In my last blog post, I shared some high-level thoughts on the financial technology (“fintech”) industry and what its increasing relevance means for traditional financial services. Beyond the fast-growing digital payments space, I identified two broad categories of fintech “disruptors” that will present opportunities going forward:
- Infrastructure companies that use modern technology to solve business and technology orchestrations that have historically been executed by banks; and
- Product companies that leverage these new infrastructure providers to rethink traditional financial services products and develop more effective solutions.
How legacy financial services players (particularly banks) tap into the new infrastructure providers and respond to competitive threats from the emerging set of product companies will go a long way toward determining their fate long term.
The “modularization” of financial services
For the entire modern history of banking, there were “rails” that moved money (or messages about money) and customers that were trying to solve a financial problem. In between those two layers, banks did pretty much all of the problem-solving facilitation. The products banks sold sat on top of a vast, complex orchestration of technology infrastructure and business processes.
Modern technology, namely cloud computing and the proliferation of application programming interfaces (APIs), has enabled the “unbundling” of this complex orchestration:
- Product fintechs are essentially disrupting the product layer of financial services by taking a “modular” mindset, attempting to break down banks (and other financial services) into component pieces and sell those pieces as standalone products. They are focusing on what their customers need and ignoring everything else.
- The infrastructure fintechs, meanwhile, are redesigning the technology and business process layers and creating new components for the product fintechs to build on.
This modularization of the various components enables new modes of competition for existing services along the product layer in the above scheme. New infrastructure technology allows for the delivery of high-quality service to these new product fintechs, as well as new offerings to other types of companies that otherwise would have difficulty connecting into the bank technology environment.
No shortage of funding for the fintechs
My last blog post highlighted the massive amounts of venture capital pouring into the fintech market over the past year or so. Product and infrastructure fintechs have been recipients of much of this funding because:
- There are hundreds of activities that reside in the business process/technology infrastructure areas of bank orchestration. Many fintechs and their backers believe the market for standalone products within those areas is big enough to support plenty of companies at high valuations.
- Many of the traditional financial products sold to bank customers haven’t been improved upon for a long time. These are huge end markets where many fintechs are confident they can achieve large enough scale by reimagining what banks have done and doing it differently – and better.
- There are many companies that have a financial services problem that is beyond the scope of their core business. They want to connect to an outside partner with an innovative culture that can solve specific problems quickly. This dynamic is expanding definitions of addressable markets for financial services.
Obstacles facing the incumbents
The modularization of bank architecture presents challenges to incumbent industry leaders (i.e., banks):
- It is hard to shift a corporate culture toward a modularized, more open philosophy when the entire history of the organization has been the opposite.
- Most banks are saddled with obsolete technology, so even if they wanted to adopt this new approach, the time and cost required to do so would likely be prohibitive.
- Banks also face a pricing dilemma: When you’ve spent your whole history bundling everything into one product offering, how do you charge for the individual components?
“Can the incumbent get product innovation faster than the startup gets distribution?” is an old tech adage that seems appropriate here. Fintechs clearly pose a challenge to traditional banks, but not every incumbent is doomed. It will be hard for many fintechs to acquire customers at favorable enough unit economics to survive long term. Some of them are selling features (not products), and the addressable markets may not be as large as envisioned for some standalone products. And while the pace of fintech innovation is accelerating, not all of these companies are super impressive; some will fail.
While banks as a group probably have more to lose than gain, those that adapt and embrace fintech (particularly infrastructure companies) could be net beneficiaries. Fintech is ultimately not a zero-sum game for incumbent banks. At a minimum though, these new fintechs are forcing legacy players to up their game and reconsider their business strategy, including the products they offer and how those products are designed and delivered to customers.