More than simply David versus Goliath

Any business in any era must be able to rapidly adjust to the ebb and flow of currents in its industry – or, better still, to anticipate and stay ahead of them. This is doubly true in the digital age, since the pace of transformation is such that any service provider standing still risks being swept away by the changing tides of customer preferences.

Anyone interested in financial services will recognize the popular narrative of disruptive innovators entering the marketplace and eroding the previously rock solid positions of incumbent institutions. Everybody loves a good story and few hold more enduring appeal than the triumph of David over Goliath.

But this story is only of limited relevance to the future of financial services – and the years ahead are likely to defy the notion of a clear separation between winners and losers. Instead, we’re seeing evidence of a great appetite for collaboration between these supposedly sworn enemies – an appetite that could soon expand much further.

Public antipathy towards banks add to the tail winds helping to propel new entrants forwards apace.

How new entrants look to get ahead

First, let’s consider some of the key factors that gave rise to the notion that new entrants could defy the odds to usurp their established rivals:

• Tech companies like Google and Amazon raised customer expectations for digital experiences, posing a new challenge for traditional financial institutions
• Public antipathy towards banks and insurers, combined with high levels of trust enjoyed by many tech firms, added to the tail winds propelling new entrants forwards apace
• An explosion in the number of new entrants, each typically offering an innovative solution to a particular area of inefficiency (unlike the direct banks of the 1990s that wanted to provide a full service rather than a niche one)
• Use of constant connectivity, automation, disintermediation and new data sources by emerging players to swiftly resolve customer pain points

Most successful new entrants have gained market share from established rivals not by offering end-to-end alternatives but by helping consumers overcome particular obstacles. Concentrating on niche areas has allowed them to be nimble and flexible in cutting costs and creating seamless user experiences.

If we consider mobile payments, we see there was an influx of new entrants three or four years ago that wanted to provide novel alternatives to the entire payments system. But the innovative offering that looks to be standing the test of time is Apple Pay – still running on the existing ecosystem but with improved interoperability and point-of-sale simplicity.

Many innovators have exploited points of friction in accessibility, increased regulatory burden, reduced appetite for risk and issues with user experience and cost (the latter often caused by incumbents’ legacy systems). In doing so, they have widened access to financial services in underserved niche areas. Alternative lenders have grown rapidly by leveraging digital tools and lean processes to radically streamline the loan adjudication process so it can be done in days rather than weeks. This change has opened the door to lending for thousands of small businesses with cash flow needs.

Furthermore, because they are many in number and work in parallel, they can iterate and test potential solutions at a rate that traditional institutions simply cannot hope to compete with. For instance, a great number of start-ups are experimenting with robo-advisors that use algorithms to automatically manage customers’ wealth. This encompasses everything from fully automated ETF-based models like Wealthfront, to emphasizing virtual human interactions as Personal Capital does, to suggesting stock picks like Motif Investing.

Why these innovations matter – threats and opportunities for traditional institutions

Many new entrants have shown they can harness their focused innovations to “skim the cream” from financial institutions’ operations in the short-term. While this is clearly a reason for concern among traditional players, it doesn’t necessarily represent a terminal threat.

As new entrants grow, they will face the kind of challenges that are encountered by any successful innovators: a crowded market, lack of scope to go beyond their initial target niche and the constant risk of sinking before they can swim. They will also have to face up to the challenges that inhibit traditional institutions today, from increased regulatory scrutiny to increased operational complexity.

These innovations must therefore be assessed for their long-term impact on financial services firms – and their potential to generate not just threats but also opportunities.

Firstly, let’s look at the threats to traditional financial insitutions, not all of which relate to direct competition:

• Blurring sub-sector boundaries – innovations widen accessibility to new products, creating competitive pressure across sub-sectors. High-margin, mass market products then suffer – as seen with alternative lending, crowdfunding and robo-advisors taking customers away from retail banks’ deposit and money market products
• Loss of customer ownership – traditional institutions often rely on bundling services together and cross-subsidization. But the proliferation of niche providers encourages customers to shop around, so that every product needs to be competitive in its own right. Tech firms offering attractive digital experiences may further erode traditional customer ownership.
• Changing customer behavior – a wider mix of products to choose from as new cashless payment methods emerge. Young adults are also being encouraged to take more control of their finances with the advent of robo-advisors – or to act as experts themselves by using emerging digital tools such as algorithmic trading platforms

