The Unbundling & Rebundling of Banks

Hans-Peter Gauster — Unsplash

“Silicon Valley is good at getting rid of pain points. Banks are good at creating them.” — Jamie Dimon, CEO JPMorgan Chase

FinTech has made massive waves across the world in recent years, with more than five thousand companies founded, raising nearly $6B in venture capital financing.

Let’s take a step back and reflect on why we have seen so many unbelievable entrepreneurs choose banks as the next establishment to disrupt. Of course, the simple answer is that banking is a large sector, with lots of room for improvement; and millennials desire digital experiences in their financial lives. While those are the most often quoted reasons we see in pitch decks today, we believe the real tailwinds behind the growth of this sector lie even deeper.

First off, an attractive quality of a market ripe for disruption is one where the critical infrastructure is already in place for innovation to be built upon. Matt Heiman at Greylock references that critical infrastructure in this post, citing data APIs like Plaid, Yodlee, and Flinks making it easier to work with financial data; payment APIs like Stripe making it easier to accept payments; and financial market APIs like Xignite, making it possible to pull in live stock prices. Having this foundation in place makes this space all the more attractive for entrepreneurs.

Second is the harsh reality that one’s financial picture today is much different than it was a decade ago.

• Real annual wages have been stagnant since 2000
• Education costs are rising exponentially
• Credit card balances are higher than ever
• Credit scores are lower than ever, limiting access to capital
• Home ownership is at its lowest level since the Census starting tracking it
• High deductible health insurance plans are now the norm
• Populations are aging and retiring older

As Sarah Tavel points out in this post, called “Saving People Money”, in response to these changing macroeconomic factors, people need new ways to save money, manage money, and invest money. Cue the need for tons of innovation.

Lastly, banks have turned into modern-day conglomerates. The large banks today offer every product you can imagine, from insurance to loans, to mortgages, to cross-border money transfers, etc.. This is a prime example of an institution that does a whole lot of things, but does none of those things really well. This is the perfect landscape for a startup to focus its efforts on a select few of those items and execute to perfection. The ability for a startup to begin “unbundling” some of those banking services is predicated on the notion that a physical presence in banking is no longer at the core of the customer experience. Alex Rampell, Partner at a16z, makes a great comparison between the financial sector and the retail one, citing Amazon as the retailer that caught these same tailwinds and removed the physical presence from the equation, allowing it to displace WalMart as the biggest retailer in the world. He leaves us with a crucial thought in this video, asking “when will banking have its Amazon moment?”.

These factors have opened up the possibility for thousands of startups to transform the way modern banking is done. Every transformation happens in multiple phases, and the first step in this equation is unbundling. The opportunity at hand is for startups to be exclusively focused on only one banking product (say savings or lending). Consider several examples of this being successful:

Alternative lending platforms such as SoFi, Kabbage, and Clearbanc have all taken advantage of the inefficiencies in the lending departments of large financial institutions. These lenders all have similar formulas in the way they disrupt traditional banks:

• High Touch: Start by focusing on a specific user and understand that user really well. This allows the company to underwrite that specific user much more effectively than a bank would. Underwriting more users means more originated loans, and lower loss ratios. For example, SoFi has focused on students, Kabbage on SME’s and Clearbanc on entrepreneurs.
• Reduce the margins banks earn on loans: A traditional bank accepts money (deposits) and pays a minimum amount of interest (<1%) and then loans that money (primarily on credit cards) for closer to 19% interest. There is a lot of margin there to cut in to for a startup. Given the lenders mentioned above don’t have brick and mortar operations to pay for, they can beat the banks loan rates in most cases, and offer credit to more borrowers.

Robo-Advisors such as Wealthfront, Betterment, and Wealthsimple have automated a routine job that was typically done by financial advisors. Large mutual funds and ETFs were already mostly being managed by algorithms, however clients had to consult financial advisors prior to investing. By removing the advisor from the equation and promising individuals a balanced, diversified portfolio that fits their lifestyle, robo-advisors are able to offer equal returns with much less management fees (typically 0.5% vs 1.5% at traditional banks).

