Why Don’t Banks Innovate?

There appears to be no shortage of opinions that banks don’t innovate (see here and here  and here  and…you can find the other 17 million references yourself). 

Rather than arguing whether or not this assertion is true, let’s assume for a moment that it is. The key question, then, is: Why don’t banks innovate (or why haven’t banks innovated)?

Is it because:

a) They’re too stupid to innovate

b) They don’t know how to innovate

c) They’re too risk averse to innovate

d) There’s been no need to innovate

If I were to take a poll, I’d bet that the majority of respondents would answer B, followed by C — even though many of you would like to select A.

I think the answer is D.

—————

When the Innovation Snobs talk about innovation I think what they’re really looking for is large-scale change in the industry. After all, there have been plenty of technology “innovations” in the industry like ATMs, online banking, online bill pay, PFM, mobile banking, remote deposit capture, etc., but none of these “innovations” seem to satisfy those that call for more innovation.

Despite these innovations, the industry has changed little in terms of power structure and business model (as it applies to the retail sector, that is). Even the sadly misguided Mashable article Can the Internet Replace Big Banks? recognizes this. 

So why haven’t we seen large-scale, transformational change — or innovation — in the industry, despite the advent of the Internet, the Web, and more recently, mobile technologies?

Because — until recently — there has been no need for the industry to change.

—————

For large scale change to happen in retail banking, three elements need to be in place: technology change, demographic change, and economic imperative.

There’s no formula, but if one of these elements isn’t sufficiently present, change isn’t going to happen. 

Since the mid-90s, the emergence of Internet technologies has created the technology change required to cause industry innovation or transformation. With the advent of mobile technologies, even more technological change is pushing the industry to change. 

Many Innovation Snobs think that this is sufficient to cause change, but it isn’t. And one reason why the technology change wasn’t enough was because we didn’t have sufficient demographic change. 

Ten, even five, years ago, Boomers and Seniors dominated the generational composition of the US population. While we were willing to try technologies like online banking and bill pay, and even willing to open online savings accounts with a firm like ING Direct, we still did our banking business the old-fashioned way: We opened up checking accounts with the same old providers we did 20 or 30 years ago (although many of them merged along the way, of course).

It’s only been more recently that the demographic shifts required to effect industry change have come about. The emergence of Gen Yers as a significant percentage of the US population is a recent phenomenon. What’s different about this generation (from a financial services perspective) is their willingness (or desire) to find an alternative to checking accounts. When Seniors, Boomers, and even Gen Xers became adults, we automatically opened up a checking account. Not so with Gen Yers.

Without this demographic shift, the simple development of online banking, bill pay, etc. was insufficient to bring about large-scale industry change.

—————

But even the demographic shift by itself isn’t — and hasn’t — been enough. There’s another reason why innovation hasn’t occurred, and I think the Innovation Snobs really miss this point: There has been (until recently) no economic imperative to change. 

Ten years ago I did some consumer research about the drivers of customer loyalty in banking. I went out to my bank clients to tell them the findings, and tell them what they had to do differently to improve customer loyalty. Their response was pretty underwhelming: “Why should we do anything differently when we’re making money hand over fist?”

They had a point. The chart below shows industry ROE from 1998 through 2009. From about 1993 through 2007, industry ROE fluctuated in a narrow band of about 13% to 15%, before falling off the cliff in 2008. 

20130325_ROE

With those kinds of returns, who’s got an incentive to change?

—————

This is why we haven’t seen the innovation that the snobs have called for. The elements of change haven’t sufficiently been in place. 

But with advent of mobile technologies, the shift in demographics, and the economic issues facing the industry, we might actually be on the cusp of some bigger change. 

Despite the rebound in industry profits since the worst of the financial crisis in 2009, ROE has not come back as fast, and is only at about half of the historical levels of 13%-15%. 

McKinsey did an analysis and estimated that industry profits could reach $154 billion by 2015, up 27% from its 2010 level. But for the industry to reach 12% ROE in 2015, profits would have to be roughly twice that amount — about $312 billion. 

