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Too big
to disrupt?

Canada’s financial institutions weathered the Great Recession much better than most, but now they face new challenges from such behemoths as Google and Apple, who want to get in on retail banking. Tim Kiladze asks if big tech has finally met its match

Under siege from Silicon Valley, Canada’s biggest bank is making a bet on the human heartbeat.

In November, the Royal Bank of Canada joined forces with credit-card giant MasterCard and Canadian tech startup Bionym to experiment with a wristband that authenticates identity by reading cardiac rhythms. If it works, the device will make mobile financial transactions infinitely more secure by eradicating old-fashioned PINs and passwords.

The unique test run comes at a crucial time for Canadian banks. Everyone from Apple to Facebook is encroaching on the territory of traditional lenders, and the threat of competition from these unusual rivals has forced financial institutions to invest in a flurry of innovations this fall.

Tangerine, formerly known as ING Direct Canada, recently unveiled biometric tools for its mobile banking app, including a fingerprint scanner that supplants old-fashioned passwords; the Bank of Nova Scotia has just designed a new app for Samsung’s smartwatch that lets users check account balances on their wrists.

For over a decade, financial institutions have watched Apple decimate record labels, Netflix disrupt cable companies, and Uber upend unimaginative taxi operators. They now fear their sector will be the next one to topple. Jamie Dimon, chief executive officer of J.P. Morgan Chase & Co., America’s biggest bank, put it bluntly last February. The leaders of the digital revolution, he said, “all want to eat our lunch.”

To stay relevant, Canada’s banks are investing big bucks in products that rival those being dreamed up by Silicon Valley’s stars. They are also working overtime to look cutting-edge – developing such features as biometric identification – because market perception matters. Apple and Samsung don’t spend hundreds of millions on advertising annually just for fun: In a world of hyperinnovation, appearing to be ahead of the pack is almost as important as being there.

This year was a particularly eye-opening one for the banks. PayPal, the payments company that made a name for itself by partnering with online auction house eBay, began aggressively marketing a mobile app that lets users pay by swiping their smartphones at the checkout counter; Facebook recruited PayPal’s former president, and reports surfaced that the social-media juggernaut would incorporate money transfers into its chat service; and Apple unveiled a secure-payments business in partnership with leading retailers such as pharmacy chain Walgreens. Even Snapchat, the text-messaging service targeted at teens, launched a money-transfer service called Snapcash.

The rationale for those aggressive moves is clear: Despite their phenomenal user growth and ubiquity in everyday life, many tech companies are struggling to make money. Amazon, for instance, lost $437-million (U.S.) last quarter, despite having a reputation as a digital-retailing genius. Canada’s Big Six banks, by contrast, collectively earned $33-billion last year, making financial services seem like a profit oasis.

As they seek to get a piece of that pie, the tech giants are preying on certain weaknesses in the banking system. Scores of Canadians are sick of shelling out sky-high monthly fees and paying $3 ATM charges, so the digital stars are marketing themselves as cheaper, tech-savvy alternatives. The new entrants also know that clients are won over more by point-of-sale ease than by bricks-and-mortar branches – and that it doesn’t take much to get someone to swipe their smartphone, instead of a piece of plastic, at the checkout counter.

In that environment, big, bureaucratic companies, historically slow to innovate, are struggling to compete. “We have to find a way to experiment, or else someone will reinvent our model for us,” says Dave McKay, RBC’s chief executive officer.

The disruptors: Five tech companies that rival historic banks

Still, a revolution won’t be easy for the upstarts: Because the Canadian banks are so profitable, they have ample gunpowder to put up a fight. They also possess a secret weapon when it comes to people’s hard-earned savings, something the tech giants can’t replicate overnight: public trust.

As much as Canadians gripe about their banks, they have learned to count on them. Even in the face of a global financial crisis, the country’s top lenders did not need a government bailout. Our banks have also played significant roles in federal policy-making since their formation, intertwining them with this country’s political and cultural identity. For decades, the media widely covered what bank CEOs had to say on hot-button issues, such as the threat of Quebec’s separation and ongoing worries about a housing bubble.

