The inside outside model for innovation
How can banks remedy their low-growth performance compared to other sectors of the economy? By taking a cue from financial services companies that have outperformed their peers.
Defined in terms of growth in total shareholder returns (TSR), the clear outperformers are Capital One, Wells Fargo, and U.S. Bancorp. While the 13 other listed U.S. retail and commercial banks with assets greater than $40 billion delivered shareholders an average annual total return of 9.5% over a four-year period, Capital One delivered 18.1%, Wells Fargo 17.3% and U.S. Bancorp 15.6%.
The common thread for these three financial institutions is innovation investment. These banks are leaders in developing new customer offerings that spur organic growth and deliver high margins. Of course, innovation costs money. And in a low-growth environment, achieving innovation sufficient enough to draw business from competitors without inflating cost structures to unsustainable levels is quite difficult.
But it can be done. Wells Fargo, for example, has made significant investments in digital labs and most recently in its startup accelerator program. Outside of North America, Australia’s Westpac provided $50 million in seed funding for Reinventure, a financial services–focused VC fund. A variation on the theme is Barclays’ “school for startups,” where cohorts of 550 startups pitch their ideas, allowing Barclays executives to directly have their pulse on the rapidly changing fintech marketplace.
Most banks, however, are stymied when they think about growth and innovation by a mutually reinforcing, three-pronged problem:
- The Apple effect. Tech-industry cycle times have ratcheted up customer expectations for innovation. For traditionally risk-averse banking cultures, this creates a conflict that requires quick marketplace responses implemented using slow and complex internal approval processes.
- Barbarians at the gate. For the first time ever, non-industry players are threatening banks, especially with bold innovations in functions such as payments, robo-advisors and crowdsourced lending.
- Defying gravity. When a bank with growth expectations of 5% to 8% gets pulled down by a market growing between 2% to 3%, the missed targets lead to lower investments, which lead to less innovation – and an increasing gap with customer expectations.
Amid these challenges, an organic, internal, business-as-usual approach to innovation is not enough. Success requires a structured, externally-oriented approach to identifying new business opportunities that overcome the fear of failure prevalent within banks today. To gain competitive advantage, banks must innovate better and faster, and they need to do it as soon as possible, but within a structured model. Because banks have spent the last several years developing a strong risk management culture, they may need to segregate innovative roles from those that support traditional functions.
We suggest using the “outside-inside” model. The inside portion is similar to what already occurs today in banks, enhanced with a few innovation best practices. The outside portion refers to arms-length investments in venture capital (VC), digital labs, or other innovation-oriented companies.
The inside role involves allocating capital and funding new projects as part of the institution’s core banking business. The banking team can also help focus their innovation partners by being clear on both their strategy (where to participate and how to win) and on the problems and unmet consumer needs in the market. This is crucial to ensuring their partners “innovate with a purpose” and improve the bank’s return on investment.
Banks also have a key role in helping pressure test emerging ideas. For example, they can provide the practical regulatory expertise developed over many years that most innovators and startups lack. To get the most impact from these roles, many banks are making innovation a central part of the organization, with key innovation leaders reporting to the C-suite or even the CEO.
The outside roles are classic fintech startup activities, but they are gently directed and even accelerated by coordinating with bank sponsors. Knowing specific problems and unmet needs in the market (from bankers) allows startups to focus their activities. Indeed, in our conversations with leading innovation experts, clearly defining the problem, although seemingly mundane, is critical to both raising the odds of innovation success and getting innovations to market faster.
This outside-inside model provides banks with the quickest route to closing the innovation gap. They can innovate quickly without having to fundamentally change their cultures faster than is reasonable.