How is the industry going to get there? For that, we can turn to another leading consulting firm, BCG. For the industry to reach historical levels of ROE, cost reduction could put 3 to 4 percentage points on the ROE level (that’s not 3%-4% cost reduction, you know). BCG believes another 2 to 4 points could come from pricing and growth.

20130325_BCG

With all the regulatory changes that have occurred in the past few years, I don’t see how price manipulation is going to help. The banks have been limited in their ability to alter interest rates and fees every step of the way. 

The demographic shift may help to fulfill the growth imperative as a new way of Gen Yers need mortgages and car loans. But the shift away from checking accounts (and the inability of banks to generate significant revenue and profits from these accounts) may inhibit the banks’ ability to put that 1 or 2 percentage points onto ROE through growth.

—————

So we may actually see some innovation in the industry over the next few years. It’s not like the banks are too stupid or don’t how to innovate. They haven’t had the economic imperative to innovate. Until now.

About these ads

25 thoughts on “Why Don’t Banks Innovate?

  1. This is an interesting point of view.
    I suppose you could also argue that banks did too much financial (their specialty) innovation… I also believe that over the last 30 years only few other industries innovated as much, But then you would always want to sell a new innovative idea to the bank and they don’t always buy into your arguments and that is real tough!
    But yes I agree banks don’t like risk, any risk, and often prefer to follow the few real innovators.
    In regards to the RoE gap, I believe it will be much more difficult to bridge the current levels with the pre-crisis levels for the only reason that risk equity is not freely available and expensive and that to cover the higher equity costs banks can only reduce expenses at the cost of some core competitive differentiators (convenience, pricing) while trust in the system is at a historical low as is their solvency. Also growth will be negative because banks have to reduce risk weighted assets and big banks are not the in-thing these days for the regulators.
    So interesting simple question but really tough answer.

    • Clive: Thanks for commenting. Regardless of whether or not I’m right about the innovation part, the more important question to me is how do banks (and the industry) bridge the ROE gap. And I agree with your assessment about why growth will be negative. To me, this is why new business models will have to emerge. As they say in the great state of Maine when you ask for directions: “You can’t get there from here.” That’s the case w/ historical levels of ROE in banking.

      • Agreed and defining a new model will require the type of innovation many bankers lack, but also it will be technology driven as well as revolutions of banking fundamentals, new paradigms. I certainly don’t have the final answer but I do know we have to think out of the box.

        • Agreed. The challenge I have in thinking about something as “technology-driven”, though, is that in banking, pretty much EVERYTHING is technology-driven these days. But I think banks will develop technology-based services — separate and apart (although maybe integrated with) traditional types of accounts. In other words, a consumer can “use” (ie, buy) a service from an FI without having to have an account with them.

          • I think that (banks developing technology-based services that are separate from their traditional types of accounts) must be in the future of financial institutions. Otherwide, they will never realize the ROE that they have sought since the decline. If financial institutions DON’T do this, they will be passed by. Other companies, new to the financial industry, already are doing this, and they are not going to stop.

  2. i guess I’m going to get bashed for this by some economists, but I have a feeling that many (not all) economists focus on ‘cost’ and ‘volume’ as factors in accordance with traditional manufacturing paradigms, while few consider ‘quality of service’.

  3. I understand your assessment of innovation being driven by technological, demographic and economic change, but is the move to innovate too late when an industry (banking) waits until all three are in alignment? In other words, shouldn’t innovation come before it is required? If we take the traditional innovation examples of Amazon or Apple, I could argue that the innovation they did preceded the market need and therefore, allowed the companies to gain market share and revenues at the expense of slow movers. Traditional banks look more like Borders or Blockbuster (again, typical examples), where a slow mover tries to innovate to survive as opposed to innovate to grow.

    My concern is that by the time many banks smell the roses and decide to react to marketplace changes, the marketplace will be well ahead of them. The innovators will be with third party suppliers who will be finding ways to bypass the traditional banking establishments to provide services to the changing demographic universe that are already using new technologies and are willing to pay for added value.