Digital disruptors, meanwhile, have stockpiled far less public confidence, most famously facing an intense backlash for the way they track user data; the recurring controversy about Facebook’s privacy policies is probably the most notorious example.

No one knows how this ends, and the uncertainty makes the fast-changing landscape only more difficult to navigate. Facebook, Google and Apple have a history of shunning the press, and all three declined or ignored our requests for comment. PayPal Canada General Manager Cameron Schmidt said in an interview that the company is trying to bill itself as a secure alternative to traditional banks, and that it seeks to “delight” Canadians – Silicon Valley’s latest buzzword.

What’s at stake is hard to overstate. Canada’s banks are crucial to the country’s stock market: The six largest lenders now constitute 22 per cent of the entire S&P/TSX Composite Index – more than all the energy companies combined – and our financial institutions are widely held in everything from pension funds to RRSP accounts. Retail services also account for 50 to 70 per cent of the industry’s profits. No matter how you feel about your bank, the potential economic and financial effects of disruption cannot be dismissed.

Chapter Two The challenge from big tech

Silicon Valley’s intense push into financial services started near the turn of the century. As Internet use soared, PayPal developed a secure way for customers to pay for purchases online, blindsiding a banking industry that was stuck in its old ways and slow to react to the digital revolution.

But then, financial institutions got lucky: PayPal’s service didn’t spur an immediate, larger wave of innovation, largely because the dot-com bust put so many startups out of business. It wasn’t until this decade that Silicon Valley got serious about its onslaught.

To disrupt retail banking, the tech giants are now zeroing in on what’s called disintermediation – not exactly a term that comes up every day, but a practice that is incredibly toxic to financial institutions.

At their very core, banks act as intermediaries, connecting consumers with purveyors of goods and services, or with other consumers: A bank may help someone pay for an airline ticket, or it may help them send money to a friend. Disintermediation strips banks of their pivotal role as the main conduit for these transactions, inserting a tech company in the middle of the equation. It “changes the direct relationship that a bank has with its customers,” says Paul Battista, a financial services consultant at Ernst & Young, who advises the country’s biggest banks. “That has profound implications.”

Payment flow: Comparing possible transactions

Select method of payment and click 'pay' button

  • Google
  • PayPal
  • Apple

Consider Facebook, which everyone is expecting will soon allow its users to send money to their friends through the service. It may seem rather harmless, but by facilitating that transfer, the social-media star puts itself between the banks and their own customers.

Silicon Valley has two ways to capitalize on this disintermediation. The first involves amassing vast amounts of information about customer habits. “One of the hallmarks of a digital era is that it leaves a trail of data,” Mr. Battista says. Disintermediation starves banks of the oxygen necessary for healthy customer relationships. Financial institutions have invested heavily, for instance, in IT systems that help them cross-sell products; if they see that a client starts paying rent on a new property, say, they can offer their own renters’ insurance. Should their access to data become diminished, so too will their capacity to make these kinds of sales.

In practical terms, a disintermediated bank may only see a transaction’s value, instead of where it took place and at what time of day. At the same time, exponential gains in computer processing power in the past decade allow the disruptors who collect this information to store and study it for very little cost. Such information, for example, is very helpful to Google – it’s why an ad for something surprisingly familiar appears when you’re searching for something not even remotely related.

The second major way that tech firms are wringing money from disintermediation – an approach preferred by Apple – is quite different. Although the user would still pay for a pair of jeans, say, with an app on their iPhone, Apple’s payment service scrubs any personal information as money moves through its system. The data can’t be tracked. In return, Apple takes 0.15 per cent of the total transaction value, just as it is paid a cut of every song purchased on iTunes. Multiply that fee by the $4-trillion in credit and debit transactions processed annually in the U.S., and the allure is evident.

Simple payment processing may not seem like a major threat to the banks, but there’s a long game to remember, says Oliwia Berdak, a digital-payments analyst at Forrester Research in London. Apple has a history of building ecosystems that devastate. And there are no assurances that processing money is its end game. “Once they have all the elements that make up a proper digital wallet – credit cards, coupons – they will be the intermediary through which [retailers and banks] will have to go,” she says.

