Banks Face the Innovator's Dilemma

Sometimes the simplest lessons are the hardest ones to learn. 

Anyone who has taken even the most basic business course in the past fifty years is undoubtedly familiar with this passage from Theodore Levitt's 1960 treatise "Marketing Myopia":

"The railroads did not stop growing because the need for passenger and freight transportation declined. That grew. The railroads are in trouble today not because that need was filled by others (cars, trucks, airplanes, and even telephones) but because it was filled by the railroads themselves. They let others take customers away from them because they assumed themselves to be in the railroad business rather than in the transportation business. The reason they defined their industry incorrectly was that they were railroad oriented instead of transportation oriented; they were product oriented instead of customer oriented."

It doesn't take a lot of imagination to rewrite that paragraph to describe the banking industry today.

Economic cycles wax and wane, but people will always look for ways to save and borrow, to move money from one place to another, and to occasionally get some advice from someone they trust. Traditional financial institutions like banks and brokerages held a near-monopoly on those activities for generations, but banks that continue to be bank-oriented will continue to lose to an increasingly broad group of competitors that are truly customer-oriented.

Mature industries erode subtly at first. Hungry upstarts nibble at segments too small or unprofitable for entrenched incumbents to waste much energy protecting. But eventually the new entrants gain traction and move upmarket to larger and more profitable segments. And new categories are invented along the way.

Think about what's been happening around the edges of the banking industry. Peer-to-peer lending platforms and retailers' captive financing programs have taken lending business that once was nearly the sole province of banks. New payments ventures like Square and Dwolla provide services that people want to use because of their great design and ease of use. SigFig is an online registered investment advisor with over $50 billion in assets tracked on its platform. Innovative startups like Simple and Movenbank are reinventing the whole notion of what it even means to be a bank. 

The scariest part? None of those companies even existed five years ago.

While the banking industry was recovering from a global financial crisis and reacting to the prospects of new regulations, smart entrepreneurs were finding new and better solutions to problems that people cared about. 

Is it reasonable to suggest that banks could have or should have been the ones to create all those new innovations given the weighty issues they were understandably tackling? Even when not in crisis mode, established companies should rationally protect their own profitable businesses, and small niches are not very attractive prospects for large companies needing large profits. 

That presents a dilemma, but not one unique to banks. It's the Innovator's Dilemma, as Clayton Christensen famously dubbed it in 1997.

Established companies correctly protect their successful businesses and are naturally reluctant to disintermediate their own products.

But those initially small niches sometimes grow into large markets that can become significant threats. Clayton describes how minimills at first could only produce low quality rebar, and the large integrated steel manufacturers were glad to get out of that low-margin business. But with their profits, the minimills were then able to invest in new processes for angle iron, then structural steel, and then eventually high-quality sheet metal, disrupting the entire steel industry in the process.