• Savings platforms such as Acorns have found new, innovative ways to encourage people to save money. They are able to offer a fully digital experience, and have ‘gamified’ saving, by incorporating goal setting, rewards points, and a social element. Alternative savings platforms can earn a higher return for clients on their savings all with free accounts that they can contribute to or withdraw from anytime.

These examples continue across every facet of a bank. This image below gives a taste of the FinTech landscape today, and highlights every element of unbundling currently under way. This is the home page of Wells Fargo and it outlines the top startups picking apart every piece of the bank.

CB Insights

Of course, unbundling is not the holy grail, it is merely phase one. Entrepreneurs’ ambitions and world domination plans are much larger than simply mastering one banking product. The first product, or the unbundling, is just the “hook” to acquire customers and begin building trust and brand name. Startups exploit the banks on one simple product as a hook to win the consumers’ business in the hopes of then being able to target that same consumer with other financial products in the future, hence phase two: rebundling. The more startups that begin offering additional financial products, the more those startups will begin to resemble traditional banks. Here are some examples of rebundling happening in action:

• Acorns has now differentiated beyond simply a savings platform by launching Acorns Spend, a debit card product.
• Square began as an easy-to-use terminal for on-demand workers to receive payment. They have now begun issuing loans to their merchants.
• Paypal has launched a prepaid debit card that includes bank transfers, deposits, and cashing checks.
• SoFi has moved beyond just student loans and into mortgages, wealth management, and life insurance.
• Robinhood has extended its trading services to cryptocurrency
• Stash has launched core banking and custodial services
• Credit Karma knows everything (far beyond just credit cards).

What has emerged in the FinTech space is a race to own the end client relationship. Each startup took a different approach, chose a different vertical, and unbundled a different element of the bank. But as all those startups look to layer on, and rebundle the core services of a bank, they will all be vying for mindshare from the same customers. Suddenly, a group of thousands of companies solving various, unrelated problems, will become competitive and will race against each other to be the “go-to” digital bank (or the ‘Amazon Moment’). Despite the numerous examples of rebundling above, we are not quite there yet. As the graph below depicts, we are still at the tail end of the unbundling phase, with startups trying to achieve critical mass in their verticals, prior to commencing the rebundling process.

Once the rebundling phase begins on a macro level, the threat to traditional banks will increase exponentially. Today, consumers excited by digital offerings startups are delivering are faced with the pain of having to piece together all of their financial needs like a puzzle (since every startup only unbundled one product). Getting all of your financial needs serviced, requires interacting with many startups. This pain still generates enough friction for consumers that they maintain their relationship with their traditional bank, and experiment with one or a few new innovative products on the side. Most customers with an Acorns account, also have a traditional savings account at their bank (likewise with investments and loans).

While we don’t expect startups to attempt to put together products that cover everything Wells Fargo offers today, we expect them to bundle a subset of elements that have high synergies. In the past, a HENRY (High Earner, Not Rich Yet) would have one relationship — a big bank; in the future they won’t have 50 relationships (one for each service) but they may have 3–8 relationships with digital rebundlers. Customers will have the opportunity to transfer more and more of their banking relationships to their most trusted digital providers, and will be able to move further away from their traditional banking relationships.

We have yet to see the true threat to banks. But it is around the corner.