    • Jim: I didn’t really think of the three elements as being in “alignment’. I see them more as “thresholds” — beyond a certain point there is sufficient change in the element to cause broader, industry-wide change. But I’d be hard pressed to measure at what point that it is on any of the three elements’ scale.

      To your question, “shouldn’t innovation comes before it’s required?” the answer is yes. But I’m simply trying to explain why it HASN’T happened so far in banking.

      Is waiting too long a prescription for death or decline? I don’t know. The regulatory environment, while particularly favorable to incumbent banks, do create barriers to entry.

  4. Question is:where must innovation of banks and banking lead to. Banks must be safe place for everybodies money. However they arenot anymore. Money on the bank must give enough profit for the bank to cover the bank hardware and software costs, the transaction costs, the communication costs, the interest promised to the client and for some profit. The loans banks provide must be “safe” and profitable also. And ICT bankingsystems must be unhackable

    And now the method and answers on the question and need: how can innovation contribute to the demands mentioned above? I do’nt know how. I hope other smart people can give them.

    • I think the real question is how you define innovation. It can be product innovation = new products that meet the client needs, process innovation = new ways of operating or managing the bank etc. But the questions is also can the bank invent a new business model which changes fundamentally the way the intermediate the markets.
      The risk for them if they remain static is that they will be disintermediated. There are signs that this is happening with for example pier-to-pier banking. If you think about it there are a certain number of services and products clients buy of which financing/ loans, investments/ deposits, payments services including cards and advisory services. Are there alternatives outside the banking industry for each of these products? The answer is yes . The only reason banks still exist is that they “guarantee” a certain level of service because of their solvency and the trust we have in them. This is under a lot of pressure, push it a little further and you will see client reducing their reliance on classic banking.
      The other point you mention is the cost of services. In order to organize the industry and avoid solvency issues regulations are becoming a huge cost factor for all banks (think of the situations of US community banks). Can the banks pass this on to clients? What is the level of pricing where customers will look at alternatives?
      As a management consultant I push for banks to improve their management competencies by looking at more advanced methods and models. Pricing is an example of this, but this represents improvements of the existing model not innovation.

  5. Ron,

    Excellent article. I wonder how much the ROE is impacted by new liquidity rules (in Europe for example) and BASEL III. Taking less risk on lending isn’t as profitable, and less fruitful on the financial markets, simply because you don’t have as much debt to sell.

    Even separating out the casino aspects of the bank, part government owned banks, facing significant regulatory challenges (like PPI mis-selling or LIBOR) have a mountain to climb before returning to profitability.

    It’s interesting that many are taking this opportunity to have a long hard look internally, and invest for the future. It’s not innovation as XEROX PARC or Sillicon Valley would recognise. If anything it resembles compliance, it’s slow moving, expensive and by the time it hits it won’t feel revolutionary.

    Banks will always feel slow, and behind the scenes the beast will be just as risk adverse as it always was. What I wonder is will be see more Credit Agricole style open API approaches and wholesale and retail banking splitting, like BT Openreach and BT Retail ~ Mid 2000s

  6. The question is really legitimate.

    First let’s remind ourselves that here we are talking about “innovation” in retail banking and not forget banks fulfill other major roles in the economy like servicing small and big companies and helpng countries and other big institutrions invest in the future for common good. So too many times I have diffculties with people claiming that because banks are not innovative enough for the new generations, alternative suppliers will push the traditonal banks aside until they die: non-sense ! Banks operate by delegation of states and manpulating money will never be like manipulating another goods.

    Second, obviously there are fields for innovation in retail banking for helping ther ustomers live a better life which simply means to let’s go back to Main Street bank as a way to resort to the natural social role of banks in society.
    But innovation is NOT publishing the latest “smart” app on a tablet: that’s pure using an additional channel to reach clents, the next step would be using connected TV, of course ! tablets may be labelled as innovation but hardly can baking usage of the tablets be called that unless for some usage which can change clients life like accessing own’s account on real-time or be notified for major events.
    By the way, where are the true innovations like mobile payments and universal third-party supplied accounts aggregation ?
    Why do we have to wait until all market actors fnd the right financial compomse on the new value chain before we c(clients and hence banks’ stakeholders) can benefit from thses innovations ?

