FINANCIAL INSTITUTIONS

SECTOR IN-DEPTH18 May 2016

TABLE OF CONTENTSFintechs and their investors aredrawn to the digital opportunity infinancial services 2Predominant fintech focus is on retailbanking services 4Fintech growth comes as bankscontend with challenges beyond newentrants 6Banks are responding to thecompetitive challenge andcapitalizing on digital opportunities 7Incumbent status also brings someimportant competitive strengths 8Banks will continue to have a place inthe future landscape, on their own,alongside fintechs and as part ofmarketplaces 8Tech landscape is fast-moving andpotential for an accelerated shiftremains 9Moody's related research 10

Contacts

Robard Williams 212-553-0592Senior Vice Presidentrobard.williams@moodys.com

Nick Caes 212-553-1382Analystnick.caes@moodys.com

Jennifer Zong 212-553-0110Associate Analystjennifer.zong@moodys.com

Elena H Duggar 212-553-1911Associate ManagingDirectorelena.duggar@moodys.com

Gregory W. Bauer 212-553-1498Managing Director -Global Bankinggregory.bauer@moodys.com

Financial Institutions - Global

Fintech Transforms Competitive Landscape,but Unlikely to Displace Banks' Central Role

The spate of new financial technology firms (fintechs) and associated investment hassharpened focus on the potential for a fundamental transformation in the way financialservices are delivered and consumed, with some commentators predicting a displacementof banks as new entrants exploit inefficiencies in product design and pricing and meetdemand for more personalized, easy-to-access digital financial services. However, while thistransformation will not be easy, low cost, or without risk for incumbents, we expect banks toretain a place at the center of the financial services industry, working both alongside and incompetition with fintechs to improve the development and delivery of financial services.

The challenge of the new competitive landscape will be one of leveraging newtechnologies and innovation to better meet customer needs. In particular, the largeMillennial cohort is typically more open to, and often expects, digital services and interfaces.Fintechs have had some initial successes, primarily in individual business lines, keepingoverhead low and operations nimble. But fintechs have yet to prove their resilience through arange of economic and financial market conditions.

Fintechs have had a head start as banks parry a number of challenges. Bank revenuesare broadly constrained by weak economic growth and low interest rates. At the same time,expenses are stubbornly high owing to some overhang of bad loans, regulatory compliancecosts (and associated balance sheet reconfiguration) and IT remediation. In some instances,these pressures are forcing banks to realign business models, geographic scope and strategy.

But incumbent banks are already responding, and they have several inherentadvantages. Many banks are well advanced in developing and implementing theirown digital strategies. Others are partnering with fintechs to leverage their models andcapabilities, fill product gaps and/or appeal to new customers. And others are directlyinvesting in start-ups and incubating others. Moreover, they have several inherentadvantages:

» Large existing customer bases and significantly greater financial resources than mostfintech startups.

» ‘Sticky’, long-term customer relationships.

» Well-developed credit underwriting capabilities, and a reservoir of data with which tobetter price, tailor and target products and services.

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This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page onwww.moodys.com for the most updated credit rating action information and rating history.

2 18 May 2016 Financial Institutions - Global: Fintech Transforms Competitive Landscape, but Unlikely to Displace Banks' Central Role

A major competitive reversal for banks is unlikely, but several forces could shift the scales or accelerate the transformationof the industry. Greater movement toward open data, for instance, could unglue one of banks’ strongest defenses by making it easierto switch financial services providers. A more defined regulatory stance would crystalize, and perhaps change, the rules of engagement.And a killer app or the entrance of one or more Big Tech players, with large customer bases and deep pockets, could quickly shift thefinancial services landscape.

Fintechs and their investors are drawn to the digital opportunity in financial servicesThe distribution and consumption of products and services is becoming increasingly digital, as technological innovations advanceand consumers increasingly demand the choice, convenience, and personalization offered by new platforms and providers. Thereare numerous recent cases, across industries, of nontraditional competitors disrupting the competitive positions and prospects ofpreviously entrenched incumbents. These new entrants have often proved able to better meet customer demands and do so morecheaply, largely through developing and applying new technologies and analysis techniques, leveraging the internet and, more recently,mobile technology.

