There’s a concept in the blockchain world called a hard fork, defined as:
“A change to a network’s protocol that makes previously invalid blocks and transactions valid, requiring all users to upgrade to the latest version of the protocol software.”
According to Investopedia, “Forks may be initiated by developers or members of a crypto community who grow dissatisfied with functionalities offered by existing blockchain implementations.”
The “hard fork” is an apt analogy for what the banking industry is facing.
Strategies focused on physical attraction (marketing) and distribution – where branches serve as customer attractors and points of service and delivery – are increasingly “invalid,” requiring banks to “upgrade to the latest version of the protocol,” i.e., digital marketing and distribution.
Banking’s hard fork is about more than just marketing and distribution, however.
Blockchain hard forks are often initiated in response to “dissatisfaction with functionalities offered” by the implementation.
It’s the same with banking. Consumers and small businesses are dissatisfied – or, at least, less than enthralled – with the “functionalities” offered by banks’ typical debit and credit products.
Banking’s hard fork will require financial institutions to create new strategies.
This is an oversimplification, but a bank’s strategy can be boiled down to:
Historically, banks sold through branches and in (more or less) narrowly defined geographic areas. That banking world no longer exists.
Three in 10 Gen Zers and Millennials now consider a digital bank or fintech to be their primary checking account provider, and I would bet that most of them have no clue where that provider’s headquarters is located (or care, for that matter).
The notion of “branch as attractor” has been eroding for 20 years as the point of attraction shifted to online search. But even this is changing, and the point of attraction is now shifting from search to platforms like Square and Credit Karma.
The shift away from “branch as attractor and point of delivery” negates the importance of geography as a way to define “who” to sell to.
When physical attraction and distribution dominated, geography created barriers to market entry and provided incumbents with a competitive advantage in a community.
That’s no longer the case.
Defining a bank’s target market as “members of a geographic community” is increasingly ineffective as geography (usually) doesn’t help a bank define a segment of customers with unique product and service needs.
Bankers have bought into the notion that their products are commodities and that the only way to gain a competitive advantage is by providing a better customer experience.
They’re wrong. Why?
Strategies that rely on: 1) branches to attract and sell; 2) geographies to determine who to sell to; and 3) customer experience to differentiate won’t produce acceptable levels of growth and return on assets.
Rakefet Russak-Aminoach, managing partner at Team8, former CEO of Bank Leumi, and three-time member of Fortune’s 100 Most Powerful Women in Business, writes:
“Neobanks have challenged traditional banks’ pricing and complexity, [but struggle] with mainstream customer acquisition and have yet to be profitable at scale.
“Embedded banking solutions are uniquely positioned to overcome the customer acquisition challenges that neobanks face, with the clear benefits of providing financial services where there is already a captive audience of customers.
“Doing so enables any company – financial or non-financial – to expand their native offering, create new revenue streams, and better serve customers across their ecosystem.”
This is as true for incumbent banks – some of whom already have a [somewhat] captive audience of customers – as it is for neobanks.
At its core, embedded finance – the integration of financial services into non-financial websites, mobile applications, and business processes – is a distribution strategy.
Instead of offering financial services directly to consumers and small businesses, a bank offers services through a company that already has relationships with them.
Why should a bank pursue this strategy?
1) Efficiency. Lower cost of customer acquisition ($5 to $35 vs. $100 to $200, according to Oliver Wyman).
2) Returns. Banks executing embedded finance strategies produce superior ROA and ROE than other banks.
SOURCE: ANDREESSEN HOROWITZ
Embedded fintech is the flip side of the coin – the integration of fintechs’ products and services into financial institutions’ websites, mobile apps, and business processes.
Embedded fintech examples SOURCE: CORNERSTONE ADVISORS
Why do it?
1) Revenue. A revenue recession in banking is depressing payments, mortgages, and overdraft revenue. Banks must recoup lost income with new products and services.
2) Competition. Platforms like PayPal, Square, Apple and Google know more about their customers than most banks could dream of knowing. An embedded fintech strategy won’t put banks on par with those platforms, but it will help expand the scope of the financial relationship they have with customers.
Pursuing an embedded finance or embedded fintech strategy doesn’t get a bank off the hook from answering the three strategy questions (who, what, and where).
In fact, choosing to pursue one of the two strategies forces a bank to revisit the three questions and address:
As banks go into next year’s strategic planning process, they should start by identifying the percent of their total revenue generated by the top four to five customer segments, products, and channels.
They should then project those revenue contributions for three years from now.
If the projected revenue contribution of customer segments, products, and channels for 2025 looks similar to the contributions in 2022, go back and start again.
This article originally appeared in Shevlin’s Fintech Snark Tank on Forbes and is reprinted with permission.