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The Intelligent Bank: The Hidden Weakness in Financial Services Business Models

(This article is the first in our new series, The Intelligent Bank: The Hidden Levers of Profitable Growth. Through this series, we will explore how emerging technologies such as artificial intelligence and machine learning will transform the industry's business models, offer a new operating model for achieving sustainable growth, and recommend paths to execution.)

Financial services companies will not be disrupted by technology, or by fintech companies. They will be disrupted by the inherent, and hidden, weakness in their business models, and by their dependence on generations-old processes which make changes slow and expensive. Technology will be the catalyst.

The winners will find new growth opportunities by taking a truly holistically approach to understanding and serving customers, addressing risk, building highly scalable and adaptive platforms, and leveraging the power of ecosystems.

Disruption is more than an overused buzzword. Used accurately, it still has the power to illuminate patterns hiding in plain sight.

Here is a simple example. We all know that Netflix “disrupted” Blockbuster, and put them out of business. Few understand how, or why.

Netflix was founded in 1998, inspired by Reed Hastings’ frustration with a $40 late fee at Blockbuster. The following year, Viacom re-took Blockbuster public, with a valuation of $4.8 billion. Blockbuster famously turned down an opportunity to buy Netflix for $50 million in 2000; it believed Netflix’s mail-order delivery model was a niche business.

Blockbuster did not reach its peak of 9,000 stores until 2004. By 2010, Blockbuster was bankrupt and three years later, its stores were liquidated.


[The rise of Netflix; the fall of Blockbuster. Graph originally by Augustine Foo.]

In the story of Blockbuster’s downfall, Netflix may have been the catalyst, but it was not the cause. The cause was Blockbuster’s business model. Rental fees generally covered costs; the company’s profitability was driven by late fees. In 2000, over 18 percent of its revenues, and almost 40 percent of its net profit came from late fees. Blockbuster eliminated those fees in 2005 under pressure from Netflix, but had to reinstate them in 2010 because they could not close the $300 million revenue hole.

For its customers, those late fees were a major irritant, and a cause of deep resentment. That was the inherent weakness. Blockbuster’s business model required a conflict of interest with its customers. That is why it lost its hold on its customers when a better option emerged, and drove its bankruptcy.

Similarly, technology-driven financial institutions will disrupt traditionally-run banks by taking advantage of this conflict inherent in financial services business models, and offer better value propositions to their customers.

But exploiting an opening will not be enough. Successful challengers will continually need to evolve while meeting customer, regulatory, and shareholder needs.  

Netflix always recognized that its success would be driven by its adaptability, not by its dependence on its existing distribution model. Its initial mail-order experience was less than ideal, but its subscription revenue model addressed a real customer desire to avoid fees. From the beginning, it organized around business capabilities, not processes, so it could quickly take advantage of technology shifts. Once broadband penetration reached critical mass among US households, Netflix disrupted itself to focus on streaming at the expense of its DVD mail order business.  

Each of its core capabilities were designed and built to be highly automated, and driven algorithmically. Netflix architected itself to quickly enter new markets, offer new products, and service to new kinds of customers with little organizational or technical friction.



What lessons does this hold for legacy financial institutions?

The industry’s business models will not be disrupted by technology, or by fintechs. Those are catalysts.
 

Existing business models will disappear when they create fundamental conflicts with their customer’s best interests.
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Technology-driven financial institutions will disrupt those models by taking advantage of these conflicts. They will sustain this advantage by building highly intelligent, automated business capabilities that will enable them to quickly adapt to changing customer expectations, market conditions, or new business opportunities in adjacent markets.

To illustrate a clear example of this dynamic in the retail banking industry, the industry generated over $11 billion in revenues from overdraft and ATM fees alone. The CFPB estimates that 61% of retail account profits stem from these fees. Other examples abound across banking, investment management and investment banking.

How might a tech-driven bank exploit these weaknesses? Here are three scenarios we can foresee over the next two to three years:
  1. Tech-driven banks with highly automated operations and systems can earn higher margins on lower spreads. This will give them an incentive to create full transparency in trading and lending markets, disrupting trading models that depend on price opacity.
     
  2. As fees race towards zero across the asset and investment management industry, investment managers will need to create new sources of value for customers beyond the Fees for AUM (Assets Under Management) model. Robo and hybrid advice offerings that empower investors by clarifying price, performance, goals alignment, and even values alignment will either augment human advisors or disrupt them. This trend will amplify as automated advice begins to cover more difficult, complex products such as insurance, annuities, and other actuarial products.
     
  3. In a highly automated world, the marginal cost of asset servicing and custodial services will drop towards zero, increasing pressure on middle and back office service providers to justify their fees. Winners will be those that transform end-to-end value streams, not just automate existing processes.
This evolution into what we call the Intelligent Bank can unlock new sources of organic growth by reducing the organizational and technical friction involved in entering new markets, serving new and existing customers more holistically, or launching new products that entail new business models. Emerging technologies such as blockchain, artificial intelligence, and machine learning—complemented by mature capabilities such as microservices, platforms and chat bots—will be the new catalysts.

The Intelligent Bank: The Hidden Levers of Profitable Growth will explain how this model can work and how to execute this approach. Sign up below to receive updates when the next installment in the series is published.