Financial services and technology analyst Cristopher Kennedy digs into his report on the banktech industry, exploring the rapid adoption of digital banking and the resulting surge in app-based consumer engagement, the evolving regulatory landscape, and the importance of technology investments for the sector.

Podcast Transcript

Chris T.
Welcome back everybody. On today's episode of William Blair Thinking Presents we welcome Cristopher Kennedy. He's an equity research analyst who focuses on the financial services and technology sector for William Blair. Cris and his team released a report called “Digital Banking, Business Banking, Embedded Finance/BaaS, Cloud Cores and More” with the goal of providing a broad update on the Banktech market, examining macro trends driving the industry and even analyzing financial performance of large providers during the Great Financial Crisis.

So, with that, Cris, I appreciate you being here. To start, I thought you could give us a bit of background on what this report is about, mainly high level. And then what inspired you to write the report in the first place, and maybe why Banktech in particular is of such interest to you.

Cris K.
Sure. Thanks, Chris. Appreciate you having me here. So we just returned from a user conference. And at that user conference, we spent a lot of time with people that live and breathe this stuff every day. The main takeaway was how important technology is for banks and credit unions. As you know, banking is a very competitive environment. And the technology is one way that these companies can compete in the market. It's a very interesting sector because like any industry, the world is always evolving. And consumer behavior is always changing. And financial institutions need to adapt and drive change, and they do that through technology.

Now, there's too many innovations in technology in banking to mention here, but for example, Credit cards began in the 1950s. That really changed the way people paid for things. ATMs started in the 1960s. That changed the way people use bank branches. Then you had banking by the phone that was a thing in the 1980s. Banking on the internet was a thing of the 1990s, so on and so forth. It's a never-ending journey and each of these cases, was driven by technology.

And lastly, I'd say that these innovations also changed consumer behavior as consumers become more comfortable using these new services. You're seeing that today with people managing their financial lives on their smartphone. I remember several years ago, people were not comfortable buying something online, because of concerns about the legitimacy of that process. But that is clearly changed. And those are the dynamics and the tailwinds that Banktech providers enjoy.

Chris T.
So, let's dive a bit into some of the key industry trends that you lay out in the report. I figured we'd start first with your research around digital banking solutions. You mentioned that digital transformation has significantly altered the way that individuals interact with financial institutions and consumer financial services. You mentioned the pandemic further accelerated this shift. I’d love to know how.

Cris K.
So in the old days, we used to rely on the bank branch to interact with our financial institution. Then ATMs came around and made that more convenient. Fast forward to today, everyone's got a smartphone. Consumers are very comfortable doing almost anything on these devices including managing your finances.

The digital channel is now the primary method that people access their bank accounts. I think the numbers went from less than 40% back in 2013 to over 66% in 2021, according to the FDIC. So clearly, consumers are embracing digital solutions.

We fast forward to the pandemic, everyone had a smartphone but we were locked down. Bank branches were open, I believe. But no one clearly wanted to go there. So consumers rely on their smartphones to do banking services. So that's just another example of the change in behavior driven by technology.

The other aspect of the digital transformation in digital banking is how consumer expectations have changed. I think we all expect and demand a seamless experience. So whether it's ordering a taxi through your phone or tapping your phone to buy something, we want that seamless digital experience, you know it when you see it, you'd like it and consumers expect this type of experience with their local bank or their local credit union. And that type of experience can be provided through strong digital banking solutions.

What does this all mean? It means that Consumers are interacting with their bank more than ever. I’m not sure the last time you visited a bank branch, but I had seen a statistic that said on average the consumer went to a bank branch about 10 times per year.

Chris T.
Sounds about right.

Cris K.
And today, the average consumer will interact with their bank through a banking app about 300 times per year. That's a lot more consumer engagement. That does a lot of good things for both the consumer and the financial institution. If the financial institution knows you better, they understand your needs, and they can provide solutions to meet those needs.

But keep in mind there are over 9000 banks and credit unions in the United States. If you look at the largest banks, they spend about $15 billion a year in technology investments. That's just one institution’s investment to capture the trends that we just talked about. Now most banks and credit unions do not have anywhere near 15 billion of assets or anywhere near that type of IT budget. So they rely on third parties to remain competitive and to adapt. And that's where banks and Banktech providers come in. At the core, Banktech provides their customers the ability to compete in a market and to remain relevant.

Chris T.
What about business banking and b2b payments? I know in your note you call out that small community financial institutions are underweight when providing business banking solutions to small and medium sized businesses. And that meeting the unique needs of serving SMB clients represents a large opportunity for financial institutions. Do you mind just breaking it down a bit for us?

Chris K.
Sure. It's a similar concept, but instead of focused on consumers, it's really working with and a focus on small and medium sized businesses. So in the US, there are over 30 million small businesses. We've seen statistics that over 80% of them rely on a Top 25 Bank to meet their banking needs. And like I said, there's over 9000 banks and credit unions in the United States that operate in these communities where these businesses are located and these financial institutions should be serving their local businesses. Serving these businesses represents a nearly $400 billion revenue opportunity for these financial institutions. And that's really what the opportunity is through digital banking.

