A System for Banking Innovation

Thomas Sargent, who won the Nobel Prize in Economics last year, has a theory about the current debt crisis in Europe. To him, it is not the debt or the “economy” that is crucial to solving the problem. Rather, it is the underlying principles of “fiscal union” and “monetary union” that matter. Put another way, who is responsible for Greece’s debts? Greece or the European Union?

America solved this very problem in 1787 with the Great Compromise, spearheaded by Alexander Hamilton. Europe is still working on it.

But what I gained from listening to Sargent speak last night to a small dinner audience at Yeshiva University, my alma mater, went beyond the debt crisis. What Sargent made clear was that everything demands a “system” and “model” that predicates “outcomes.” In other words, our collective aim — or at least the aim of economists — is to find order in the chaos.

As I reflected on what he said, I wondered, is there an order in banking innovation? Are there principles that can be defined that will yield the desired “outcome”?

As Sargent made clear last night, good questions should beget more good questions. (He told a wonderful story about his wife. He said he once mentioned to his wife that he occasionally gets questions that he simply cannot answer. Sargent said she told him that rather than answer those questions, he should simply ask a question to which he knows the answer — and answer it.) To me, that question is, what is the desired outcome in banking innovation?

This is not such a simple question for if you answered “make more money,” you would be wrong. There are many ways to “make more money” in banking in the short run only to end up eroding bank earnings in the long run. The best example of that are banking fees. Sure, in the short term they ply banks with revenue, but in the long-run they damage the bank’s brand and erode the customer’s loyalty.

So what is the desired outcome of banking innovation? My hope is that the desired outcome is to enhance the customer’s financial life and experience while supporting the bank’s financial aims. An innovation in banking should be a “positive,” not a “negative.” It should foster something good for the consumer, while secondarily it fosters good for the bank.

This is lost on many financial institutions, because they are addicted to crack cocaine-like banking fees. Just today the Consumer Financial Protection Bureau held a forum in New York on overdraft fees. One of the CFPB’s initial conclusions was that consumers could, in fact, avoid overdraft fees, but didn’t know it. Certainly, banks can inform them of the opportunity to avoid the fees — if only the banks weren’t addicted to the fee income.

What is a “good” banking innovation, though? How would Sargent define that?

To me, there are two elements: advancement and security. An innovation in banking must better a product, a practice, a protocol — something. It must improve the experience or the result for the consumer. What’s the point of adding a mobile banking platform, if its service is worse than the one through an online banking portal? Why add a credit card product with more fees or restrictions, not less? Why create a mobile payments system that is more cumbersome or slower than using good, old-fashion dollar bills? No, an innovation needs to be an improvement; that’s element one.

Element two is security. Banking cannot function without security. A banking services provider — notice I used the term “banking services provider,” not “bank,” because I am including every venture that provides smidgens of banking services, such as PFM providers — must make security as great a priority as innovation. One cannot function without the other. The most innovative product means nothing if its security is lax. And the greatest security in the world is useless if the product or service is too constrained to use.

Security also needs to be a foundation of the banking brand, too. And that is why non-bank brands are starting to cover themselves in the blanket of security. Such brands simply cannot do financial services without it.

The best example of this is Google’s Good to Know marketing campaign. When I first saw it a few weeks ago, I couldn’t understand what Google was getting at. Do I really need to know all these mundane elements of how Google manages data, for example? This is not exactly Will Ferrell doing stand-up comedy.

But I do, or rather Google needs me to know these things, because it cannot sell its Google Wallet service without first establishing its security bona fides.

Banks often forget this point. Or make too much of it. To my mind, it seems as though bankers think that consumers believe in bank “security” the longer the bank remains a “rock” of consistency. That bank is here today; it was here yesterday; it will be here tomorrow. Just “being” is the best way to convey security.

The thing is “just being” can morph into “not doing anything new,” and that is a dangerous proposition. The drive to innovate has to be married to the drive to maintain a baseline of security. I see too many banks, especially small banks, whiffing on this. There are exceptions, of course, but there are too many banks that fall into a pattern of dis-innovation.

Of course, innovation costs money, and there must be a return on that investment. Small banks have a hard time with this one. There are two responses to this obstacle: 1) innovation doesn’t have to be grand; and 2) sometimes the bank has to suck it up and invest. When I think of innovations that are not grand, I think of custom emails and URLs, blogs, refinements into underwriting guidelines or product terms. These are innovations just the same. But just the same, there must be an allocation of capital to innovation. There’s an old business saying by Theodore William Schultz, another Nobel Laureate in Economics: “if you don’t grow, you die.” You don’t want your bank to die, do you?

Well, I’m nearly certain this blog does not merit a Nobel Prize, but I hope it establishes to some small measure a principle of banking innovation, which is that innovation, we have defined it, must be intertwined with security. In truth, this effort to define a “system” for banking innovation is in homage to Thomas Sargent, who has spent his life thinking about, well, everything. That next banking innovation — let’s give him a bit of credit for it.