The right approach to digital-only banks

As banks work to compete in an increasingly digital world, many are exploring new launching digital-only brands. Banks of all sizes, including industry heavyweights Chase, Citi and Wells Fargo, are in various stages of developing such “parallel” banks. As digital-only banks have achieved rapid customer growth overseas, these institutions are trying to get ahead of the trend here in the U.S.

These digital-only brands also afford banks an opportunity to find new ways to appeal to digital-first customers, while serving them at a lower cost without the overhead of maintaining branches for them. Of course, these digital-first customers also tend to be from younger demographics that represent the next generation of core banking customers, making them vital to banks’ future. While so-called neobanks — startups that similarly offer digital-only banking services — provide an alternative to traditional financial institutions for these younger customers, launching a parallel brand gives traditional banks a means to ward off that threat.

However, financial institutions are still learning the ins and outs of launching and operating a parallel bank as well as what exactly these ventures should aim to accomplish. There are two different approaches banks can take to developing a parallel brand. One approach relies on banks’ existing IT infrastructure, while the second involves creating a new digital organization from the ground up. Given the struggles that banks have had with digital transformation in recent years, they should not pass up the opportunity to take the ground-up approach.

Banks can view a parallel brand as nothing more than a new brand attached to the parent institution. In this case, the parallel bank is simply an extension of the original organization, relying on the same legacy technology infrastructure. This relegates the parallel bank to a branding exercise — it’s essentially the same institution wrapped in a new marketing strategy aimed at younger customers who don’t frequent branches.

While this branding can deliver some of the aforementioned benefits, the other approach can deliver far more. This second approach is to treat the parallel bank as a new kind of organization altogether — one that is free from the constraints that have hampered legacy banks’ efforts at digital transformation. In this case, the parallel bank is more than just a marketing initiative. It is a sandbox that allows the parent institution to learn how to build and operate a truly digital organization.

Taking this approach requires building a new technology infrastructure that supports the parallel bank’s ability to integrate new technologies and partners and iterate quickly on new products and services. This will allow the parent organization to gain greater knowledge about emerging technologies, potential startup partners, new business models, different organizational structures and forward-thinking recruiting tactics as the parallel banks experiments and grows.

This more radical approach engenders all of the benefits associated with the branding-only approach, but also gives the older bank a wealth of knowledge and experience about digital transformation. Furthermore, the new bank will be better positioned against competing digital-only players if it is free to innovate without being shackled to legacy technology and processes.

Despite these further benefits, this approach also raises the risk of eventually trying to integrate two organizations built atop very different infrastructures. This can be an incredibly complicated task, as evidenced by the troubles BBVA experienced when it tried to integrate previously acquired the digital bank Simple. If the parallel bank eventually outgrows its parent organization’s customer base and business, the older bank may be stuck with an expensive branch network, declining customer base and legacy infrastructure that makes it hard to merge with its parallel offspring.

However, there should be no rush to integrate the older and newer banks to begin with. As soon as the two organizations merge, all the opportunities to experiment and gain knowledge from the new digital bank disappear. The parallel bank should be viewed as a long-term effort to gain the competencies and capabilities necessary to compete in a digital environment.

More important, developing a digital-only parallel bank shouldn’t preclude the older organization from pursuing its own digital transformation. Over time, the older organization must gradually apply the knowledge and expertise gained from the parallel bank’s efforts to innovate and iterate on new technologies and ideas. It will likely take many years for the new organization to outgrow the old one. That time should allow the older organization to adopt much of the same infrastructure, services and practices as the newer one, making it easier to integrate them when the time comes.

It will also provide time for the parent bank to rationalize its branch network based on customer needs and preferences. The final merged organization may well resemble PurePoint Financial, a division of MUFG Union Bank that operates as a “digitally led hybrid bank” that offers online savings products but also operates 22 digitally enhanced branches where customers can visit a savings specialist and get advice.

Other outcomes are also possible. The parent organization may find that it makes sense to keep the two organizations separate long term even after it transforms itself, allowing each organization to possibly focus on different customer segments or services that they each specialize in. There are a multitude of possibilities for the endgame, but banks should not forgo the opportunity to operate a truly digital bank built atop a modern infrastructure given the pace of change in the industry today.