    The reasons are very simple and builds up my third point:
    1- object of innovations in finance are intangible and , until now, not patentable which means the competition can very rapidly copy any product and there is some issues with coming up with any reasonable ROI figures which may deter any general mangement in investing heavily in innovations
    2- until the change/attrition ratio reaches a worrying level, there are no reasons why banks would fiercely fight each other for customers: there is competition but nothing alike the ones existing in industry and we are more under a cartel regime than anything else; hence a comfort attitude, close to disrepect, from the marketing departments towards the clients
    3- major innovations, like new payment schemes, still require standardisation among banks as to guarantee wide acceptance of these innovations

    As expressed earlier, if Y gen customers would effectively, “en masse”, switch from traditional banks to other new / more advanced providers and also because now banks, due new stringent regulations need more fresh money to cope with them, will there be the need to fight for retaining and acquiring customers, which obviously s far more effective trigger to innovate than just because fashionable press articles and frustated clients blogs request it.

    You would have noticed my deep interest in the concept of innovation in Bank as I founded 4 years ago an Innovation Club gathering the Innovation Directors of the major Banks & Insurance comapnies in France to deal with these issues in retail and it s a fragile domain !! The Club has site which is globally in French for obvious reasons. http://innovation-finance.altran.fr
    The interesting thing is that we are not only discussing between us these issues but we launched 2 co-opetitive projects to push innovative marketing (in fianance) methods like Design Thinking and already produced 2 POCs.

  7. Interesting question, but not backed by any sound evidence. Leaving aside wholesale banking, where innovation is even too much, too fast, too blurred …. To me this article is totally unclear about the standards in use to say that retail banks do not innovate. 1) benchmarks: with respect to what kind of similar industry? Insurance: no game. Health services: no game. Mobile communications: but for pricing (which is not at all customer oriented), I’m eager to know in what respect their rate of innovation should be considered higher than that of a retail bank 2) definition: what is an innovation? Product? Process? Channel? Organization? I dare say that, as a general drawback of a very poor customer perception and relatively low level of investment on above-the-line advertising, when banks start selling protection policies or mobile phones SIM cards through branches that is not rated as innovative as when supermarkets sell personal loans at their counters 3) Measure: time? The amount of time the average family needs to perform the average weekly bank transactions has much more than halved in the last 10 years. Ain’t that innovation? What other service industries can display similar technology-driven effect? Other metrics?
    Last paragraphs about ROE level and how to go back to old glory days are much clearer but, again, it is not proven that declining ROE will spur innovation. Another point of view could be that, despite the very high level of innovation, Bank’ ROE has been severely affected by a much tougher regulation affecting transactions, cards, investments products, at a level unseen in other service industries.

    • Gianluca — Thanks for your comment. You raise some great points. The blog post most definitely does NOT address the “standards in use to say that retail banks do not innovate.” That’s because there are no standards. I actually believe that banks HAVE innovated, but it seems to be a common perspective among many industry observers/participants that they don’t. Many of these observers/participants go on to claim that banks “must” innovate if they are to remain in existence.

      Rather than argue that banks HAVE innovated, I conceded the point (for the purpose of this blog post), and tried to explain to the Innovation Snobs that there’s a reason why “innovation” — defined as sweeping industry change — hasn’t occurred to the extent that they have called for.

      The other point I’d like to address is that I don’t believe I ever used the words “old glory days.” The point about ROE is that when your business (or industry) is performing well, there is little impetus to change (even in the face of technological change). When your business/industry isn’t — and management perceives there to be a burning platform — change happens quicker.

