Survival of the Fittest

“It is not the strongest or the most intelligent who will survive but those who can best manage change.”

Charles Darwin introduced the concept of ‘natural selection’ or ‘survival of the fittest’ over 150 years ago. It describes how the prospects for an organism’s survival are determined by how well it adapts over time to changes in the environment. Those that fail to adapt quickly enough simply die out.

Businesses are subject to that same paradigm. Companies throughout history have had to adapt to environmental changes related to factors such as economic conditions, laws and regulations, geopolitical events, changing competition, labor issues, new processes, and technologies, etc.

Change can occur in longer cycles over a period of time, and can also happen fairly abruptly. We have examples of both happening right now which have profound implications for the future of financial services companies.

A longer-term change affecting business is the digital transformation of our economy. This change is not new — it has been happening over the past 20 years. Since it has been unfolding over a long period of time, this change has been harder for some companies to recognize and adapt to with any sense of urgency.

The current pandemic is a recent event that came upon us suddenly. In addition to causing illness and death, it has also created financial hardships for many consumer and business customers. It forced rapid changes in the way companies interact with their customers, employees, and communities. The pandemic is more of an event whose impact is evident to all and required immediate changes to business models.

The Digital Transformation

This longer-term change — the ‘digital transformation’ — relates to the process of integrating rapidly advancing digital technologies into all areas of a company. These technologies allow businesses to better understand and connect with their customers. They can also drive tremendous improvements in productivity and operating efficiency.

Companies such as Amazon, Netflix, Apple, and many others have been successful in using new technology to make their customers’ lives simpler. They offer anytime, anywhere access to their products and services. They remove ‘friction’ from the experience by making fulfillment of a customer’s needs just a click or two away.

The successes of these companies in creating superior customer experiences in their niche businesses have raised expectations across the board. People have come to expect the same quality, ease of use, and customization of their experience from all the companies they work with.

Achieving this requires re-thinking the business model and how value is delivered to customers. It requires a digital transformation. As one futurist put it:

“Digital transformation closes the gap between what digital customers already expect and what analog businesses actually deliver.”

From an internal perspective, another driver of the transformation is the need to sustain a competitive position within the industry through the adoption of highly efficient and cost-effective technologies. Many banks are still reliant on paper-based processes and procedures that require significant manual work and are inefficient, time-consuming and expensive. Redesigning the processes around new technologies can significantly lower operating costs. This is becoming even more essential to maintaining profitability given factors affecting other areas of the financial services business.

The fact that this technology-driven transformation has occurred over time makes it less obvious over the course of a month or quarter or year. But looking back at where were 5 or 10 years ago versus where we are today can help emphasize the changing nature of the world. And the pace of this change has been increasing rapidly to the point where companies in all industries must take note and respond appropriately.

Covid-19 Has Upped the Ante

The Covid-19 pandemic should have removed all doubts about the importance of banking through digital channels. With social distancing and ‘stay at home’ orders deterring customers from using branches, the value of having a strong digital banking platform became obvious to everyone.

Customers who may have previously been reluctant to embrace mobile and online banking were forced to make the change. Having now experienced the convenience, they may be reluctant to return to physical offices for needs that can be addressed through digital channels.

Financial institutions that lacked the ability to open new deposit accounts or accept loan applications via mobile and online channels were suddenly placed at a significant competitive disadvantage. Companies had to pivot quickly to develop new ways of serving their customers, while at at the same time implementing new working models for their own employees. Years’ worth of evolution and change was forced to occur in a matter of months. And those changes are ongoing.

This is a time of tremendous uncertainty. What the ‘new normal’ of the future will be and when we’ll get there is a topic of much debate. While we have no data points from the past to use to help model what the next year or two might look like, it’s likely that many or most of the pandemic-inspired changes that occurred in 2020 are likely to become a fixture of the future.

