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How a bank should respond to ‘disruption’

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The word ‘disruptive’ is being bandied about liberally in the debate about new competitors, such as Zopa.

First, as I’ve said before, banks don’t really have any competition except between the incumbents, due to the structure of the industry.

Second, where there are openings, then disruptive new players may find a way to find a niche which is what Zopa and their brethren are trying to do.

So what exactly is ‘disruptive’.

Well the term ‘disruptive’ in the management school sense, was coined by Clayton Christensen, the Harvard Business School Professor who wrote the book “The Innovator’s Dilemma”.

I've seen Mr. Christensen present this concept a couple of times, and he talks about two types of innovation: sustaining and disruptive.

Sustaining innovation targets the existing market, whilst disruptive innovation either creates new markets or takes root with the incumbent’s worst customers.

And a disruptive innovation cycle goes something like this ...

An industry grows up around a product or service.

Over time, many companies enter the market and compete.

Gradually, the competition moves from being the basic product to being the best product for a target market segment.

As a result, lots of different market niches emerge, and competitors compete on building more and more functionality to appeal to their target markets.

This leads to inefficiencies as the competitors add a lot of form and function that no-one needs but they have to add this as, otherwise, there is no desire to replace and repurchase.

The industry over time becomes one where a lot of the price of the goods is going into form and function that the customer does not require, and so new competition comes in and disrupts the incumbents who are now too blind to see the folly of their ways.

The new competition enter with a new technology or approach.  This new angle allows them to build the same product, but often stripped to the bones into the original basic and functional product and at a fraction of the price of the incumbents.

The new competitor wins eventually, because the incumbents laugh it off when they first see.

The incumbents dismiss the new competition as being trivial. 

They pour scorn on it, as it is a no-frills basic service compared to their beautiful, functionally rich offer. 

The real issue though, is that the incumbents dismiss it as trivial but the market - the customer - does not. 

The customer wants it because it is cheap and simple, rather than expensive and complex. 

They want it because they are paying for what they get, rather than the irrelevant form and function the incumbents have added on top that they do not need.

By the time the incumbents realise this, it is when the new competitor is succeeding.

By the time the new entrant is succeeding, it is because they have reached critical mass (above 2.5% of market share, according to some).

By the time they have critical mass, the industry has disrupted and it is too late to turn things around for the incumbents, who are stuck with legacy structures and products.

And so the industry reignites and rebuilds in a new business model, having been disrupted by a new competitor using new technology to build a new way of doing business.

Mr. Christensen used the car industry as his major case study, although he says you can apply this to any industry such as mobile telephones (Nokia v iPhone) or computing (Google v Microsoft), but let’s look at the car industry.

In the USA in the 1950s, Ford and General Motors were rocking and rolling with the Mustang, Chevvy and more.

Ford and GM built bigger, brasher, louder and weirder cars to create appeal to more and more diversified customer segments.

The cars were not cheap and most Americans were happy to buy used vehicles because they could not afford new ones.

Then a strange little company came into the US car market from Japan called Toyota.

Toyota’s offer was a really cheap, basic car with no bells or whistles, and not particularly attractive.

Ford and GM laughed at the new entrant as just cheap rubbish, and particularly derided the fact that after just a few years most Toyotas became rust buckets.

But guess what?

A large part of America that could never previously buy a new car could suddenly afford to do so.

This did not impact Ford or GM who just measured their new car sales and had no track on the second hand market, but a lot of that market were switching to buying new Toyotas.

After a few years, Toyota’s success meant that they could start up-scaling their car offer to slightly better cars at a cheaper price.

Meanwhile, Ford and GM were losing a few customers who used to buy their entry-level cars.

These customers now realised that (a) the resale value of their car was going down, because people were buying fewer second hand cars; and (b) they could now buy better new cars, with more spec than they could previously afford, if they bought Toyota's up-scaled offer.

These customers were typically the entry-level Ford and GM purchasers, so Ford and GM weren’t too worried as they didn’t make margin from those guys.

