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The Innovation Dilemma in Financial Services

Customers place a lot of value on innovation when selecting financial services products. They now identify “Innovative” as an attribute that stands out in terms of differentiation. Yet, most retail banks and credit unions struggle with innovation (as do most companies).

In 1997, “The Innovator’s Dilemma” was published. It is considered one of the most important books chronicling how innovation takes place, and why it’s common that market leaders and incumbents fail to seize the next wave of innovation in their respective industries. The author, Clayton M. Christensen, argued it’s not necessarily that incumbents fail to develop disruptive technologies because management is unable to identify new trends and ideas, but that they fail to value innovations properly because incumbents attempt to apply them to their existing customers and product architectures.

“The very decision-making and resource allocation processes that are key to the success of established companies are the very processes that reject disruptive technologies . . . Successful companies want their resources to be focused on activities that address customers’ needs, that promise higher profits, that are technologically feasible, and that help them play in substantial markets,” he wrote.

It’s not just banks and credit unions that struggle with innovation. Remember the Baldwin Locomotive Works? Of course, you don’t – hardly anyone does. BLW was an American manufacturer of railroad locomotives from 1825 to 1956. For decades it was the world’s largest producer of steam locomotives, but struggled, as did most of its competition, to compete as demand switched to diesel locomotives. Baldwin produced the last of its 70,000-plus locomotives in 1956 and went out of business in 1972. Now, General Electric is the world’s largest builder of diesel-electric locomotives.

Do we fly on Vanderbilt airplanes or drive Vanderbilt automobiles? Vanderbilt practically owned the steamship and railroad transportation businesses in the late 1800s, yet the company failed to capitalize on the nascent automobile and aviation industries of the early 1900s.

And who can forget Sony? In the late 1990s, they had the Walkman, the artists, the record companies – they had it all. It would have been very easy for them to combine those assets in new, innovative ways. Yet Sony, more concerned with protecting CD sales and digital rights management, missed the opportunity Steve Jobs saw. In the first ten years since iTunes made its debut, the global record industry shrank drastically, from $38 billion in revenue to $16.5 billion. Meanwhile, Apple grew into one of the world’s biggest companies.

So, what inhibits innovation in banking? Arguably, the industry is under attack. The industry isn’t as “safe” and predictable as it used to be. A steady surge of fintech and regulations are driving more power to the customer (and correspondingly less to the banks); the pace of change is increasing and almost every element of the industry’s value chain is being impacted.

Fintechs develop and deliver solutions much faster than traditional firms, and that is what customers have come to expect. Younger, more nimble companies are willing to take risks. They are willing to experiment, fail and pivot in a way traditional banks are not.

The innovation gap is not closing anytime soon. However, there are ways for banks to manage innovation in a way that provides strategic value and not distraction. Another well-regarded book about innovation published in 2009, “Change by Design,” outlines a straightforward way to classify innovation and understand its business impact.

An organization can:

  1. Manage the status-quo by incrementally improving the existing offering to the existing customer base;
  2. Evolve the current offering by adding new products and services but sticking to its captive market;
  3. Adapt the existing offering to target prospective customers in new market segments or territories; and
  4. Revolutionize its business by creating a brand-new value proposition with a completely new offering for new customers.

The basic idea here is that disruptive innovation can be funded only if incremental and evolutionary innovations succeed in generating new value.

Research shows companies that allocate about 70% of their innovation activity to incremental initiatives, 20% to evolutionary ones, and 10% to revolutionary ones outperform their peers, typically achieving a P/E premium of 10% to 20%. The research also shows that for direct returns on innovation, the return ratio is roughly the inverse of the ideal allocation above: incremental innovation efforts typically contribute 10% of the long-term, cumulative return on innovation investment; evolutionary initiatives 20%; and transformational efforts 70%.

It will be increasingly challenging for banks to thrive just by optimizing the as-is when the entire industry is facing a growing level of uncertainty. Nonetheless, it is important for banks to manage innovation from a portfolio perspective, determine the potential impact of different types of innovation, and to balance risk among incremental, evolutionary and revolutionary ideas.

Author

Scott Albahary works with banking and wealth management clients to significantly improve business processes across the full client lifecycle, including prospecting, on-boarding, servicing, channel management, advisor platforms, integrated reporting, and customer analytics. He has extensive experience with client centricity; client acquisition and retention; client service platforms and contact center services as well as integrating solutions from multiple vendors.

                         

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Scott Albahary, Chief Strategist, Financial Services

Scott Albahary applies his wide range of knowledge and skills to advise Perficient’s financial services clients on business and technical strategies and on defining, developing, and implementing these specific strategies.

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