Banks and financial technology startups are learning to cooperate as well as compete — and consumers at every income level will be the winners.

The traditionally buttoned-up U.S. banking industry is not immune to the digital disruption that has upended almost every other area of business. As loyalty to traditional banks dwindles and more consumer activity takes place via smartphones, the financial services industry is turning to financial technology (generally known as fintech) to reach new customers, improve service to the ones they have, and perhaps even tackle the global problem of socioeconomic inequality.

Banks initially considered the emergence of fintech startups a competitive threat. However, as the field matures, the two are becoming as likely to collaborate as to compete. The resulting push and pull between new and established institutions is transforming the consumer finance industry, guiding people toward better financial decisions, expanding access to credit, and delivering more innovative services to more people in less time, often without requiring them to set foot in a branch office. And unsurprisingly, the Tepper School of Business is not just studying this innovation, but helping to steer it.

The new world of banking

When the birth of the smartphone collided with the aftermath of the 2008 financial crisis, the consumer banking industry went into a customer relationship tailspin. Digital commerce accelerated. Social media emerged and began driving customer activity. Smartphones became ubiquitous. Companies in other industries started leveraging big data to deliver seamless real-time personalized service through individual mobile apps. Next, businesses began linking apps to provide a unified digital experience — for example, allowing someone to tell a friend where they’re meeting, send the friend a map, hail a ride and pay for the ride, all within a popular messaging app.

Today, customers have come to take that level of service and support for granted, and they’re disappointed in banks that fail to deliver what are often considered basic operations. Inevitably, fast-moving fintech startups have emerged with more accessible, affordable approaches to services like lending and payment transfers, luring away existing customers who have lost trust and loyalty in legacy institutions.

There’s lots more to know about customers, but we don’t necessarily have the tools to know it.
— Gunjan Kedia, MSIA ’94

At the same time, fintech startups have demonstrated the existence of enormous unsatisfied demand for financial services among the unbanked and underbanked — a demand so vast that one in 10 applicants for the 2016 class of Startupbootcamp FinTech, one of a global collective of industry-specific startup accelerators, aimed to tackle issues of financial inclusion. Many of the resulting solutions focus on the millions of people worldwide who have little or no access to traditional banking but do have mobile phones. Others provide services to those who don’t earn enough to maintain a bank balance or who can’t get credit because an adverse event like illness, divorce or unemployment has stained their financial history. Yet more solutions target people who can’t find the products and services they need at traditional banks, often because they’re new to the job market or have no credit history in the United States.

At first, banks took on these direct challenges from fintech companies by developing their own competing technologies to win back former customers and lure in new ones. Over time, however, they’ve moved toward a more cooperative model of acquisitions and partnerships. The result is a vibrant ecosystem of both emerging and established companies that are setting new standards for banking best practices.

Methods of disruption

After revolutionizing online payments in the early days of e-commerce, online financial pioneer PayPal is now transforming as technology evolves. Mobile transactions made up just .05 percent of PayPal’s total payment volume in 2007, the year the first iPhone was released, but almost a third — more than $33 billion — in 2016, said Gordon Sheppard, MSIA ’86, lead product manager for PayPal’s risk platform.

One way PayPal continues to innovate in fintech is in finding new ways to use growing amounts of transaction data to create new services. For example, it applies sophisticated analysis to patterns of transactions to detect fraud in seconds rather than hours. “Machine learning and data models give us contextual information to understand where you are and what you’re doing so we can determine, for example, if it’s really you making a transaction in a foreign country,” Sheppard said. 

PayPal is also part of the fintech trend toward finding new ways to assess people’s eligibility for credit. The company’s Working Capital program, for example, offers credit to small business owners based on their past use of PayPal.

Another company reinventing credit is SelfScore, which Kalpesh Kapadia, MSIA ’99, founded in January 2013 after his sister arrived from India as a student with no U.S. credit record. Without Kapadia to co-sign her apartment lease, credit card application, student loan and even the lease for the car she needed to get to her paid internship, his sister would have struggled — a dilemma he remembered many of his international classmates encountering.

“There are 1.1 million international students in the U.S. spending $32 billion each year, which is an enormous market,” Kapadia said. “I wanted to make a bet on them by offering them credit.”

SelfScore offers a private-label MasterCard that requires no Social Security number, no cash deposit and no co-signer. The company uses a proprietary credit scoring method that Kapadia claims has a 92 percent correlation to the FICO credit score, but is based on educational history, existence of personal or family assets, prediction of future earnings, lasting identifying characteristics like phone number and mailing address, digital identity verification from social media, and other signifiers of future financial stability. The SelfScore credit card carries a 19.49 percent APR after the first six months without interest, and Kapadia notes that the company excuses the first late payment and offers a higher credit limit at better terms later to customers who manage their accounts responsibly.

SelfScore currently serves international students from 126 countries attending 662 American universities, but CEO Kapadia has his eye on a bigger prize: “We want to expand to serve all millennials,” he said. “Credit bureaus are stuck in the past. They’re no indicator of the future.”