Let’s conclude by summarizing what all of this means for Inovia in terms of how we allocate capital and make investment decisions in the FinTech space. Here are some of the key elements we look for:

Having a unique and differentiated customer acquisition machine: the ability to acquire customers cost effectively is of utmost importance in the FinTech space. As mentioned above, owning the client relationship is the holy grail, and having a customer not only counts as revenue for the current product, but also allows the startup to target that customer with additional banking products in the future. Here are some examples of unique customer acquisition strategies that have proven successful for FinTech startups;

• SoFi began by targeting students with its loan products. This led them to be able to use universities as distribution channels and acquire students cheaply (this customer profile was being ignored by traditional lenders). They coined the term HENRY to describe their target customer. This profile was not of interest to banks since they were not wealthy enough (yet) to drive a significant amount of business.
• Clearbanc offers revenue-based financing to entrepreneurs. They quickly realized that many small businesses use Facebook as their primary advertising channel and that one of the barriers for small businesses is access to capital. Clearbanc partnered with Facebook to help provide capital to these small businesses (much of it to be re-invested in Facebook ads for customer acquisition). This allows Clearbanc to acquire users cheaply through the Facebook merchant network.
• Affirm allows consumers to pay for large retail purchases in installments. Rather than target consumers directly, Affirm used merchants as their distribution channel. Once a customer reaches the cash, the merchant would ask the customer if they wanted to pay using installment payments (powered by Affirm). This turned the business into a B2B model of selling to merchants rather than a B2C model of competing on customer acquisition.

A well-thought out rebundling strategy that involves owning the end consumer or merchant: Entrepreneurs need to think about pitching the big vision from day one. Building a massive business in the FinTech space will not happen with a series of accidental product additions along the way that we “hope” consumers will enjoy. Owning the end customer should be the objective from day one, it is the core of the business and the reason for existence. Then it is up to the entrepreneur to experiment with various “hooks” to lure in their first batch of customers cheaply. These hooks are more flexible and far less important than the actual master business plan. Here is some advice on choosing the right hook:

• Test and iterate quickly on initial customer segments you are targeting and the product offering you’re selling. Try something and kill it within a few weeks if you are not luring a unique kind of individual. It is crucial to find a differentiated customer base to initially target, rather than going after the same customers as everyone else.
• Pick something that resonates with millennials. For example, Ellevest creates mutual funds tied to the unique career path of women, OpenInvest allows clients to add social impact stocks to their portfolio and Quantopian allows anyone to create financial trading algorithms. The overall vision of all of these companies is to be the trusted financial partner for their target client base, however they have all approached the market with hooks that resonate deeply with that market they are targeting.
• Once you’ve found a differentiated customer base and a product that resonates with that base you will begin attracting attention to yourself. The idea is that you can use your initial base as a springboard to layer on your rebundling strategies in a more cost effective way. Start with engaged users, build brand awareness among them, garner attention, and then begin rebundling.

Innovate in a new area of banking: Over 40% of all investment dollars into FinTech startups to date have been poured into the alternative lending space, leaving massive industries (such as mortgages and insurance) with few well-funded companies. Additionally, there potentially many innovative ways to improve one’s financial lives that don’t even exist yet and are not even done by banks. Finding a new way to add value financially is a compelling way to disrupt the antiquated banking industry. Examples of radically new financial products are;

• Mortgage companies like Ribbon, Point and Properly that allow consumers the ability to sell their homes more efficiently and even offer the possibility of unlocking some of the equity in their home (things banks don’t do today).
• Contextualized insurance companies like Lemonade, and Slice. Today, an individual may act as a business one day (renting our their home on Airbnb, or driving their car for Uber) and as a regular citizen the next. Insurance needs to adapt to understand the context in which your assets are being used.

Create your own infrastructure and be self-reliant: Many FinTech companies simply add a new layer or application on top of existing banking infrastructure. This is a great way to validate the problem, but in the long-term the majority of the gains will still accrue to the financial institution serving as the infrastructure layer. FinTechs that are self reliant can be more disruptive and rebundle other apps even easier than those that rely on others. This is one example of a well-planned rebundling strategy from the start.

At Inovia we look to partner with audacious founders building enduring technology companies. It is clear that the ability to have an impact on one’s financial experience has the potential to disrupt everything we know about our banking systems. Those are the types of ‘big bets’ we thrive in undertaking.