Disruption

In future posts I want to discuss some of the specific business models and existing firms that I believe will succeed but today let’s step back and look broadly at the process of disruption. Like ‘big data’, disruption has become a Powerpoint staple, mainly for people who are faking it.

Many people who talk about disruption in finance seems to me to mean something like this — The big, bad banks now face nimble, smarter and, very probably, more ethical competition. These insurgents have better products and services. The banks could re-invent themselves but they won’t, at least not in time. Bank management teams are, it seems, full of people who — besides being ethically-challenged — are either too dumb or too self-interested to see and make the changes necessary to compete with the new FinTech firms. They may, of course, buy some of these new players but then they would destroy them, anyway. All of which adds up to a process of disruption which will see one set of industry players largely replaced by another.

Nonsense, I say.

Disruption as a term in this context was given substance by Clayton Christensen, a Harvard Business School Professor. Famously, the concept was adopted and used by Andy Grove at Intel in setting strategy and making real changes to the firm’s product range and target customers. There are still questions about disruption and how it works and, no doubt, the debates will go on. The characterization of disruption above, however, which I honestly believe is what many people have in mind when they use the term, is a travesty. Christensen has written several books over the years on the topic. I recommend his ‘Innovator’s Dilemna”.

The process of disruption might be (hugely) summarized as follows:

• Successful incumbents have grown very good at giving their customers what they want. That is why they have become large firms. In effect, it is the needs of the customers, as perceived by management at these firms, which effectively allocate resources within a firm. This is a kind of equilibrium position from which it is difficult to deviate. Any allocation of resources on different lines is likely to appear (and may well be) highly inefficient, especially when viewed through the lens of ROIC.
• Firms continue to innovate along the lines of the products they already produce. Over time, there is a very high risk that products become over-engineered[1]. This creates the possibility of new players with “worse” products (having fewer but all the required features, for example, i.e., less highly engineered) entering the market at a highly competitive price. If this is in a product segment with low margins, the incumbent will be tempted to cede ground and will experience an initial rise in its overall ROIC as it abandons low margin businesses.
• Over time, the new players continue to innovate and migrate to higher margin segments. They start to eat into the value chain. The higher ROIC of the incumbents turns out not to be sustainable. The existence of the incumbents can become questionable.

Does this process of disruption describe what is going to happen in financial services? Partly, I believe.

One characterization of the ongoing move in asset management from active to passive is this kind of disruption. The consumer is shifting from an expensive and over-engineered product, the actively managed fund, (which also generally fails to deliver, we may add) to a simpler and cheaper offering. The unbundling of many banking products will follow a similar trajectory.

On the other hand, there are some areas where Fintech is harnessing information technology to deliver a better product and doing so, the new firms believe, at constant or even improved risk levels. The speed of credit approval decisions in unsecured consumer and SME lending is one example.

In neither case can we characterize Bank management as being simply slow or obtuse. I recognize, of course, that many Banks are handicapped by legacy systems and that incentive structures, stock market demand for near term performance and considerations of career risk all tend to favour the relatively short-term rather than the genuinely transformative.

But the main obstacle to Banks transforming themselves is the pattern of resource allocation within firms as recognized by Christensen. The current pattern or equilibrium is what brings in revenue today — it appears to be what customers want, however much they may grouse. Innovation and radical changes in products and services are open to new firms because they are starting from a much lower base. To the incumbent these may well seem to offer only short-term pain with reduced revenues and returns. The paradox of disruption is that management teams making apparently rational decisions and responding to their customers perceived needs miss the necessary large strategic changes that would save their firms.