In evolutionary biology there is the well-known theory by American biologist Stephen Jay Gould of punctuated equilibrium — that species are generally stable, changing little for millions of years until this pace is “punctuated” by a rapid environmental change resulting in a new species. We’re witnessing this theory in real time.
For years, banking has been slow to change and adapt but, as a result of the current remote environment, banking is going digital at an electrifying pace. The wisest banks are doubling down on their digital strategies, smart banks are rushing to invest in digital, and everyone else is waiting to go the way of the dinosaur. COVID-19 has punctuated the digital transformation, and banks that hesitate to commit to digital will get left behind. The institutions that survive will be the ones that understand their role in the online landscape and capitalize on today’s accelerating trends.
The survivors are quickly adapting to the new digital reality. With widespread vaccination, a return to “normal” life at least six months away, and discomfort with physical interaction likely to last much longer, it’s not surprising that 82% of consumers are concerned about visiting bank branches in the future. This is a massive problem for many regional banks.
I caught up with the team at AQN Strategies, a boutique consulting firm that brings practitioner experience to consumer and small business lenders. John Crenshaw, a partner at AQN, said he had recently worked with a regional bank that was originating more than 80% of new credit card accounts within branches to existing customers. That is a very narrow market to start with, and what happens to that business as branch numbers and branch traffic continue to decline? Maybe the best way to frame this is through the words of Microsoft founder Bill Gates: “Banking is necessary, banks are not.”
With the old model increasingly in doubt, traditional banks have two choices: hunker down and hope to survive or focus on innovation and put real money into research and development. Those who opt for survival by digging moats and building walls will find themselves like Rip Van Winkle — by the time they wake up, the world will have moved on. The old school must do both simultaneously.
Unless a bank can differentiate itself on offerings or customer experience, it will find itself increasingly irrelevant, hemorrhaging talent, shuttering branches and looking after primarily older, non-digital customers. It eventually ends up as a utility, unable to recoup its cost of capital, let alone deliver a decent return on equity (ROE). The best of these banks will get acquired. The rest will look as old-fashioned and rundown as a Sears store.
During these next six months, banks must prepare for the new reality by committing time and money toward enhancing their digital capabilities with the help of fintechs. The case is clear; according to McKinsey, 63% of customers are interested in digital banking apps, yet only 35% of bank technology budgets are devoted to innovation.
Finding the digital edge
The classic example of a digital challenger taking down a stale incumbent is Netflix destroying Blockbuster. Game-changing technology won out — and big — with the punctuating event being the rapid rise of ubiquity in internet and streaming. While inertia makes it unlikely that incumbent banks will suffer a “Netflix moment,” scale alone is not enough, and the advantage it offers will fade incrementally each passing year.
Banks that lack scale, such as regional banks, are at an even deeper disadvantage. Beyond having smaller war chests, regional banks’ operational philosophy poses challenges. Many focus heavily on earnings, net interest margins, charge-offs, and efficiency ratios, yet increasingly lose deposits to the money centers. To be blunt, regional banks are underperforming and becoming less competitive. According to the Federal Reserve Bank of St. Louis, regional banks’ return on equity has hovered around the cost of capital since the 2008 financial crisis. Rising compliance costs and the continued shift to lower returning assets means ROE continues to decline. On top of this grim outlook, many regional banks are located in geographies that don’t appeal to top talent, although remote work due to Covid-19 may ameliorate this.
But regional banks don’t need to give up hope entirely. There are paths forward, although some are painful:
- Figure out what you do best: Trying to be everything to everyone while being everywhere is not a strategy. Figure out your comparative advantage and double down on it.
- Seek out new audiences: Half of America is not being served by banks. That’s over 150 million people — about as many people as voted in the 2020 election! A massive group of people is just waiting for a financial institution to meet their needs. If you don’t have the analytical horsepower to identify and convert them on your own, partner with someone who does. Every bank wants a super-prime Affirm/Peloton-type opportunity. These are few and far between. Regional banks must get comfortable expanding their customer base by moving down market or targeting the “silver” population. This is especially important in their own backyards, where they can leverage their brand and extensive data to generate positive selection over national subprime issuers.
- Rationalize your branches — now: This is the time to bite the bullet and not cling to the past. Focus on where your core customers are, whether it’s urban, rural or suburban, and super-serve them. The trend is clear. AQN mentioned they’ve seen this play out in several engagements, noting that deposit customers traditionally bought other financial products from their deposit bank. But that continues to decline as digital spaces make it so much easier to shop for, compare and switch to other products. Traditional banks continue to focus on higher penetration of their existing customer base, even as those bases shrink.
- Partner with fintechs: Fintechs are exploding around niche market problems, leveraging top talent and creating products customers love that can help banks transition to digital. Watch, collaborate with, build and buy fintechs. Use them as partners, and harness their competitive advantages. Banks can’t afford to ignore them.
Some critics might caution that it isn’t a good idea to make big changes when the future is so ambiguous. Why not wait until business returns to normal to buy a fintech? Fintechs are coming of age and the window to acquire will narrow. Undoubtedly, the window will close on differentiating yourself with digital, leaving some banks wishing they had acted sooner, when valuations were lower and opportunities were widely available.
COVID-19 has undeniably accelerated the transition to digital banking. Tomorrow’s winners and losers will be dictated by bold investment and astute leadership today. Regional banks must focus on adapting to an online banking environment and transitioning to entrepreneurial and innovative cultures that embrace the evolving consumer landscape. Fintechs will figure largely in the picture and can create a win-win-win relationship with regional banks and their customers as they look to scale up their customer experience and broaden their suite of offerings and expertise. Regional banks must avoid the trap of — as we used to say at Capital One — “monovarability.” They must lean into digital. Using COVID-19 as a fig leaf to avoid addressing digital deficiencies until later could be fatal.
Though economic recovery might be slow, banks must be ready to welcome the future’s economy with open arms. The winners will quickly adapt to the new digital reality. Those most adaptable to our new environment, not those focused on survival, will win out.
Nigel Morris is the co-founder and managing partner of QED Investors, a fintech venture capital firm focused on disruptive, high-growth financial services companies. QED has made numerous unicorn investments, including in Credit Karma, NuBank, Avant, SoFi, Klarna, GreenSky, and AvidXchange. Morris co-founded Capital One Financial Services in 1994, and retired from the company in 2004.