Innovation in commercial banking is doomed because the upside is so limited

Innovation in commercial banking is doomed because the upside is so limitedThink about a commercial bank, the kind you see sprinkled throughout most large cities. Its business model has two parts: accepting deposits and issuing loans. The key to a commercial bank as a business is that it pays less to depositors than it collects from borrowers, in the form of interest.

Commercial banks are commodity businesses

We can quickly see, from the nature of its business model, that a commercial bank is a commodity business. A dollar from First National Bank is just as valuable as a dollar from Second Regional Bank.

You can say the same thing about oil and gas companies. The barrel of oil that ExxonMobil produces is just as valuable as the barrel of oil that Chevron produces. (There are some industry-specific nuances here that I’ll skip over. The point is that the market establishes a value for a standard barrel of oil, regardless who produces it.)

Commercial banks can’t deliver a “better” dollar. All commercial banks offer the same dollars. So differential performance comes from how banks engage their customers and how they manage their costs.

Compare commercial banks to consumer products companies. Apple made a smartphone that was demonstrably better than any other phone on the market. It made a fortune. The only real constraints were the size of the market and just how much better Apple’s phone actually was.

Tesla is trying to do the same thing with automobiles. Luxury brands do the same thing with jewelry and accessories.

The point is these companies can deliver a “better” product than their competitors. And that “better” product will justify higher prices, or higher sales volumes, or any other number of benefits.

Commercial banks can still differentiate themselves

Commercial banks can’t offer a differentiated product, if you view the product as the dollars it pays to its depositors or the dollars it lends to its borrowers. But commercial banks can differentiate in how they interact with customers and how they manage their costs.

For example, First National Bank may offer better customer service than Second Regional Bank. First National might offer more intuitive online navigation. Unfortunately for the banks, these distinctions are on the margins. The core offering, the dollars themselves, are a commodity.

Banks can also compete on interest rates. First National might offer depositors a higher rate, or offer borrowers a lower rate. But that’s a race to the middle. There is an upper limit on the rates a bank can offer for deposits. There is a lower limit on the rates a bank can accept for loans. The financial performance of a bank is under constant squeeze.

The key difference between banks and consumer products companies is how they can differentiate. Consumer products companies can deliver products. They can pursue step change improvements in the value consumers get from the product itself. Apple created a visibly better cell phone. It had features and capabilities no other phone had. 

Unfortunately for commercial banks, there’s no such thing as “better” loan. The bank can offer better rates. It can offer better service. But the main offering, the loan itself, is a commodity. It’s an important qualitative difference between commercial banks and consumer products companies.

Innovation around an offering is different than innovation of an offering

Again, we need to acknowledge that commercial banks can differentiate themselves. A commodity business can offer consumers real reasons to choose its offering. But the differentiation is qualitatively different for a commodity business than for a non-commodity business.

In the world of commodities, innovation is focused on customer experience and cost. And the upside is limited for commercial banks in both these areas.

Commercial banks already use technology to make life very easy for customers. Sure, some banks do it better than others. But the gap is small, particularly when you consider the hassle of switching banks.

Likewise, the margins for commercial banks are small. According to the Federal Reserve Bank of St. Louis, the net interest margin for all U.S. banks is now about 3%, a low for at least the last 30 years. This result isn’t surprising. You can only increase depositor rates, and decrease loan rates, so much before you’re no longer profitable.

In the two areas where commercial banks could most differentiate themselves, customer experience and cost reduction, real constraints already exist. Banks are already suffering dramatically diminishing returns in these areas.

Not all commodity businesses face such a strong constraint. Return to the oil and gas example above, about ExxonMobil and Chevron. There’s considerable room to push costs lower. That’s why scientists and engineers are working so aggressively in that industry. 

You can drill and complete oil and gas wells more efficiently. You can also capture more oil and gas from each well. There are several ways you can improve the financial performance of oil and gas companies, even though they ultimately deliver a commodity.

That’s the real difference with banks. The margins are already tight, and there aren’t a ton of cost dollars to pull out. That’s part of the reason banks resort to leverage. The only way for them to meaningfully increase their profitability is to borrow money themselves. They then lend that borrowed money at a premium. It’s a risky strategy that figured prominently in the Great Recession.

An important lesson: not all innovation is created equal

Painting with a super broad brush, I’d say as scientists and engineers, we glom onto innovation. It’s what we do. We make products, services, systems, better. We rigorously identify the root causes of suboptimality. Then we vigorously attack.

Commercial banking shows that not all innovation will yield the same rewards. There are some really interesting problems to solve in the world of commercial banking. Unfortunately, at least from the perspective of existing banks, the returns from solving these problems are small.

Having said all of this, all hope isn’t lost. Innovation is unlikely to bear much fruit the way commercial banks are built today. But what if innovation completely flips commercial banking on its head?

What if we move to a peer-to-peer lending model? In that case, we’re decoupling depositors from borrowers. Lenders and borrowers have an existing social connection. And lenders have their own capital to loan. They don’t have to rely on capital from depositors, which complicates the model.

This isn’t to say that peer-to-peer lending will supplant commercial banking. It might not. The point is that innovation in banking could be highly consequential. It’s just unlikely to make a difference with commercial banks as we know them today.

Some questions to ask yourself, when pursuing innovation

When you’re faced with an innovation challenge, think about the business model. Are you trying to fundamentally improve the product or service? Is it possible to find a step change improvement?

Or are you innovating around the product or service? Are you offering oblique improvements, that while important, have limited impact?

Even in a commodity environment, innovation can yield meaningful differentiation. Still, it’s important to know how high the ceiling is. If the ceiling is low enough, we might need to find better ways to spend our time and energy.

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