In recent years, these approaches have been directed at the financial services industry, with early successes and innovative views ofhow existing and emerging techniques and technologies can transform the sector. There has correspondingly been tremendous growthin the number of fintech firms and associated investment.

Fintechs mostly comprise smaller start-ups, though some large public companies are among their number, and provide a range ofservices targeting both retail and corporate customers, including wealth management, small business finance, consumer finance,insurance and payments.

» Estimates for the number of fintech-related start-ups range as high as 4,000 firms, globally, and total fintech investment has risenfrom about $2.4 billion in 2011 to over $19 billion in 2015 (Exhibit 1). In addition, the rising number of ‘exits’ via acquisitions and asmall number of IPOs (Exhibit 2), as well as increasing corporate investment, suggest that the sector is becoming more established.

» This growth, while underpinned by the application of emerging technologies, reflects the large potential customer and revenuebase (for example, Moody’s-rated banking institutions generated over $1.2 trillion in aggregate pre-provision income for full-year2014) and, importantly, the potential to attract and capture the large Millennial cohort (those born between 1980 and 2000, seeBox page 3), who are typically more open to, and often demanding of, digital-based services.

Exhibit 1

Global Fintech Investment and Number of Deals, 2011-15Exhibit 2

Global Fintech 'Exits', 2011-15

Source: CB Insights Source: CB Insights

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3 18 May 2016 Financial Institutions - Global: Fintech Transforms Competitive Landscape, but Unlikely to Displace Banks' Central Role

Millennial cohort is large and uncompromising in demand for digital services...

The Millennial cohort provides much of the impetus for the digitization trend, especially across consumer service segments. In 2014, this group, bornbetween 1980 and 2000, surpassed Baby Boomers (ages 55 to 74) and Gen-Xers (ages 35 to 54) to become the largest age group by populationglobally.

Millennials are typified as being demanding of choice, convenience and personalization in their relationships with service providers, with technologyhaving played an important role in their lives from a very young age. For example, according to a recent study by Payfirma, Millennials are 2.5 timesmore likely to be an early adopter of technology than older generations and more than 50% of Millennials report that they are the first to try a newtechnology. These traits are particularly apparent in their bias toward consuming services on mobile devices.

» Mobile demand in payments, for example, is rising quickly, with 44% of Millennials responding that they would rather use their mobile phonethan cash to pay for smaller items, 45% looking to mobile payments to split expenses with friends, and 62% reporting that they would becomfortable connecting their payment info to an app from a retailer or service they use frequently.

...but not yet dominating consumption of financial services

However, while Millennials have greater educational attainment than earlier generations – 45%1 of Americans aged 25 to 34 have a post-secondarydegree versus 30% in 1992 – they are still relatively young and many entered the work force during or immediately following the great recession. It'stherefore likely to be a few years before this large group predominates in the consumption of financial services.

Indeed, Millennials lag prior generations along a number of indicators important to financial services firms: they have lower household formation andhome buying rates, a higher student loan burden, and lower earnings and higher debt-to-income ratios than did other cohorts at a similar age.

Exhibit 3

Size of World Population by Age Cohort, 2015Exhibit 4

Use of Mobile Banking in Past 12 Months in the US by Age

Source: US Census Bureau Source: Federal Reserve (based on the Fed's 2015 consumers' use of mobile financial servicessurvey, only including respondents with a mobile phone and a bank account)

Exhibit 5

Median Income for US Population of 25 -34 Years Old, 2014 Constant Dollars

Exhibit 6

Debt to Income Ratio for US PopulationExhibit 7

US Households Owning Their PrimaryResidence

Source: US Census Bureau Source: PEW Research Source: PEW Research

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4 18 May 2016 Financial Institutions - Global: Fintech Transforms Competitive Landscape, but Unlikely to Displace Banks' Central Role

Fintechs' strengths go beyond cost and convenienceBecause they are generally new and nimble, fintech firms are generally building their systems and distribution platforms from theground up, often with a core focus on collecting, analyzing and developing original data with which to tailor what products to offer,when, how and to whom.

