Everyone, it seems, is starting to take note of the burgeoning “Fintech” scene. Jamie Dimon even specifically referenced the threat from Silicon Valley in yesterday’s letter to shareholders’
“There are hundreds of startups with a lot of brains and money working on various alternatives to traditional banking. The ones you read about most are in the lending business, whereby the firms can lend to individuals and small businesses very quickly and – these entities believe – effectively by using Big Data to enhance credit underwriting. They are very good at reducing the “pain points” in that they can make loans in minutes, which might take banks weeks. We are going to work hard to make our services as seamless and competitive as theirs. And we also are completely comfortable with partnering where it makes sense.”
The fact is that banking is a field in which there hasn’t been much innovation. High barriers to entry and regulation have maintained a cozy oligopoly that didn’t feel the need to change things. Margins were good, and consumers had little other choice, so there was a natural conservatism to new ideas. The greatest innovation for many of these banks in the last 10 years was putting their annual report online. However, with the cost of innovation coming down, and with the power of the networks proven in so many other fields, startups are now attacking this “final frontier”
But it seems to me that many banks are still left confused by Fintech. It’s got to a size now where they can’t ignore it – but is it friend or foe? Consultants are telling them that they need to “plug-in” to the scene – to take advantage before other competitors do. And many banks are now allocating a fair chunk of capital to get involved – Santander and BBVA have funds of $100m, HSBC has allocated up to $200m, while Barclays and Citi have launched their own accelerator programs. Bank CEOs are increasingly talking about the “need for innovation” and “customer-centric models”, but I sense that behind the headlines, they remain confused. To my mind there are two types of company within the Fintech sphere – and an understanding of the sector requires a differentiation between the two. The point is not that one model is better than the other, but that they are completely different models.
- The companies that facilitate the way things are done now. These companies provide a service that integrates into existing financial infrastructure – making existing processes faster and more efficient. Typically they are software companies or they have created a way to make an existing process more efficient. These are natural partnerships for the banking sector
- Companies that are disruptive. They want to completely change the way a service is delivered to the end customer. Peer-to-peer lending, for example, aims to disintermediate the bank’s role entirely
In 1955 Eastman Kodak was the largest tech company in the world. They had a long history of innovation – starting in 1888 when the first Kodak camera was launched with the slogan “You press the button and we do the rest” (I love that slogan because it captures fantastically how focused they were right from the start on customer experience). They were relentless in providing customers with an exceptional experience. In 1963 they were the first to market with their “Instamatic Camera”, allowing customers to load the film in a pain-free way. A “Kodak Moment” became synonymous with capturing life’s most important moments. Then in 1975, continuing in the spirit of innovation, Kodak engineer Steve Sasson built the world’s first digital camera. However, fearing for the high margins of the film business, management promptly buried the technology. And it remained buried until competitors commercialized digital cameras in the 1990s. By this point, Kodak was too far behind in terms of innovation to catch up and the rest, of course, is history.
The lesson from Kodak is now an often-repeated favorite of business schools across the States. Kodak forgot that they were in the story-telling business, not the film making business. They focused on the margins they were making now, not the value they were providing to consumers. And this is why they failed.
So what business are banks in? Are they focused on matching savers and borrowers in the most efficient and elegant way? No, of course not. They’re in the spread making business – they look to make a spread between the rate they borrow at and the rate they lend at. Listen to the financial presentation of a major bank and you’ll see the language reflect this: Deposit spreads, yield curves and jaws. It’s all about creating a margin. And if they’re not doing that then they’ll spend money to get the consumer behavior they want (If I see another HSBC advertisement at the next airport I go to, I think I’m going to lose it!) Look at the sell-side research function of investment banks. Are they looking to supply customers with higher quality, independent research at a lower price? No, they’re focused on maintaining what margin they have left and getting sales people to push their product to PMs as hard as they can.
For the banks trying to embrace innovation, they face many of the same issues that Kodak faced in 1975. Do they adopt a disruptive technology, and cannibalize their existing profitability? While this might be the correct strategy for the long-run, it’s likely to decimate the business model in the short-run. Even if the executives on the ground see the potential, it’s unlikely to be taken up at a board level. A large bank just won’t risk taking this kind of hit to quarterly numbers. Disruptive businesses that take capital from banks will end up with the worst of both worlds – the technology will never realize its full potential and the implementation will be disruptive only in so far as it makes everyone’s life much more difficult. For entrepreneurs with a disruptive business, this is why it’s better to stay well clear of the banks and vice-versa. I would love to believe that a bank can genuinely forge ahead with a better way of doing things, but sadly experience tells me otherwise.