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Bank differentiation: table stakes aren’t enough

Banks need to understand and embrace differentiation as a critical factor to achieving sustainable profitability.

by Karan Oberoi

5 mins read

Introduction

More of the same, no more.

a16z (formerly Andreesen Horowitz) has a reputation for understanding competition. The serial tech investors, with a portfolio that includes Airbnb, box, Slack and Coinbase, recently outlined criteria for sustainable differentiation for commoditized financial products. The lessons for banks are unmistakable.

Stairways to differentiation heaven

A16z partner, Joe Schmidt, highlights three key "stairways" that pave the path to building lasting differentiation in commoditized financial services:

  1. Higher conversion rates

  2. Lower cost of capital

  3. Lower operating cost structure

These stairways are a sign of how fintech challengers are maturing from a simplistic focus on aggregate user growth to sustainable, defensible economics. Margins feature frequently in his advice. McKinsey agrees.

The focus on sustainable, defensible differentiation is also reverberating around the banking world. Rising interest rates and macroeconomic shocks have complicated banks models, while bank failures in the West have threatened the deposit base of small and medium-sized lenders as depositors move their money to safer (read: larger) banks.

All this combines to create a unique set of pressures for today’s bank executives, particularly as they seek to squeeze the maximum value out of the technology investments they know they need to make to compete for tomorrow’s customers.

Farewell to feature parity

Digital transformation for financial institutions is a multi-decade process. Spurred by new competitors and in some jurisdictions, regulatory changes, banks took comfort in the beneficial economics their balance sheet gave them combined with the regulatory moat a full banking license provides. This meant innovation could be viewed as a piecemeal exercise where the bank’s current offering was benchmarked against the features of the most advanced competitor in the market. Banks would then add the features to bring them up to par. In ideal circumstances, this meant deploying already proven technology and avoiding the potential regulatory scrutiny of being first to try something new.

And yet, what has this approach yielded?

  • Expensive tech budgets: What was meant to be a cost-effective exercise in buying proven commoditized software actually turned out to be a Trojan Horse of ballooning technology integration and maintenance costs.

  • Me-too offerings: Banks that wanted to show their customers they were getting an offering that was at least as good as their competitors discovered that they had less to set them apart from their competitors. This made has indirectly enabled the deposit switching that has kicked off since the US Federal Reserve started raising interest rates.

  • Growth at the top: Some banks didn’t follow this strategy, and it’s benefited them. A quick look at J.P. Morgan Chase in the US or India’s HDFC show that strong tech investments are yielding higher deposits and profits. Consider this chart from McKinsey’s 2022 Global Annual Banking Review.

As with all technological shifts, the tech comes first and then a new mode of action creates the real value. Banks need to apply their technology budgets toward a new goal — differentiation.

Returning to Schmidt’s Led Zeppelin-themed advice for fintech founders, how should banks differentiate?

  1. The first step is to understand the customers you have and those that will help you build profitable margins.

  2. Assuming the demographic planning is accurate, banks’ next step is to re-architect their bank around those chosen customers. The customer journeys, product mix and personalization should all create an experience that would be prohibitively expensive for a competitor to replicate.

  3. The next step is making hard decisions about what features will generate ROI and meaningful engagement with customers is far more important than chasing simple parity. Banks also need to invest in a technology toolkit that allows them to quickly stand up those services that don’t differentiate while investing in building the customized services their customers will return for.

  4. The final step in the differentiation journey is to create a holistic view of their chosen customers, giving the bank the platform to personalize individual offerings to retain and upsell those customers with services they need and want.

As a16z knows from years of successful investing, over time, differentiation and margins are what set the winners apart from the competition