Amazon, as well, may provide important clues to what the banks will face from the likes of Apple: The digital retailer’s website has become a go-to destination for so many types of goods that it sets the retail industry’s rules. If its payments business is wildly successful, Apple may develop the same kind of pricing power that has allowed Amazon to big-foot the likes of the large book publishers. In that scenario, Apple could jack up transaction fees whenever it so chooses. And it won’t just be the banks who suffer then: Eventually, those hikes are likely to be passed on to the customer in the form of higher prices.

Chapter Three What happens next?

The big fear for the banks, though, is that this is just phase one. If Canadians get comfortable with moving their money through Apple or Facebook, they may one day be confident enough to store that money with them as well. Ultimately, that would mean the banks have less to lend, and loans are where they make big money – which explains why a startup called Lending Club is generating so much buzz.

The company, which went public last week in a deal that valued it at $5.4-billion (U.S.), provides an online platform that matches borrowers directly with lenders, offering a new way for riskier clients to get money at cheaper rates than those offered by the banks. What started in 2007 has caught on like wildfire; since its inception, Lending Club has made $6-billion (U.S.) worth of loans.

PayPal is also creeping into this territory. What was once solely an online payments company is quickly evolving. Just like a bank, PayPal now stores money for customers, and lends it too. Working Capital, its brand new borrowing arm for small businesses, has been so successful that it is going global less than a year after launching, starting with Britain and Australia.

Because Working Capital is making PayPal more like a bank, the company is expected to face increased regulatory burdens: Lenders are required to hold certain amounts of capital that protect them from potential losses on loans they’ve issued. It’s not yet apparent how tech companies will clear this hurdle.

That complication aside, PayPal and its peers have all sorts of technological expertise that helps them serve the masses. Instead of competing with the banks on the traditional playing field – in branches, for instance – they can build a brand new arena in the cloud and on mobile devices that the legacy lenders have been slow to gravitate toward.

Companies born in the digital era have also learned how to make products that are incredibly easy to use. Despite being in her 50s, an age group that typically isn’t considered tech-savvy, Toronto IT recruiter Sonia Cameron, is a self-professed Apple aficionado. “Every time I go to an Apple store, I’m always amazed at the demographics,” she says. “There are babies to 90-year-olds. That’s what Apple brings to the table.”

Ms. Cameron sees it in her own children, who range in age from 7 to 32. Her oldest son, Jamaal, now an engineer, played with calculators when he was younger, notes his mother; she compares that to today, when “babies are touching your iPhone, and they know how to swipe.”

Canadian banks, by contrast, aren’t known for being nearly as imaginative – and their big investments this fall will take time to catch on. “I don’t see a big innovative push in the Canadian banking space,” says Chris Wu, a 35-year-old Toronto-based digital-product manager who has worked everywhere from startups to Rogers Communications. “They’ve basically taken the ATM, digitized it, and dropped everything that isn’t easy to do” on a phone.

Because many banks ignored Silicon Valley’s threat for so long, they now face a time crunch and a talent shortage in their quest to keep the new rivals at bay. That problem is only exacerbated by a fast-paced market in which “innovation cycles are unquestionably shrinking,” notes Todd Roberts, head of retail payments at Canadian Imperial Bank of Commerce.

Another major hurdle: Trial and error isn’t in the banks’ DNA. RBC chief McKay, a graduate in math and computer science from the University of Waterloo, visited Facebook’s headquarters in Menlo Park, Calif., and witnessed one of its legendary “hacks” – a 48-hour cram session during which coders develop a new product or service. Being there, he quickly realized that banks don’t move nearly as quickly. “Because we have big, complex organizations with integrated systems … it takes a while to build something that works,” he says. To be competitive, he believes new rules must be enforced, such as killing misguided projects before they become too bloated. “We have to find a way to fail fast.”

Chapter Four Why the banks can’t be discounted

In this race, it can be easy to write off the banks. Some people even take pleasure in predicting their demise. The truth is, they aren’t nearly as lost in the woods as the naysayers would claim.