Now, I think they can capture this by providing strong service, which is a hallmark of community financial institutions, but technology is also a part of that aspect. These solutions can include accounts payable or accounts receivable, software business to business payments, working capital lending. There's a whole host of services that these institutions can provide. That should be at the fingertips of a business operator at their local bank or credit union. And this could be done through a digital offering. So we think we're earlier in this transition on the commercial banking side relative to the consumer side. There's clearly an opportunity with the same concepts.

Chris T.
Let's move on to your section around embedded finance and banking as a service. I think it'd be helpful if you could just break down what both areas are and maybe why they can be beneficial to both non-financial and financial institutions.

Chris K.
Sure. So we did a white paper on this topic last year, and it's all related. But embedded finance at the core is the integration of financial services into a business process, a website or digital app. One of the largest technology companies that we all know, they have an ecosystem. In that ecosystem, you can listen to music, you can watch TV, you can also get a credit card, a savings account, a debit card, insurance, what have you. And those are all examples of embedded finance. Consumers like it because it's a seamless experience. The brand likes it because it represents revenue opportunities and it helps create a stickier customer. And these experiences are powered by both financial institutions and fintech companies, and they're enabled by open banking and banking as a service.

Open banking is the provisions access to financial data. I like to think of it as the exchange of financial data outside of a financial institution. Now, this has been around for a while. Its technology is improving, and consumers appear more comfortable sharing data, and the regulatory environment is helping accelerate that trend. Clearly, more data can drive more value.

Banking as a service enables essentially any brand to utilize a financial institutions product suite and or their regulatory capabilities. So the large technology company that we talked about, which is not a bank, can seamlessly offer you an FDIC insured account by working with a bank and a fintech. This is a massive opportunity. Embedded finance is estimated to exceed $7 trillion by 2026. That represents a $40 to $50 billion revenue opportunity for companies in the ecosystem. We've seen data that shows that banks that participate in the banking-as-a-service market can generate higher returns whether that's higher ROA or ROE, what have you, so it's a clear opportunity within that market.

Chris T.
So obviously, it's a clear opportunity, financial opportunity for banking-as-a-service. But then there’s also this regulatory risk that is rising for the space. Do you mind just talking about what the risks there are and then how it might impact the space overall?

Cris K.
Sure, just because of the large market opportunity, there's a lot of companies that are going after that market, there's been a lot of growth in the industry. This technology is changing fast. It's probably ahead of where the regulators are, but we've seen data that suggests a number of banks that are focused on banking-as-a-service has nearly doubled over the last couple of years, but it still stands at less than 140 institutions in the market.

That's a relatively small set out of the 9000+ institutions in the US when you look at the amount of regulatory activity against banking-as-a-service banks. I think there was one activity back in 2002. It was five last year, and so far this year, there's been five year to date. There's a very small sample set, but clearly a trend that's worth watching.

I think every regulatory action has been different. Several have to do with managing third party relationships because we have a fintech involved. We understand that the regulators are trying to create a framework to help better manage these risks, but it's clearly something that that's worth watching.

Chris T.
Got it. Let's touch a bit on your section that breaks down the bank tech spend environment and then bank health as a whole. I know that you mentioned that many US financial institutions remain in a relatively healthy position and obviously, some exceptions exist, but they're in a pretty good position to navigate the environment in 2024. How so from your point of view.

Cris K.
Sure. So first off, we're not bank analysts, but the data that we've looked at suggests that financial institutions remain in a good position. Industry profits have come down about 10% since the peak in 2021. They remain solid at over $270 billion. Obviously, we've had a few big failures over the last 18 months, but it's been very concentrated to a handful of situations. Interest rates are clearly our topic to watch. But in our view, the market is relatively healthy.

Chris T.
Let’s also touch on your section about financial institution consolidation. You say it's now concentrated at the smallest institutions. Why is this the case and do you expect more of this consolidation to continue?

Cris K.
Sure. So there were 30,000+ institutions back in the 1930s. Now there are just over 9000 institutions in the US. If you look at the data over the last 20 years, the number of institutions have been declining at about a three and a half percent clip per year. Most of the consolidation has come from the smallest institutions that would be banks with less than 250 million of assets, credit unions with less than 50 million assets. Collectively those institutions have fallen about 6% per year, while the larger institutions have actually grown about a percent per year. I think that's an interesting dynamic that would surprise most people and you don't really see that dynamic changing. Why is this happening? It's because it's a very competitive market and competition is fierce and in order to remain relevant, we need to keep up with industry trends.

Chris T.
Well, Cris, this has been great. Before we go, I figured as a last question you could briefly touch on IT spending and why bank technology providers are positioned to navigate any potential slowdowns in the future well. Which was the last part of this report

Cris K.
Sure. So as I mentioned, we spent a lot of time with bank operators and credit union operators and it's clear that they understand the need for strong technology solutions in order to remain competitive and to ultimately grow their business. And because of a lot of the trends that we talked about today, it's our view that bank IT is not discretionary, and companies that provide strong solutions are in a good position for future growth.

Chris T.
Terrific. Thank you again for joining Cris. For those interested you can go ahead and request a copy by reaching out to us at or reach out to Cris directly. Thanks again for taking the time to be with us today. Hopefully we can do it again sometime soon.

Cris K.
Thank you, Chris.