Further, these firms generally have much lower cost bases than traditional incumbents – avoiding, for example, the need to buildlarge branch networks, while often leveraging the flexibility and cost-effectiveness of cloud-based technologies. And, perhaps mostimportantly, at least from a cost perspective, most fintech business models stop short of obtaining banking licenses, thereby avoidingthe compliance requirements and regulatory scrutiny that absorb a material share of traditional banks' resources.

Predominant fintech focus is on retail banking servicesWhile the majority of fintechs have to date focused on establishing themselves in single business lines, these could be a first step inattracting and retaining customers before expanding into additional products and services to increase customer 'lifetime value'.

New entrants have tended to concentrate on the consumer banking segment, largely through lending, financing and payments-relatedproducts and services (Exhibit 8). In each of these areas, fintech has not only opened the door to a new customer experience, whichmay set a new baseline for product demands/expectations, but also could contribute to the compression of margins on products andtransactions.

In the corporate banking segment, customers may be apt to take a more conservative approach toward the adoption of new serviceproviders, prefering to maintain primary relationships with one or more established banking institutions that are able to offer a fullrange of products and services rather than establish new relationships with, potentially, multiple fintechs.

Exhibit 8

Distribution of Investment in Venture Capital-Backed Fintech Companies by Business Segment, 2015

Source: CB Insights, Moody's Investors Service

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5 18 May 2016 Financial Institutions - Global: Fintech Transforms Competitive Landscape, but Unlikely to Displace Banks' Central Role

Lending and Financing – low costs a competitive strengthFintechs are targeting customers in the unsecured personal loan and small business segments, with a value proposition of easier andquicker application and approval processes. These products have proven popular with customers who have been denied credit by atraditional bank, have short-term liquidity needs, and/or are members of unbanked or under-banked populations.

» With their lower cost bases and readily scalable internet platforms, these new entrants have the potential to drive down lendingspreads across credit products, particularly as many operate under models that avoid the need to obtain a banking license, therebyremoving traditional bank regulatory requirements and associated capital costs.

» It is important to note, however, that if fintechs stop short of obtaining banking licenses, they must partner with licensed banks forloan origination (and pay associated fees) as well as the structuring, marketing and sales of funding notes. This model thus retainstraditional banks as key participants in the process. Moreover, since the focus is on customers that are often shut out of bank-ledcredit granting, the competitive threat is not as material as would be the luring of banks existing customers.

Retail Payments – fintechs drive an improved, if not yet cashless, user experienceRetail payments have also seen a considerable volume of new entrants and material take-up by consumers. Here, fintechs’ productsand services have particularly focused on solutions for peer-to-peer (P2P) payments, mobile wallets that allow payments to be madevia smartphone with stored credit card information, and foreign exchange and remittances.

» New entrants in the payments segment, which include start-ups as well as large, established corporates such as Apple Inc. (Aa1Stable) and Samsung Electronics Co., Ltd. (A1 Stable), are leveraging the ubiquity of mobile devices and technological advances tomake payments easier and more secure.

» While a fully cashless society may be some way off, these firms are supporting the growth of digital payments through improvedfunctionality and user experience for both consumers and merchants, while also offering the potential for providers and retailers tocollect and exploit data to increase value-adds.

» As consumers shift toward single (or at least fewer) payment cards, traditional banks could lose credit card customers or, whereretailer financing options take hold, see the loss of this product altogether.

» However, similar to the lending and financing segment, these new entrants are largely leveraging existing infrastructures to supporttheir offerings, often teaming with banks to access merchant networks, and customers are predominantly linking to existing creditcard or bank accounts.

» Further, as noted below, traditional banks are launching their own mobile payment applications and, with large existing customerbases, have a competitive advantage over new entrants in terms of customer acquisition.

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6 18 May 2016 Financial Institutions - Global: Fintech Transforms Competitive Landscape, but Unlikely to Displace Banks' Central Role

Fintech growth comes as banks contend with challenges beyond new entrantsThe recent growth in the fintech sector has come as banks are facing a difficult operating environment. The associated constraints onbanks' financial flexibility could provide an opportunity for fintechs to gain some competitive advantage.

» The outlook for bank revenues and profitability remains muted, with low interest rates continuing to weigh on net interest margins,restrained demand for new credit as global economic growth remains lacklustre, and regulatory and conduct costs expected to stayelevated.

