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Banks Face the Innovator's Dilemma

Sometimes the simplest lessons are the hardest ones to learn. 

Anyone who has taken even the most basic business course in the past fifty years is undoubtedly familiar with Theodore Levitt's 1960 treatise “Marketing Myopia”:

"The railroads did not stop growing because the need for passenger and freight transportation declined. That grew. The railroads are in trouble today not because that need was filled by others (cars, trucks, airplanes, and even telephones) but because it was filled by the railroads themselves. They let others take customers away from them because they assumed themselves to be in the railroad business rather than in the transportation business. The reason they defined their industry incorrectly was that they were railroad oriented instead of transportation oriented; they were product oriented instead of customer oriented."

It doesn't take a lot of imagination to rewrite that paragraph to describe the banking industry today. Economic cycles wax and wane, but people will always look for ways to save and borrow, to move money from one place to another, and to occasionally get some advice from someone they trust. Traditional financial institutions like banks and brokerages held a near monopoly on those activities for generations, but banks that continue to be bank oriented will continue to lose to an increasingly broad group of competitors that are truly customer oriented.

Mature industries erode subtly at first.

Hungry upstarts nibble at segments too small or unprofitable for entrenched incumbents to waste much energy protecting. But eventually the new entrants gain traction and move upmarket to larger and more profitable segments. And new categories are invented along the way.

Think about what's been happening around the edges of the banking industry. Peer to peer lending platforms and retailers' captive financing programs have taken lending business that once was nearly the sole province of banks. New payments ventures like Square and Dwolla provide services that people want to use because of their great design and ease of use. SigFig is an online registered investment advisor with over $50 billion in assets tracked on its platform. Innovative startups like Simple and Movenbank are reinventing the whole notion of what it even means to be a bank. 

The scariest part? None of those companies even existed 5 years ago.

While the banking industry was recovering from a global financial crisis and reacting to the prospects of new regulations, smart entrepreneurs were finding new and better solutions to problems that people cared about. 

Is it reasonable to suggest that banks could have or should have been the ones to create all those new innovations given the weighty issues they were understandably tackling? Even when not in crisis mode, established companies should rationally protect their own profitable businesses, and small niches are not very attractive prospects for large companies needing large profits. 

The Innovator's Dilemma

That presents a dilemma, but not one unique to banks. It's the Innovator's Dilemma, as Clayton Christensen famously dubbed it in 1997.

Established companies correctly protect their successful business and are naturally reluctant to disintermediate their own products.

But those initially small niches sometimes grow into large markets that can become significant threats. Clayton describes how minimills at first could only produce low quality rebar, and the large integrated steel manufacturers were glad to get out of that low margin business. But with their profits, the minimills were then able to invest in new processes for angle iron, then structural steel, and then eventually high quality sheet metal, disrupting the entire steel industry in the process.

Consider seemingly innocuous innovations like prepaid cards and online-only banks. To some they don’t seem to threaten the more profitable core banking businesses today, but they could very soon.

And the pace of change is increasing. It took 13 years for the new product known as television to reach 50 million users. No one had any idea what a "tablet" was or what they would even do with one when Apple launched the iPad, but it reached 50 million users in just 18 months, and created a whole new category that is already a serious threat to the PC industry.

The Innovation Imperative

Bankers take too much comfort in the perceived protection provided by operating in a highly regulated business. Relying on regulations to protect the industry will only hasten its reduction to utility status. Regulations are also not a good excuse for not innovating.

The highly regulated healthcare industry invests 10-15% of its revenues back into research and development, and represented 21% of the $603 billion spent globally on R&D in 2011, according to Booz & Co. Financials don’t even make the list, lumped in instead with the 2% of “other” industries, collectively in tenth place.

So what business are banks in if they are not in the banking business? They are in the business of helping people achieve their financial goals. Hardly a groundbreaking idea, but in my experience not one that most bankers spend a lot of time and energy addressing. While shareholders and regulators cannot be ignored, customers really do not care about your net interest margin or the duration of your loan book.

 Banks that will thrive in this new era will find new ways to be relevant and provide value to their customers, and some of those ways may not involve traditional banking products. Bankers need to really listen to their customers, discover their financial pain points and embrace creative ways to address them.

 If they don't, someone else will.

(This article originally appeared in American Banker.)


Comments: (4)

A Finextra member
A Finextra member 01 February, 2013, 08:37Be the first to give this comment the thumbs up 0 likes Great post, JP. The problem of where banks are heading can indeed be attributed to the flawed mentality. However, there is also issue of corporate culture which cannot match that of a startup. That's what happened to PayPal, for example. Creating in-house startups rarely works with such entities as banks, for many reasons. Startups can make a decision and implement it in the matter of weeks, if not days (or hours). Banks needs months...
Jp Nicols
Jp Nicols - FinTech Forge - Seattle 01 February, 2013, 17:24Be the first to give this comment the thumbs up 0 likes

So true!

Ketharaman Swaminathan
Ketharaman Swaminathan - GTM360 Marketing Solutions - Pune 06 February, 2013, 12:45Be the first to give this comment the thumbs up 0 likes

Why do we take a regulated industry like banking and keep quoting examples of disruption from transportation, consumer electronics and other unregulated industries? I suspect it's because there are hardly any examples of successful disruptors in telecom, utilities and other regulated industries. Compared to them, structured financial products like CDO, CDO2, CDS and MBS prove that banking is a lot more innovative. The very fact that these products sold so well establishes their customer-centeredness as well. 

As I've argued in my JIBC op-ed article titled "Impact of Regulation on Financial Services Providers", some nonbank financial products are too small to threaten banks (e.g. Dwolla, PROSPER) and the others will simply cease to exist in the absence of the banking rails on top of which they’re built (e.g. Facebook Credits which has, since then, ceased to exist despite the continued presence of the underlying banking rails). 

That said, it’s not as though regulation has totally paralyzed banks. There are several areas in which banks can enhance their services to become customer-centric. But they involve operational improvements rather than large-scale innovation.

A Finextra member
A Finextra member 06 February, 2013, 13:37Be the first to give this comment the thumbs up 0 likes

Did regulation protect consumers from overcharging, bad practice and plain fraud (to name a few "unpleasantries")? Not at all. How many "FSA regulated" entities screwed up BIG time?

Regulation often leads to status quo complacency and inertia. Banks are bad innovators not because they are regulated, but because they don't have too (i.e. don't give a damn).

Funny enough, regulation was the key disruption factor in the mobile industry (in the EU). There is more to come there...

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