2022 to create a BaaS business in the United Kingdom.

Generative AI and the future of banking

Artificial intelligence (AI) technologies are increasingly integral to the world we live in, and investors are taking notice. Generative AI is among the advanced technologies for which investments are accelerating, thanks to its potential to transform business. According to McKinsey research published in June 2023, generative AI could add the equivalent of $2.6 trillion to $4.4 trillion annually  across as many as 63 use cases.

Generative AI’s impact on the banking industry will be significant, delivering benefits beyond existing applications of AI in areas such as marketing. As our colleagues have written, this technology could generate an additional $200 billion to $340 billion annually in value, arising from around 2.8 to 4.7 percent increase in the productivity of banking’s annual revenues—if the use cases are fully implemented. 1 “ The economic potential of generative AI: The next productivity frontier ,” McKinsey, June 14, 2023. For fintech, we expect a commensurate impact, if not more, given the already high exposure to tech.

Generative AI’s impact—and resulting reinvention—will span three broad categories:

• Automation. Half of today’s work activities could be automated between 2030 and 2060, according to McKinsey estimates. 2 “ The economic potential of generative AI: The next productivity frontier ,” McKinsey, June 14, 2023. Fintech firm Intuit, for example, has introduced a generative AI operating system on its platform. Its custom-trained large language financial models specialize in solving tax, accounting, cash flow, and personal finance challenges, among others. 3 “Intuit introduces generative AI operating system with custom trained financial large language models,” Intuit press release, June 6, 2023.
• Augmenting and enhancing productivity to do work more effectively. Generative AI could enable labor productivity growth of 0.1 to 0.6 percent annually through 2040, depending on the rate of technology adoption and redeployment of workers’ time to other activities. Morgan Stanley is building an AI assistant using GPT-4 to help the organization’s wealth managers quickly find and synthesize answers from a massive internal knowledge base. 4 “Morgan Stanley Wealth Management announces key milestone in innovation journey with OpenAI,” Morgan Stanley press release, March 14, 2023.
• Acceleration. Organizations can use generative AI to extract and index knowledge to shorten innovation cycles, thereby enabling continuous innovation.

To capture these opportunities, fintechs need an ecosystem of capabilities and partners that will allow them to move fast. First movers will accrue competitive advantage as they build their capabilities and mobilize with a focus on value, rather than rushing to deliver pilots. To do this, fintechs should consider investing more in people and change management, given generative AI’s unique potential to influence the future of work. Fintechs could think about developing a medium- to longer-term talent strategy and find ways to emphasize change management and adoption. Fintechs that delay building their capabilities risk becoming the disrupted instead of the disruptors.

To retain their competitive advantage, fintechs must continue to innovate. The next big disruptor is always around the corner. Technologies like generative AI are predicted  to revolutionize the competitive landscape of finance over the next decade (see sidebar “Generative AI and the future of banking”). WeBank’s CFO Arthur Wang is one executive who appreciates the urgency. He told us, “Even though our bank has been around for almost eight years, we consider ourselves a start-up. We’re always exploring better fintech technology. WeBank’s strategy is to provide better, more inclusive financial services—to the mass population as well as small and medium-size enterprises—with leading technology. We do business 100 percent online, so we rely on technology.” 30 See “ Making financial services available to the masses through AI ,” McKinsey, August 9, 2022.

A tight labor market has also made it more challenging for fintechs to attract and hire tech talent. Our survey uncovered a shift in the perception of fintechs as riskier employers. As a Europe-based fintech executive told us: “Fintechs are less attractive now because it is clearer that it is a ‘high risk’ job compared with established institutions. On the other hand, large fintechs are laying off, which can create a new pool of talents to attract.”

In such an environment, fintechs must work toward strengthening their culture and mission and, consequently, their hiring strategy. One European payments fintech, for example, has differentiated strategies based on the profile of open roles. An executive at the firm says it has been easier to recruit people for junior roles, since these workers are more eager to join a growing organization. “It is a different story with experienced profiles—for example, management team or 35-plus years—where recruiting is more difficult and retention is crucial,” he said. To attract such people, the firm offers stock options and other incentive packages. Meanwhile, an Africa-based payments and remittances fintech casts a more global net: “We hire globally, regardless of location, gender, or race,” an executive told us. “We have no quotas and try to just find the best person for each role.”

The fintech industry is undergoing a sea change, so players will have to evolve to survive. Approaches will vary, depending on each fintech’s maturity level and its vertical and geographic focus. The framework for sustainable growth, described in this report, provides a strong foundation:

• Measured growth based on a stable core. Ensure there is a strong and stable core business with a targeted and proven market fit before expanding, rather than trying to grow while strengthening the core.
• Programmatic M&A. Pursue M&A strategically and establish mutually beneficial partnerships based on a programmatic strategy rooted in value sharing (with incumbents and other fintechs), as opposed to pursuing M&A only as a response to a low-valuation environment.
• Cost discipline. Control costs to withstand the new funding environment while remaining flexible, nimble, and compliant.
• Keep the culture alive. Maintain the agility, innovation, and culture that have been the bedrock of disruption so far.

Decisions taken today will likely set the pace for fintechs over the mid to long term. The present conditions therefore call for a careful evaluation and focused implementation.

Lindsay Anan is an alumna of McKinsey’s San Francisco office, where Alexis Krivkovich and Marie-Claude Nadeau are senior partners; Diego Castellanos Isaza is a consultant in the London office, where Fernando Figueiredo is a partner and Tunde Olanrewaju is a senior partner; Max Flötotto is a senior partner in the Munich office; André Jerenz is a partner in the Hamburg office; and Zaccaria Orlando and Alessia Vassallo are associate partners in the Milan office.

The authors wish to thank Sonia Barquin, François Dorléans, Carolyne Gathinji, Eitan Gold, Carolina Gracia, Sheinal Jayantilal, Uzayr Jeenah, Yelda Kayik, Mayowa Kuyoro, Marina Mansur, Farid Minnikhanov, Bharath Sattanathan, Rinki Singhvi, and Katharine Watson for their contributions to this report.

This report was edited by Arshiya Khullar, an editor in the Gurugram office.

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