» Although banks are working to control expenses, including through reductions in branch networks (often rendered redundant ascustomers increasingly utilize internet platforms), operating costs remain stubbornly high owing to some overhang of crisis-era badloans, IT remediation, and broader restructuring of business models, geographic footprints and strategies (Exhibits 9 and 10).

Exhibit 9

Global Systemically Important Banks, Excluding Chinese G-SIBs,Headcount and Cost-to-Income Ratio

Exhibit 10

Chinese Global Systemically Important Banks, Headcount andCost-to-Income Ratio

Source: Moody's Investors Service, FactSet Source: Moody's Investors Service, FactSet

» At the same time, the continuing phase-in of various regulatory requirements is keeping compliance costs high, and placesrestrictions on some business activities, which further complicates the task of balance sheet and business model optimization. Withtheir room for maneuver constricted, particularly their ability to improve profitability through increasing leverage, some firms arestruggling to repair their balance sheets in the near-term.

» Growth of the fintech sector also comes as banks face rising capital requirements, which may be leading to a pullback from lendingor higher pricing in certain client segments, providing new entrants with potential pricing advantages.

» However, we expect continued broad improvement in banks’ solvency and funding and liquidity profiles, as further micro- andmacroprudential regulations come into force, with many firms making significant progress in meeting new requirements, which willfree up financial and managerial resources that can be trained on developing and implementing digital strategies.

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7 18 May 2016 Financial Institutions - Global: Fintech Transforms Competitive Landscape, but Unlikely to Displace Banks' Central Role

Banks are responding to the competitive challenge and capitalizing on digital opportunitiesMany incumbent banks have taken steps to maintain their competitive position in the new landscape, with a number of firms havingalready achieved some success in developing digital strategies and underlying capabilities. These include, for example, leveragingtheir internet platforms to reduce the size of their branch networks while maintaining, and often growing, strengths in deposit taking(Exhibits 11 and 12).

Exhibit 11

Branches and Deposits, US BanksExhibit 12

Branches and Deposits, EU Banks

Note: US banks includes FDIC-insured commercial banks.Source: FDIC

Note: 'Customer Deposits as a % of Liabilities' is the weighted aggregate for a sample of55 EU banks.Source: ECB, EBA

Internet and Mobile platformsTraditional banks have offered online banking access for some time now, and the largest banks in particular have expanded services viathese platforms, leading to increases in reported customer satisfaction. A number of banks have more recently focused on building uptheir mobile banking offerings.

» For example, JPMorgan Chase & Co. (A3 Stable), Bank of America Corporation (Baa1 Stable), and Wells Fargo & Company (A2Stable) have among the most downloaded mobile applications among financial services firms, reporting over 60 million mobileusers between them, while Danske Bank A/S' (A2/A2 Stable, baa1) mobile payments application has reportedly been downloadedby 90% of smartphone users in Denmark.

» In the same vein, DBS Bank Ltd. (Aa1/Aa1 Negative, aa3) recently launched Digibank, a mobile-only bank in India that providespaperless, signature-less and branchless banking services, by leveraging the government-issued biometrics-enabled identificationcard.

Partnerships with FintechsIn addition to the oft-noted origination service that WebBank (unrated) provides to marketplace lenders – encompassing loanoriginations and associated compliance with related consumer protection and banking regulations – a number of other banks haveentered into partnerships with fintechs.

» For example, JPMorgan Chase recently launched a partnership with fintech small business lender, OnDeck (unrated), leveraging thelatter’s application, scoring and approval platform to provide loan funding to small businesses. Under the agreement, the loans willbe branded as a Chase product, subject to Chase’s pricing and risk parameters, but the credit approval process will be more flexibleand quicker than if run through Chase's internal program.

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8 18 May 2016 Financial Institutions - Global: Fintech Transforms Competitive Landscape, but Unlikely to Displace Banks' Central Role

Investing and IncubatingTraditional banks have also joined the wave of direct investment in fintech startups, such as:

» Banco Santander S.A. (Spain) (A3/A3 Stable, baa1) has been at the forefront of digital banking/fintech for some time, and launcheda $100 mm venture capital fund that focuses on early stage fintech companies, and invests in fintech companies directly, witha portfolio that includes, Ripple (unrated, cryptocurrency), Kabbage (unrated, alternative lending), and iZettle (unrated, mobilepayments).

