Fintech, short for ‘financial technology’, is shaking up the retail banking industry. More commonly Fintech has been used as an umbrella term to denote the industry comprising companies that have utilised these technologies.

It is the impact these companies have had on the strategic behaviour of retail banks that I will consider in this article, arguing that many retail banks have an innovation problem and that only certain strategic approaches will allow retail banks to develop the technological capabilities they will need to compete effectively with fintech companies...

There is little doubting the disruption these fintech companies have caused. Fuelled by new technologies, changing consumer preferences and widespread distrust of traditional banks following the financial crisis, new entrants have made their presence felt and have increased their market share in almost every single product category one associates with retail banking: payments, lending, insurance and even asset management. A recent PWC report found that 70% of CEOs of incumbent retail banks (ie your traditional banks: Barclays, CitiBank etc.) were somewhat or extremely concerned about the disruption these challenger banks (the new fintech companies) would bring.

These concerns are well founded, with 125,000 individuals switching banks in 2016 in the UK alone; and, as numerous consultancy reports have detailed, much disruption having occurred already with more expected along the way. Deloitte’s, for example, claim fintechs will entirely ‘upend the competitive dynamics of the financial ecosystem’. It is thus a matter of when not if this disruption occurs. With this broad consensus that the dynamic of the industry will palpably shift, it is of better use to consider what the incumbent banks have been doing in response to these threats- three general strategies appear to dominate.

The first, and most common approach, is to launch ‘sustaining innovations’. These improve products along dimensions of performance without fundamentally shifting the function of banking. All of us have benefited in some form from this approach. The proliferation, for example, in mobile apps is indicative of this; apps improve our banking experience, however, they do not dramatically change what banking is- it thus sustains the status quo.

The problem with such a strategy is that it is inherently unambitious and opportunistic and could leave many incumbents lacking the technological capabilities necessary to compete with challenger banks. ‘More apps’ is not a panacea, banks need to think carefully about what customers want.

Customer experience these days is everything in retail banking and new technologies could greatly enhance this function. Consider fintechs like Kasisto which leverage their AI capabilities to communicate directly with customers. Having access to this technology allows them to offer a far greater customer experience than your typical mobile banking app. Thus the problem with these sustaining innovations is that they induce banks into not doing enough, meaning that in the future they are unlikely to possess the technological capabilities necessary to compete with fintechs.

This brings us to the second approach which we refer to as ‘outsourced innovation’. In this case innovation does not occur within the firm, rather it is delegated to others. In theory it could allow banks to access new technologies and improve their capabilities. Three tactics dominate here: direct equity investing; launching incubators and accelerators; and acquisition.

The first two have been largely unsuccessful; both failing for the same reason: they provide no mechanism by which innovation can flow back to the incumbent bank. According to a report by Toptal these two approaches reflect 30% of the activities of incumbent banks in this space. Axa for example, launched a $200 million fund for fintech firms in 2015; Barclays have set up a large accelerator for fintech companies called RISE.

However, aside from the returns coming in off these investments, and in gaining an understanding of how fintechs operate (as with the incubators and accelerators) banks often do not add to their tech arsenals in pursuing this approach. Barclays, for example, have managed to partner with some of the firms that pass through its programme; but more often than not the good ones then move on and become entirely independent entities. For example CHAINALYSIS recently left the RISE programme for greener pastures sharing none of the capabilities it had developed under RISE’s wing.

This leaves us with acquisition, which would seem to offer more scope for banks to enhance their tech capabilities as they could directly accesss new technological capabilities. Goldman Sachs and CitiBank have been the most prolific in this department with CitiBank, for example, having made over 25 acquisitions of fintech companies.

Before evaluating aquisition though, it useful to consider why banks have largely failed to innovate in house.

Firstly, one must consider the legacy IT infrastructure of retail banks. Much of the software here is based on the dated COBOL (a type of programming language often used by business). The problem: this makes it extremely difficult to integrate and harmonise new software…thus even if they develop the right technologies, they may not be able to use them. HSBC and Natwest in particular have struggled with this. Secondly, is the organisational priorities and practises of incumbent banks. Banks may not want to develop new, riskier technologies as they are already experiencing increasing returns through the sustaining innovations outlined above- thus the low appetites for innovation within their banks constrain their ambition.

Thus acquisition is not always a solution, as the potential for the new technologies usage may not be considered fully and banks will struggle to integrate it effectively into their IT systems.

This leads us to the most effective strategy- ‘the independent model’. This essentially sees banks creating offshoot organisations that escape many of the problems outlined about.

One application of this has been to create an entirely independent organisation. Marcus by Goldman Sachs is the paradigm for this, and has, as of 2017, accrued $3bn in loans and $20bn in deposits in the US alone.

It works for two reasons. Firstly, in escaping the ideological constraints of Goldman it can think differently; as its head Harit Talwar said: this allowed it to develop an ‘outsider mentality’ and develop financial competences completely different to Goldman’s. Secondly, as it was a new organisation it could start fresh from the IT side, thus new technologies could be easily integrated. For example, Clarity Money, an AI fintech acquired by Goldman, had much of its software integrated seamlessly into Marcus.

Collaboration is another approach that has worked. Here Banks and Fintechs partner to create independent organisations. For example CitiBank partnered with the smaller fintech company ‘HighRadius’ to launch Citi Smart Match an independent organisation that increases the efficiency and automation of the cash application process of matching open invoices to payments received for its corporate client. Its independence was key here and solved the same two problems outlined above that Marcus did.

In short, retail banks are struggling to adapt to changing conditions- some more than others- the situation is not yet terminal though. The shackles that have constrained the innovative activities of incumbents must be overcome; the key, it would appear, is independence. Only through breaking out of their existing organisations is it likely incumbent retail banks will be able to innovate to their full potential and compete effectively with fintech companies.

This article is based off a paper written by the author. For readers that want to explore this area further or access the paper for a more in depth view of these findings please contact the author at C.Martin7@lse.ac.uk.