CIBC and RBC in particular have taken the threat of disruption seriously for a few years. In 2012, CIBC became the first Canadian bank to launch a mobile wallet, developing an app of its own that lets clients pay for goods and services with their smartphones – a product that rivals the innovations of Google, PayPal and Apple. RBC now has a similar offering, and it is doing what it can to partner with rivals. Earlier this year, it teamed up with Facebook to allow its clients to transfer money to one another through the social-media company’s chat function.

Canada's big six compared (2014)

  • Employees
  • Branches
  • Assets
  • Net Income

  • Royal Bank
  • Toronto Dominion
  • Bank of Nova Scotia
  • The Bank of Montreal
  • CIBC
  • National Bank of Canada
SOURCE: 2014 Annual Reports

At the same time, Silicon Valley’s sweethearts are hardly infallible. Despite their disruptive powers, the tech giants have skeletons in their own closets – in the form of failed products. Apple Maps and Google+ are two of the best known disasters. There’s no guarantee they’re won’t be more.

More significantly, Google has already stumbled spectacularly in the payments business. The mobile wallet it launched in 2011 flopped because “there was a lot of mistrust on the side of merchants as to how Google would use the data,” recalls Ms. Berdak, the digital-payments analyst. Similar privacy concerns have plagued other disruptors. Facebook has long dealt with them, and Uber is now reeling from the news that its employees can openly track where its users travel and at what time.

Although Apple is trying to circumvent those worries by building a system that scrubs data as money moves through it, its business may not prove to be any more lucrative. When its Apple Pay service launched in October, U.S. drug stores Rite Aid and CVS had plans to be on board. Not even a month later, they changed their minds, announcing their intention to build in-house services.

Twitter co-founder Jack Dorsey set out to dominate this same space with a service named Square, designed to help people pay with a credit card almost anywhere. If a yoga instructor holds a class in the park, say, students can pay by swiping their card through a small reader that attaches to the instructor’s smartphone. Despite spending hundreds of millions on marketing and designing an easy-to-use interface, Square is stumbling because competition from rival products is so fierce.

The extent to which technology companies can reach into the financial world also has limits, unless they radically change the way they operate. Banking is a “very complex, capital-intensive business,” says CIBC’s Roberts. “It’s highly regulated, and it takes a lot of skill to run one of these [institutions] well.”

If the disruptors want to ultimately look more like banks, they will have to comply with additional regulations that call for things like deposit insurance and cash cushions to protect against loan losses. Ottawa seemed unwilling to fight back when Netflix batted away a request to disclose user data from the national telecommunications regulator, but Canada’s powerful banking watchdogs aren’t likely to roll over when the financial system is at stake.

Add to that the difficulty of dealing with a diverse client mix. The banks’ “customer base is very, very heterogeneous,” says Ms. Berdak. “Some of them are old, some of them are very used to using branches.” Because of that, even the most wildly successful payment model will take time to catch fire – and that, in turn, will give the banks time to respond.

“Payments are not like buying a new widget or a new phone at the store,” says Mark O’Connell, head of Interac Canada, whose debit system is by far the preferred method of payment for transactions under $50. They are “ingrained in people’s daily behaviours” and “changing ingrained behaviours takes more time than every prediction I’ve ever seen.”

In fact, if anything, Canadians are increasingly loyal to their financial institutions. As online services, such as automatic bill payments, tie people to their lender of choice, it requires more and more ingenuity to sway a client to leave. Five years ago, about 15 per cent of Canadians were prepared to switch banks, according to Scotiabank. New data show the figure is now roughly half that. Ultimately, the success of the disruptors will hinge on whether such loyalties can be swayed.

The banks also boast a wild-card advantage – one that gets lost in all the anger over ATM fees and credit-card interest rates. “We are entering a dynamic period when consumers will likely be assessing who they are willing to trust in this complex world of digital/mobile shopping, payments and couponing,” consulting firm Alix Partners wrote in an influential survey released earlier this year. In this era, “banks seem to start with a significant trust advantage.”

This is especially true in Canada. Despite problems in the past, including two bank failures in the 1980s, our lenders were praised globally for their strength during the recent financial crisis: While American banks had to take government bailouts, Canada’s lenders survived the storm all on their own. That track record builds a level of trust that’s tough to match.