» Banco Bilbao Vizcaya Argentaria, S.A. (BBVA, A3/Baa1 Stable, baa2) has announced a number of strategic priorities related totransforming customer experience, optimizing capital allocation, and improving overall efficiency via technological innovation.The bank has also launched a venture capital fund, which has invested in companies such as Coinbase (unrated, bitcoin), Prosper(unrated, marketplace lending), purchased Simple (unrated, online banking), and holds a 29.5% stake in Atom (unrated), the UK’sfirst mobile-only bank. In 2016, BBVA announced it will invest a further $150 million in Propel Venture Partners (unrated, $250million total invested), which will manage the investment independently.

Incumbent status also brings some important competitive strengthsTraditional banks' position in the transforming landscape is bolstered by a number of strengths that, while open to erosion andcertainly not guarantees of success, place them in good stead as the industry evolves. These include:

» Large existing customer bases and associated data that can be used to better price, tailor and target products and services;

» Long histories and capabilities in credit underwriting;

» Traditionally ‘sticky’ customer relationships as represented by the resilience of deposit products; and,

» Well-developed compliance infrastructure and long-standing relationships with, and experience navigating, various regulatorybodies.

Also, even though revenues and profitability are low by historical standards, banks still have significant financial resources comparedwith the typically much smaller start-ups that account for the vast majority of fintech firms. Accordingly, banks retain the ability tocontinue to build out their digital platforms, or acquire fintech firms that offer a valuable addition to their capabilities or product suite.

Banks will continue to have a place in the future landscape, on their own, alongside fintechs and aspart of marketplacesTaking these factors together, it is clear that traditional banks will need to continue to adjust (and invest) in order to remaincompetitive. But they will have some time, as Millennials continue to find their financial footing and become more profitablecustomers. And banks are not inherently disadvantaged or incapable of the changes that will need to be made to compete as thefinancial services landscape transforms.

While it is likely that some firms will lose business and possibly exit certain product/customer segments, still others will thrive in theseareas through one or a combination of strategies, that include:

» Overarching business strategies and platforms that position them as financial services providers that offer customers the full suiteof services in a manner that best fits their needs, including via digital platforms;

» Partnerships with fintechs to round out their offerings, while remaining in customers’ consideration set; and/or,

» Membership or hosting of one or more financial services marketplaces (akin to e-commerce) in which customers can chooseamong service providers.

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9 18 May 2016 Financial Institutions - Global: Fintech Transforms Competitive Landscape, but Unlikely to Displace Banks' Central Role

Tech landscape is fast-moving and potential for an accelerated shift remainsOne important factor to consider when attempting to predict the pace and path of this transformation, and which likely contributesto concerns regarding incumbent banks’ ability to compete with new entrants, is the shortened ‘time to mass adoption’ of newtechnologies and products.

This potential for new products/services to catch on quickly does leave open the possibility of a similar phenomenon within thefinancial services industry. Accordingly, we do see a number of potential inflection points that could signal or lead to an acceleration inthe large scale restructuring of the sector.

Reduction of ‘stickiness’ of current banking relationships

» Development of ‘open data’, which would allow financial institutions to more easily share and access customer information as wellas reduce frictions for customers to change or access alternate/multiple financial service providers.

» Fintechs offering competitive or alternative deposit products – for online-only firms, this will be accelerated with the continuingdevelopment of identity verification and data security.

More definitive regulatory stance

» To date, much official sector positioning has been around encouraging innovation as part of broader economic development goals,with many bodies actively encouraging the entrance of new financial service providers.

» However, most agencies have avoided making any broad pronouncements regarding prudential supervision or broader financialstability implications. This is starting to change, though, as fintechs' models and associated risks become more clear, and businessvolumes increase.

» That said, as many fintechs' business models include avoiding gaining banking licenses, which materially contributes to their lowercost bases, consumer protection authorities are the primary regulatory constraint on these firms and their activities, focusing, forexample, on data security, customer privacy and informed consent, and product pricing rules.

Entrance of ‘Big Tech’

» To date, the largest consumer technology firms have largely stayed out of fintech, with some notable exceptions, including mobilepayment products offered by Apple and Samsung, as well as Google Inc.’s (Aa2 Stable) entry via Compare (unrated), a pricecomparison application.