  8. Your comments are consistent with findings in a recent PwC study on branch innovation which points out that banks are going to have to innovate to cope with a hangover from the financial crisis and unprecedented regulatory challenges. PwC is projecting annual growth at 5%, but major regulatory changes to depress that level while increasing operational costs. All of this taken together points to an innovate or perish type scenario for retail banks.

    Regardless of anyones point of view on innovation as expressed by yourself and the many comments on this page, innovation will be a way of life in the years to come.

  9. Innovating ahead of the curve is a must for most large banks. Extensive federal regulations limit their ability to respond quickly to market changes and trends. In many situations, if they waited until it was necessary to innovate, they would miss the boat. I agree that innovation has been fairly non-existent – mobile banking, “Smart” ATMs, online banking…these are changes in the way consumers interact with the bank, but they are not an overhaul of the industry. I would consider innovation to be something like biometric customer identification, for example. This would prevent account fraud and theft, while also making debit cards and credit cards obsolete. However, this would require major innovation of retail businesses on the spending/receiving end of things. Perhaps limitations in payment processing by those receiving consumer funds may be one of the factors that have kept banks from making some advancements.

    • Banks don’t necessarily have to over think innovation, but simply take a consumer perspective. For example, making use or better use of text alerts when a CD is coming due, or a payroll check clears, or when interest rates rise. Branch hours in areas with large clusters of branches can be varied to support banking at later or weekend hours. The list goes on and on.

  10. I’m not sure if I agree with you here. On the retail banking side, there’s been a number of innovations. It’s whether they are recognised as innovation or not. One can look to the channel executions for retail banking to see that technology change has resulted in a fundamental enablement of banking services across new channels. Yes they’re probably not exciting, and, no, the fundamental operations of what a customer might do hasn’t changed (deposit, account balance). In this instance I’d go as far as to say that innovation doesn’t necessarily mean transformation, and we can expect that the core customer operations to not change, even if the means in which we execute them, will change.

    On the investment banking side, I’ve seen a number of “innovations” from a financial product perspective, as well as technology. One would argue that investment banking’s innovation mindset borders on near fetishism levels. What is missing in investment banking is innovation that sticks. Where, retail and commercial banking is almost utility-like, the scope for change in Global Markets is absolutely immense.

    I expect the next couple of years to bring innovations focussed on communication and process optimisation, and more fluid ways of working that will challenge the current models.

    The notion of customer at the center, as jeff above touched on, will continue to make headway into how banks work. Regardless of whether that customer is an end customer, or an internal customer.

  11. Great post! Like you said before their really isn’t a reason for the banks to innovate. Yes, their are smalls places where they can change and grow but nothing large enough to make a big deal about. Thanks for the post!

  12. Pingback: 9 Types of Blog Headlines from the Experts

  13. Pingback: It’s Time to Stop Reading the Teleprompter | Social Assurance

  14. Pingback: It’s Time to Stop Reading the Teleprompter | Social Assurance

  15. Pingback: So You Want to Be an Innovator? | Bank Innovators Council

  16. All great comments but this is number 7000… :)

    Well done to Ron for getting such a well rounded, well written and well frequented blog by such clever folk… i wish i had the time and the ability!!

    David

  17. Very interesting post and comments. Re. Jim Marous’ point that innovators will be third-party suppliers finding ways to bypass the traditional banking establishments, this has been very much my finding in some recent research I’ve been conducting on financial services innovation. Companies such as Currency Cloud have been utilising the travel industry’s model of unbundling, often just offering one discrete part of the banking value chain, like FX transactions. While regulation undoubtedly creates barriers to entry, technology innovation such as cloud computing not only helps to overcome these barriers, but also allows new entrants to operate profitably at much lower levels of scale.

    Banks are realising that the barriers to entry are falling too. For example, what’s interesting about p2p lender Lending Club is that banks form a significant part of its lending base. This is because it allows them to outsource unsecured lending (and avoid the constraints of regulation) while still holding onto their customers. Feel free to access a copy of my research on 11 new market entrants that are challenging banks to respond to their innovative models here:

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s