Even Mr. Wu, who would seem open to experimentation given his age and technology literacy, admits he is keen to try something like Apple Pay only because there’s a safety net. “I’m still dealing with [the banks] at the end of the day,” he says. “It’s still coming back to the credit-card system and the banking system.”

Mobile banking like you’ve never seen it

Chapter Five Hubris, innovation, trust

Still, Canada’s banks can’t afford to get cocky. Hubris, after all, has hurt them more than once.

When ING Groep came here in 1997, the Dutch giant marketed itself as a “virtual” bank that had no branches and focused on a simple, unrivalled product: high-interest savings accounts. Unfazed, Canadian banks dismissed the threat. Fifteen years later, the Bank of Nova Scotia spent $3.1-billion to acquire ING Direct Canada (since renamed Tangerine) and its 1.8 million customers.

The same thing happened when U.S. credit-card companies MBNA and Capital One crossed the border and offered large credit limits. By the time MBNA was swallowed up by TD in 2011, it had amassed approximately 1.8 million Canadian accounts. Capital One, which remains an independent company, had roughly $4.9-billion in loans out to Canadian cardholders at the end of 2013.

This time around, the banks aren’t taking as long to respond, but they still face an uphill battle as they develop rival services and work to sell themselves as innovative. CIBC’s mobile wallet had a slow rate of consumer adoption, and RBC acknowledges that it has sunk millions into projects that barely had uptake or never saw the light of day. By contrast, whatever Apple launches is automatically considered cool and garners reams of international attention.

Warding off the unusual competition will also require bags of money: In 2013, the country’s banks shelled out $13-billion on technology, according to IDC Canada, a consultancy. This heavy cash outlay is required just as banking profits come under the gun. This fall, Toronto-Dominion Bank and Scotiabank – two of the country’s three largest financial institutions – both started talking about the need to cost cuts, and Scotiabank has already slashed jobs.

Luckily for the lenders, their biggest advantage is arguably priceless – and has absolutely nothing to do with innovation. Trust is something that must be earned over time, and the banks have already spent decades building this goodwill. “We have the advantage,” says RBC’s McKay. “We can’t squander it.”

Tim Kiladze covers banking for The Globe and Mail’s Report on Business.


Story by Tim Kiladze

Video Timothy Moore

Graphics, Interactive Development Jeremy Agius, Murat Yukselir

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For years, financial institutions worried that Apple, the world’s largest company by market value, would move into payments. That nightmare became a reality in September when chief executive officer Tim Cook unveiled Apple Pay, a payments system designed to be so secure that it would rid the sector of fraud. After installing the app on an iPhone and inputting debit card and credit card information, users can pay for their goods and services at the checkout counter by swiping their phones. Across the industry, the big fear is that Apple will be the banks’ Waterloo given its history of disruption. iTunes, for instance, helped dismantle the music industry.

Despite its history of innovation, Google struggled to make its mobile wallet catch on. Launched in 2011, the product was designed to store debit cards, credit cards, loyalty cards and gift cards in a mobile app that could be used at the checkout counter. However, user adoption has been low, and there are many studies that analyze what went wrong. One of the core problems: Merchants did not trust what Google would do with the data it collected. By simply processing transactions, the tech company could analyze who was buying what, and then target ads to these people – data the merchants would rather keep to themselves.

Founded in the late 90s, PayPal is the veteran Silicon Valley star in payments. Created to facilitate money transfers online, the company was best known for its affiliation with auction house eBay. Over a decade later, PayPal now looks much more like a bank – the company will store your money, and it also lends money to small businesses. To win people over, PayPal charges low transaction processing fees as well as a low-fee alternative to traditional chequing accounts.

In 2010, Square’s card reader was hailed as a revolutionary product. By plugging the device into the headphone jack of a mobile phone, Square allowed almost anyone to process credit card and debit card transactions – meaning yoga teachers could accept these forms of payment in the middle of a park. But rival products have cropped up since its launch, and this cutthroat competition has made Square stumble. Jack Dorsey, the company’s founder, who also co-founded Twitter, is now trying to revive the hype following reports that the company lost $100-million (U.S.) in 2013.

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