» However, a large technology – software or hardware – firm, with all of its customers, market power, and deep pockets couldpotentially tip the scales. For example, Chinese e-commerce firm, Alibaba Group Holding Limited (A1 Stable), has leveraged itsmassive customer base to offer variety of financial services through its financial services arm, Ant Financial (unrated).

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Moody's related research

» Asset Management - Global: Digital Adaptation Shapes Tomorrow's Asset Managers, May 2016 (1027563)

» Proposed Class Action Lawsuit Against Lending Club is Credit Negative for Sector, May 2016 (1024902)

» 2016 Banking Outlooks: Global and Regional Perspectives on Key Bank Credit Factors for the Coming Year (Presentation), January2016 (187021)

» Marketplace Lending ABS – Global: 2016 Outlook - Marketplace Lending Platforms Will Continue to Evolve, Expand Loan Types,January 2016 (SF420505)

» ABS - Global: 2016 Outlook – Marketplace Lending Platforms Will Continue to Evolve, Expand Loan Types, December 2015(1009326)

» ABS - US: Mobile Phone Financing Is Similar to Other Consumer Lending but with Several Unique Risks, February 2016 (1013117)

» ABS - US: Viability of Current Marketplace Lending Model Depends on Ongoing Litigation, Including Possible Supreme CourtReview, November 2015 (1009374)

» US Consumer ABS: Understand the Risks of Marketplace Lending Securitizations, May 2015 (1004845)

» Peer-to-Peer Lending: Prospects and Pitfalls, January 2015 (177574)

» US Payments Systems: Apple Pay Heats Up the Mobile Payments Revolution, but a Winner Has Yet to Emerge, November 2014(1001449)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of thisreport and that more recent reports may be available. All research may not be available to all clients.

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11 18 May 2016 Financial Institutions - Global: Fintech Transforms Competitive Landscape, but Unlikely to Displace Banks' Central Role

Endnotes1 According to a recent study by The Council of Economic Advisers.

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12 18 May 2016 Financial Institutions - Global: Fintech Transforms Competitive Landscape, but Unlikely to Displace Banks' Central Role

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Additional terms for Japan only: Moody's Japan K.K. ("MJKK") is a wholly-owned credit rating agency subsidiary of Moody's Group Japan G.K., which is wholly-owned by Moody'sOverseas Holdings Inc., a wholly-owned subsidiary of MCO. Moody's SF Japan K.K. ("MSFJ") is a wholly-owned credit rating agency subsidiary of MJKK. MSFJ is not a NationallyRecognized Statistical Rating Organization ("NRSRO"). Therefore, credit ratings assigned by MSFJ are Non-NRSRO Credit Ratings. Non-NRSRO Credit Ratings are assigned by anentity that is not a NRSRO and, consequently, the rated obligation will not qualify for certain types of treatment under U.S. laws. MJKK and MSFJ are credit rating agencies registeredwith the Japan Financial Services Agency and their registration numbers are FSA Commissioner (Ratings) No. 2 and 3 respectively.

MJKK or MSFJ (as applicable) hereby disclose that most issuers of debt securities (including corporate and municipal bonds, debentures, notes and commercial paper) and preferredstock rated by MJKK or MSFJ (as applicable) have, prior to assignment of any rating, agreed to pay to MJKK or MSFJ (as applicable) for appraisal and rating services rendered by it feesranging from JPY200,000 to approximately JPY350,000,000.

MJKK and MSFJ also maintain policies and procedures to address Japanese regulatory requirements.

REPORT NUMBER 1023176

MOODY'S INVESTORS SERVICE FINANCIAL INSTITUTIONS

13 18 May 2016 Financial Institutions - Global: Fintech Transforms Competitive Landscape, but Unlikely to Displace Banks' Central Role

Contacts

Robard Williams 212-553-0592Senior Vice Presidentrobard.williams@moodys.com

Nick Caes 212-553-1382Analystnick.caes@moodys.com

Jennifer Zong 212-553-0110Associate Analystjennifer.zong@moodys.com

Michael R PortaVP-Senior ResearchWriter

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