But while David’s slingshot posed only a clear and present danger to Goliath, many of the innovations we look at in this report also offer opportunities for bigger players, including:

• potential to obtain sophisticated capabilities at low cost by learning from or acquiring cutting-edge solutions (e.g. a new generation of platforms and managed service providers focusing on specific operational processes)
• modernizing inefficient financial services infrastructure (e.g. potential to revolutionize transfer of value through decentralized technologies behind cryptocurrencies)
• creation of new channels to give financial institutions a more central place in their customers’ daily lives (e.g. connected insurance) fulfilling customers’ diverse demands without taking on all the risks involved and rapidly scaling up by leveraging digital platforms (e.g. mutual funds distributed via robo-advisors)

This balance of threats and opportunities means the future landscape in financial services is unlikely to be populated by many outright winners or losers. Rather, companies must adapt and be willing to compromise and collaborate. They can help themselves by clearly defining whether they wish to focus primarily on customer relationships or developing products.

Striving to offer best in-kind services will be essential amid intense competition and ever-greater customer choice. Success will also depend on leveraging innovations to enhance efficiency and transparency in working with outside institutions (such as with decentralized systems and market platforms, for example).

Why the impetus to collaborate is a two-way street

The tendency for new entrants to “skim the cream” as described earlier may benefit consumers by increasing choice and stimulating greater competition. But it also has a natural limit, as do efforts to capture customers that have been underserved or simply not served at all in the past. Older institutions could still largely retain control of the crucial mass-market.

If new entrants wish to continue growing, many of their early advantages may erode over time as they attempt to scale across customer segments and face greater regulatory scrutiny. At the same time, incumbents are being challenged by consumer demands for greater choice and transparency, out-dated IT systems and regulatory compliance driving costs higher. They generally recognize that the innovation imperative is stronger than ever – but also know it may not be feasible to solve all these problems acting alone. 

What does all this uncertainty mean? Put very simply, it means a powerful impetus to collaborate exists within both established institutions and innovators. Incumbents should ask whether this great wave of new entrants would be best viewed as an external R&D function rather than a threat. Innovators can use partnerships with bigger rivals to ensure their ideas are implemented at scale and become widely accessible to consumers – some already have.

The banking-as-platform movement seeks to prevail upon large financial institutions to expose their APIs in a standardized way. This would support the growth of an innovative community of developers in a manner comparable to that used by Google and Apple to meet their customers’ demands. Already we have seen innovation by Ripple Labs help financial institutions modernize their internal settlement processes with decentralized protocols, thus paving the way for a streamlining of how value is transferred in the future.

New entrants can use collaboration with established firms to integrate themselves into the existing value chain, while major players gain through slicker, streamlined processes and potentially through reputational benefits. Collaborations must go beyond superficial customer-referral or vendor-client relationships and instead help seed an ecosystem that nurtures innovations without compromising systemic stability.

For instance, Pandai, a P2P lending platform in China, is working with a number of large banks and insurers – and not only by sharing customers. It is also creating new investment opportunities, sharing risk adjudication capabilities and supplementing the usual product offerings (with default insurance, for example).

It should be clear to incumbents that refusing to rethink their role in the wider financial eco-system could result in business failure. This fate will inevitably befall a small number of firms, just as a certain number of failures must be expected in any efficient marketplace. But it’s a mistake to think that most traditional financial institutions are too intransigent to survive – or even to thrive – in their future environs.

Why cultural differences don’t preclude collective gains

In short, the disruption and evolution of financial services is not a zero sum game. Not all innovations introduced by new entrants are existential threats to traditional financial institutions. Many are too geared towards a specific niche to be anything of the kind. Furthermore, incumbents realize that new entrants already have strong incentives to innovate and that the benefits of innovations often stretch far beyond the company responsible for them.

Looked at from this perspective, it’s not so surprising that deep-rooted cultural differences between innovators and incumbents are not proving a bar to collaboration. Caricatures through which each side may sometimes view the other – reckless innovators who ignore the rules or self-serving bankers with regulators in their pockets – must be put aside.

When shared in the spirit of cooperation, radically different perspectives can help all parties better understand a complex environment and chart a way forward. Such partnerships can offer incumbents many benefits, such as implementing cutting-edge innovations at scale, modernizing infrastructure and enhancing digital experiences for customers.

It’s only natural that new entrants will always unleash a few slingshots at Goliath. But in the future of financial services, many could end up reinforcing his armor and helping to make him less vulnerable.