UK: Digital Transformation Meets Regulation 4.0 In 2030 (2/3): Where Should Incumbents Play?

As regulators continue to develop their response to disruptive innovation, the regulatory risk – what type of regulatory change will occur in response to innovation – for incumbents is increasing. In our previous blog we explored how regulators may respond to innovation by presenting two forward-looking regulatory scenarios. In light of this, how should incumbents approach their digital transformation? In this blog, we explore where incumbents should play to hedge against regulatory risk by assessing their optimal digital transformation target and their geographic footprint.


Despite this rising regulatory risk, incumbents cannot afford a "wait and see" approach delaying their decisions to invest in digital transformation. Indeed, three interrelated trends in particular underlie the necessity of digital transformation: profitability, customer centricity and competition. In terms of profitability, on average, from 2005 to 2016, the return-on-equity (ROE) for European and US retail banks has decreased by 9% and the cost-to-income ratio has increased by 6.8%, despite renewed effort on cost containment. Digital transformation can help increase ROE through various levers, including through cutting costs sustainably. Indeed, Temenos and Deloitte estimate that banks running modern core banking systems have enjoyed on average a 28% higher ROE and a 6.5% lower cost-to-income ratio than banks running legacy applications.

There is a continuing focus on customer centricity – an approach to banking where customers are considered primary stakeholders and which results in increased trust-based relationships. The aim here is to establish long-term banking relationships by leveraging customers' data to provide more personalised products and services. Incumbents still have much to do. Examples of providing seamless 24/7 interactions across multiple channels continue to rise, such as video on demand service for mortgage advice, which is not based on appointments and reduces waiting time to talk to a specialist.

Finally, in terms of competition incumbent retail banks are increasingly at risk of losing their market share to non-traditional players. In particular, the spectre of BigTechs is looming. Incumbents' services around payments and lending, in particular, will continue to face a higher risk of market share loss as these services offer more opportunity to create differentiated customer experiences. BigTechs have a competitive advantage over incumbents insofar as they have no technological legacy issues, have significant volumes of customer data, large cash reserves for investing in new ventures, and, critically, are better positioned to attract the already scarce talent. It is also clear that the interplay between customer centricity and competition puts pressure on incumbents' cross-subsidisation business model, which will further indent their market share.


We have segmented the disruptive innovation underpinning digital transformation into four maturity clusters:

  • cluster 1 – high maturity: online banking, mobile banking, wearables and biometric security;
  • cluster 2 – medium maturity: cloud, blockchain, chatbots, open banking and cryptocurrencies; and
  • cluster 3 – low maturity: quantum computing, virtual reality, artificial intelligence, initial coin offerings and sonic payments;
  • cluster 4 – next frontiers of future disruptive innovations.

The value of undertaking digital transformation based on "cluster 1" and "cluster 2" typically scales linearly. The value of adopting digital transformation based on "cluster 3" and, in particular, "cluster 4" will be determined by a more complex set of factors.

In our previous blog, we explored the interplay of three factors (and the two regulatory scenarios that could result, whilst keeping in mind that are many other scenarios that could also be considered):

  • risk management;
  • regulatory design and architecture; and
  • regulatory convergence. 

Alongside these factors, the "disruptive innovation maturity level" (degree of adoption and penetration of disruptive innovation by market players) should be considered. This results in us identifying four forward-looking scenarios for digital transformation (Figure 1):

  • scenario 1: with the flow;
  • scenario 2: clear waters;
  • scenario 3: against the flow; and
  • scenario 4: turbulent waters.

Each scenario then identifies where incumbents should play to hedge against regulatory risk by assessing their digital transformation target and geographic footprint.

In "Scenario 1: With the flow", stagnant economic growth results in sluggish profitability, which puts pressure on incumbents' budget for innovation (organic and inorganic) and on new entrants' capacity to attract funding for innovation. Customers are becoming increasingly vigilant towards data privacy risks. In an attempt to counter this stagnant economic growth, regulation acts as a facilitator for innovation. New entrants emerge slowly.

In this scenario, incumbents focus their efforts on augmenting their existing digital transformation perimeter across the international footprint. This can be achieved through:

  1. investing in the existing value chain to generate scale;
  2. retaining the existing customer base by alleviating their key pain points as part of the customer experience journey; and
  3. acquiring a small set of new entrants based on their capacity to achieve 1. and 2.

In "Scenario 2: Clear waters", strong economic growth results in solid profitability, which allows incumbents to invest in innovation (organic and inorganic) and new entrants to attract funding for innovation. Customers are becoming ever more demanding in terms of their experience. Given that market players (incumbents and new entrants) are effectively managing the risks related to disruptive innovation, regulation acts as a facilitator for innovation. New entrants emerge quickly and competition from both incumbents and new entrants accelerates.

In this scenario, incumbents focus their efforts on advancing new digital transformation frontiers across their international footprint. This can be achieved through:

  1. developing in-house disruptive products and services to generate new market penetration;
  2. expanding the customer base by offering a highly anticipative customer experience (giving customers what they need before they know to ask for it); and
  3. buying a large set of new market entrants based on their capacity to achieve 1. and 2.

In "Scenario 3: Against the flow", uneven economic growth results in unbalanced profitability, which channels incumbents and new entrants to pursue innovation, and subsequently operate, on a more geographically constrained basis. Customer demand is becoming ever more heterogeneous. As national and/or regional protectionism are on the rise, regulation acts as a deterrent because it is divergent (gaps and/or inconsistencies within the regulatory framework). New entrants emerge slowly but compete aggressively with incumbents.

In this scenario, incumbents focus their efforts on optimising their existing digital transformation perimeter across the domestic footprint. This can be achieved through:

  1. developing an agile operating model to generate speed;
  2. optimising the customer base through micro-segmentation; and
  3. buying a small set of new entrants based on their capacity to achieve 1. and 2.

In "Scenario 4: Turbulent waters", high profile cyber-attacks and data privacy wrongdoings undermine confidence in the financial services sector. Customers are ever more protective in terms of their data usage and privacy and exercise their civic muscle to ensure market players are held accountable. Consequently, regulation acts as a deterrent, whereby it de-risks market participants by limiting both the depth and breadth of the applications of disruptive innovation. The number of both new entrants and incumbents shrinks.

In this scenario, incumbents retrench their existing digital transformation perimeter across both the international and domestic footprint. This can be achieved through:

  1. minimising the interconnectedness with third parties within existing value chain;
  2. divesting from products and services which are high impact in terms of customer mistrust if things go wrong; and
  3. pausing on acquisitions.

Incumbents should start now using this or similar scenario analysis as a tool – for developing a long-term corporate strategy – to help them determine:

  • which of their existing fundamental assumptions about the future of digital transformation must be re-examined;
  • which actions they should stop if future events indicate that digital transformation is headed towards "Scenario 3: Counter the flow" or "Scenario 4: Turbulent waters"; and
  • which actions they should take if future events indicate that digital transformation is headed towards "Scenario 1: With the flow" or "Scenario 2: Clear waters". 

Since scenario analysis is an art rather than a science, incumbents should adopt a "learning by doing" approach and probe earlier scenarios that with the benefit of hindsight turned out to be wrong, so as to identify what went wrong. The next blog post in this series will explore how incumbents should play to win.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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