High-cost areas in the banking industry, like retail services and wealth management, are ripe for disruption.
— Ashish Jain, BSBA ’03

New approaches to underwriting credit risk don’t apply only to millennials who couldn’t otherwise get a credit card. SoFi, a personal finance company focused on lending and wealth management, opens doors to financial services often unavailable to those without a strong credit history. SoFi, which stands for “social finance,” considers education, career experience and monthly income versus expenses as it considers whether to approve a potential “member,” said Ashish Jain, BSBA ’03, senior vice president of capital solutions. The combination of additional data and automation lets SoFi process loan applications about twice as fast as a standard bank and offer life insurance quotes in minutes without medical tests, he said.

“We provide a fast, transparent, easy process for getting financial services to a customer demographic that doesn’t have an affinity with retail banks and wants to do everything quickly on their smartphone,” he said.

The demographic in question is the global group of millennials who have just emerged from college into high-paying jobs but haven’t yet established a financial history. They’re known as “HENRYs” — High Earners, Not Rich Yet. SoFi’s business model is predicated on gaining their lifelong loyalty while they’re still financing their student loans, then retaining it as they develop a need for mortgages, personal loans, wealth management services and life insurance.

SoFi bolsters these services by offering hosting informational events in 60 cities around the United States, as well as a career advisory group that helps members navigate questions like how to get a raise. After five years, SoFi has more than 260,000 members, 40 percent of them acquired through referrals, with plans to grow to 2 million members in five more years, Jain says.

The company is also growing: It raised $500 million in venture capital in February, boosting its estimated valuation to $4.3 billion, according to a report in Fortune. The same report indicated SoFi would be introducing a checking account in the first half of 2017, providing more services to its members.

Tradition, moving forward

Unlike SoFi, many fintech startups operate outside the heavily regulated financial services industry, which frees them to think outside regulations. That makes them harder for banks to compete with — but it also makes it harder for them to compete with banks. This may explain why a recent report by consulting firm PwC and Startupbootcamp FinTech found that banks and startups are moving toward greater collaboration.

“As innovative as they are, sometimes it seems that fintech startups underestimate the regulatory and trust requirements of the banking and financial services industry, which are substantial. Those realities have to be taken into account for any partnership to be successful,” said Gunjan Kedia, MSIA ’94, vice chairman of Wealth Management and Securities Servicing for Minneapolis-based U.S. Bank, the fifth largest commercial bank in the country. “When done right with the correct understanding, partnerships with startups are wonderful. They make us better. Banks benefit from their thinking.”

Large incumbent banks now have to be technology companies, even though that’s not in their DNA.
— David Passavant, MBA ’09

U.S. Bank is a partner in Zelle, a new payments network owned by major banks that allows fast, secure person-to-person money transfers via mobile app. The bank also has multiple internal businesses, which Kedia is responsible for enhancing with technology.

One of them is wealth management, one of the fastest-growing areas of fintech investment both in general and at U.S. Bank. The bank is rolling out robo-advising and artificial intelligence that will ask customers questions about their goals and lifestyle, provide automated advice based on the answers, and guide them to a human advisor who can flesh out the suggestions via the digital channel of the customer’s choice. Far from replacing human agents, the technology makes the human connection more effective, Kedia said. “The cutting edge today is not just real-time access and interaction. It’s also about delivering in digital form the trustworthiness, validation and advice people used to get at their bank branch.”

Tepper School: Bringing finance and tech together

It’s not enough for large incumbent banks to work with technology firms. They essentially have to become tech companies themselves, said David Passavant, MBA ’09, senior vice president of enterprise innovation at PNC Bank. Otherwise, they can’t fully leverage all their assets — not just huge data sets stretching over years, but longstanding customer relationships, institutional memory and established distribution channels from the consumer website to the business sales team.

That’s what drove PNC to partner with the Tepper School to create the PNC Center for Financial Services Innovation, which brings finance, academia and Pittsburgh’s thriving fintech startup ecosystem together to understand how customers behave in the digital economy.

“Tepper is right down the road, and as virtual as society has become, there’s a benefit to sitting in a room and talking through problems together,” Passavant explained. “There’s also no disputing that the Tepper School is a leader in analytics, computational finance, operations and technology leadership. And finally, the school is a conduit to the rest of the CMU campus, which allows us to take a powerful multidisciplinary approach that includes technology, business, marketing and psychology.”

Incubating FinTech Innovation. . .

Five years into its mission of advancing financial services through technology innovation, the PNC Center for Financial Services Innovation is moving to the next step: converting research into tangible products and services.

In January, the Tepper School and PNC announced the creation of numo, a technology incubator that will operate as a subsidiary of PNC with the mission of creating fintech from within the bank.

“The incubator is PNC’s response to the challenge of becoming a great technology company,” said David Passavant, MBA ’09, senior vice president of enterprise innovation at PNC. “We created it to supercharge the commercial impact of our work coming out of the Tepper School, as well as provide a vehicle for collaborating with other universities. It will allow academics to apply their research immediately and turn their ideas into products and even companies.”