They made margin from the big spenders.

So, let Toyota have a few of the muckrakers with their rust buckets. We’ve got our big expensive and loyal customer base who spend lots and give us profits. We’re happy with those.

Over the years, Toyota upscale again, bringing in a new brand called Lexus.

The disruptive cycle went from rust bucket to luxury vehicle over a period of about 25 years.

Today, Ford and GM are dinosaurs dying in the heat of the comet that hit their industry called just in time manufacturing, total quality management and Japanese methods of sourcing and producing.

You could take this story and apply it to any industry. Think British Airways v Virgin or Easyjet; AT&T v Verizon; WHSmith and Barnes & Noble v Amazon; Thomas Cook v Expedia; and so on.

Or banks v social finance, lenders v social lending, and Lloyds and their cartel v Zopa and their brethren.

Zopa’s big attraction is that they purely provide a platform for people to sell money to those who want to buy money. Zopa sets no rates and makes their margin on the difference between the buy and sell rates, a few basis points of margin in other words.

That’s the razor thin margin I referred to in my earlier post this week.

The point I should underscore here by the way is that it is not that social lenders are necessarily cheaper as product, in the sense of the car illustration, but that they are cheaper as an operation.  Because they operate at razor thin margins, they give all of that margin that banks would take - the 1%+ differential - and give it directly to the customer.

That is their secret - not cheapness, but sub-1% margin operations.

The result is that Zopa and their brethren are disruptive innovators, gaining bank’s customers who seek to borrow money at discounted rates from people who have money based upon basis point differential, rather than percentage point.

Equally, as banks currently offer really bad rates for lending and saving, they’ve already risen above being off-radar as they are taking at least 1% marketshare, and possibly 2% (see yesterday's blog). This is because, as I've been telling all my mates who have bank savings accounts earning sub-4% interest, they could get 6% or more return on their savings through Zopa.

Is the risk greater with Zopa?  No.  They use the same risk management systems as the banks called Experian and Equifax.

What if people don't pay me back?  If you're worried about that, they offer an insurance policy you can buy for a small premium to cover your investment.

As a result, Zopa’s funders and borrowers who are giving and taking money (liquidity) on their platform are building and, since this crisis hit, building more and more rapidly.  This is because savers and borrowers can see that they can get better rates here than they can find anywhere else.  Slowly, this will attract more money and, like Toyota, over time it may attract a lot more.

Once the banks notice the loss of their loan book, it is too late.  The new operations will have critical mass and once you see critical mass, the train has left the station.

So you can't get on the train - it's left - and if the new competition operates at margins of around 0.5%, then a bank cannot compete.  Reason: how can a bank with 1,000's of branches, staff and fixed cost, suddenly operate at zero margin?

Add on to this the social, human and fun bit, and you can see where this goes, in terms of really innovative disruption.

Now, right now, banks laugh at this new competitor because it is an irrelevant bit of fluff on their shoulder, a flea on their backside, a noise that cannot be heard.

After all, Zopa is purely attracting muckrakers buying rust buckets.

But, as this week’s blogging has started to find, maybe they are not. And maybe its not them anyway. Maybe it will be Prosper, Boober, Smava, PPDai, SmartyPig, Wonga or one of the many, many others out there.

So a bank should compete.

How should a bank compete?

Do what Caja Navarro have done, and create a hybrid social lending model that is bank run but the exchange of monies is between mums and sons, dads and daughters, aunts and cousins, friends and strangers.

Why should a bank compete?

Not because it will make the bank money in the short-term, as the margins are rubbish, but it will keep the bank in the food chain and stem the tide of any demand that disappears to a new fledgling before the fledgling finds its feet.

That’s the real answer to this innovator’s dilemma.

After all, if you just laugh at the flea on your backside, before too long you find the nasty little parasite has sucked all the blood out of you and ... you die.

Chris Skinner Author Avatar

Chris M Skinner

Chris Skinner is best known as an independent commentator on the financial markets through his blog,, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal's Financial News. To learn more click here...

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