To optimize resources, numo will only work on a handful of technology development projects at a time. Passavant anticipates that multiple projects in the numo portfolio will involve faculty and students at the Tepper School, but numo will also accept direct applications from entrepreneurs.

“This is an opportunity for fintech firms to combine their efforts with financial institutions in interesting alliances that create a blend of trust, customer relationships, technology, and new products and services,” said Sunder Kekre, director of the PNC Center and Vasantrao Dempo Chair Professor. “It will be competition and partnership at the same time, in an ecosystem that includes the regulated financial institutions, the universities where knowledge resides, and the entrepreneurs who have the great ideas.”

Since its launch in early 2013, the center has conducted more than 50 fintech projects in areas ranging from detecting fraud with machine learning to improving passwords and other data security practices. Alan Montgomery, associate professor of marketing, is one of more than 100 Carnegie Mellon researchers affiliated with the center.

“This is a critical time for banking,” he said. “They have to become more creative about monetizing the data they collect to create value for consumers and charge them for that value. That’s an area banks are not great at, and improving that is what fintech is all about.”

For example, Montgomery analyzed large amounts of financial transaction and customer behavior data to create an econometric model that can predict when consumers are likely to overdraw their account. A bank could use this model to warn customers that they’re about to overdraw their account in the next few days — or more broadly, Passavant notes, a bank could determine whether a customer is on the verge of a financial crisis and help forestall it with a mobile alert offering a bridge loan.

Another of the center’s projects explored the fate of bank branches when the adoption rate for mobile banking rises from its current 30 percent. Even if 80 to 90 percent of banking is mobile and digital in a decade, some people will still need to perform some transactions in person. Montgomery attempted to predict what those transactions might be, how often they might occur, and how a bank could use that information to optimize its smaller branch network for size, staffing, location and services offered.

“The competencies that great tech companies have a deep bench in, like data analysis and the ability to build, launch and test systems quickly, are skills that most banks don’t have,” said Passavant. “By partnering with an institution like the Tepper School, PNC can directly fund research to tackle problems we’re interested in and be actively involved with faculty who are doing work that’s applicable to business decisions, immediately and in the future.”

The future of fintech

No one knows when the next industry-shaking technology will emerge, or what it will be. However, it’s not hard to extrapolate from current technology trends and guess what’s just beyond the horizon for fintech and banking.

More ways to offer credit. As it becomes easier to connect sophisticated data analysis tools to mobile platforms, the way banks assess and deliver credit to consumers will become faster and more precise. SoFi’s current mortgage process, whittled from 70 days down to just 30, will seem slow; SelfScore’s use of alternative data to predict creditworthiness will seem rudimentary. Innovation is happening so quickly that what is impossible today will be commonplace tomorrow.

“We’re still in the early stages of seeing variations on products that don’t fit the traditional loan categories but can offer the right amount of credit at the right time to the right person under the right terms,” Passavant said.

The continuing rise of blockchain. The World Economic Forum believes that blockchains — distributed, encrypted digital ledgers created by specialized algorithms that verify the validity and authenticity of transactions — could store as much as 10 percent of global GDP by 2027. The forum thinks the blockchain could also reshape financial services in many ways, including improving real-time monitoring, speeding clearing and settlement time, and minimizing fraud.

Enhanced services through artificial intelligence. Kedia, who sits on the Tepper School’s Business Board of Advisors, believes AI will become far more prevalent in providing consumers with information, both because it frees customer support representatives for more complex tasks and because it can turn vast amounts of customer data into highly targeted real-time offers. The PwC/Startupbootcamp report on fintech trends predicts that AI will learn to answer increasingly complex questions both from customers and internally, and recommends that banks start thinking about use cases where AI could help solve customer problems.

Outreach to the financially under- and unserved. Roughly 2 billion people globally are unbanked, meaning that they have no access to banking services. Others are underbanked, lacking appropriate tools to manage their money wisely. In the United States alone, roughly half the population lives paycheck to paycheck, using bank alternatives like check-cashing services because traditional banks don’t meet their needs. Fintech is already widening the possibilities available to both groups through entirely mobile-based services, peer-to-peer lending, new payment technologies, and credit scoring for individuals and small businesses without traditional credit histories. Financial services firms could combine these technologies with others that track behavior and spot spending patterns to educate people about finances, help them make wiser decisions, and offer them services they previously couldn’t access.

These trends echo the impact of the digital economy in other industries. The use of big data, machine learning and other technologies to improve customer experience through self-service and increased access is becoming nearly universal. Accordingly, fintech is going to look more and more like technology in other industries — and financial services firms will increasingly conduct business as do other kinds of companies.

“The companies we spend the most time learning from are companies that have created their own markets, like Facebook, or companies that have redefined what it means to shop, like Amazon,” Passavant said. “Fintech increasingly looks less specific to financial services and more like part of those broader trends. Technology is redefining what it means to bank, and we want to be part of that redefinition rather than just going along for the ride.”

We want to replicate the Silicon Valley fintech ecosystem on this side of the United States.
— Sunder Kekre, Director of the PNC Center for Financial Services Innovation, Vasantrao Dempo Chair Professor