Many Banks Have Been Slow to Change

Banking has historically been an analog business, with legacy practices, processes, and technologies from a paper-based world being very slow to change. It has been an industry ripe for disruption.

Major banks have responded to the digital transformation challenge by investing hundreds of millions of dollars annually in new technologies and processes. New digital-only banks and FinTech companies with lower operating costs and state-of-the-art systems have risen to lure customers away from traditional institutions. Leading technology companies including Apple, Google, Facebook, and Amazon are also entering the arena by offering financial services either directly or in partnership with established banks. These deep-pocketed, highly customer-centric competitors are likely to present a major challenge to all traditional financial institutions, including the nation’s largest banks.

But change has been slow in coming for many smaller institutions and has been pursued with widely varying degrees of urgency. A strong economy through 2019 masked some of the impact of the rising threat to business development and competitive standing by generating solid earnings performance at most companies. This encouraged complacency.

Lacking direct evidence that their traditional business model was under assault, banks delayed investments in new digital technologies and processes. A fairly common practice has been to adopt a “wait and see” attitude, thinking that they could address the issues when the need became more apparent.

Others say they are adopting a “fast follower” approach where the leading companies take all the risks of introducing new features and technology, and their bank will follow up on whatever seems to work the best. Unfortunately, it’s usually the innovators that reap the rewards, and the ‘fast following’ part is seldom ‘fast’. This means the company is constantly lagging behind, trying to play catch-up.

Capital needed to finance transformative changes has been squandered over the past several years as many commercial banks decided to shower shareholders with benefits through high dividend payouts and stock buy-backs to prop up sagging share prices. Arguably, that money could have been better employed by investing in the long-term survival of the company.

Banks Face Additional Challenges

While the pandemic has increased the importance of digital capabilities, it has also created more conventional challenges that will command the attention of all financial institutions as we roll into 2021. These include:

Deteriorating credit quality in both consumer and business loan portfolios. Rising delinquencies from financially-stressed loan customers will lead to higher levels of non-performing loans and chargeoffs.
Loan growth will slow as banks tighten credit standards and competition becomes more intense for a shrinking pool of strong borrowers.
Deposits have been increasing recently for most financial institutions, buoyed by federal stimulus payments. Longer-term, that money may disproportionately flow to larger banks due to their perceived strength and stronger digital capabilities.
Spread income has been under pressure for some time now, and this will only increase as a result of the low-interest rates in general and credit quality issues with loan portfolios.
Non-interest income is also likely to decline as loan originations and sales slow, and pressures continue to mount to reduce or eliminate fees on deposit accounts.
Efforts will become more intense to reduce operating expenses to offset declining income levels.

While the industry as a whole still enjoys strong capital ratios, the experience of the Great Recession has shown how quickly capital can be eroded as loan losses rise. This threat can lead to a ‘circle-the-wagons’ response where management attention becomes focused on the problems with the biggest short-term regulatory consequences. Critical longer-term projects to invest in digital capabilities may be considered less essential and put on hold until the current storm blows over.

The Risks of Not Prioritizing Change

The problem, though, is that digital transformation investments are critical to long-term survival and may have longer lead times. Deferring these projects until the economy and earnings stabilize may leave companies so far behind the technology curve relative to the larger bank and FinTech competitors that they may never be able to catch up.

Customers are increasingly demanding strong digital tools and capabilities. They are also looking for clear evidence that their financial institution has an understanding of their unique financial needs and can proactively offer them relevant financial solutions. There’s likely to be a limit to their patience as they wait for their bank or credit union to rise to meet their expectations. The barriers to switching to a new provider are not that high, and large institutions with both advanced technology and strong balance sheets have been seeing a steady influx of new accounts.

In late 2018 the research firm Gartner published a prediction that by 2030 80% of the ‘heritage’ financial institutions that existed at the time will be irrelevant. Events of the past two years will likely have accelerated that timeframe, making the evolution of business models all the more critical for those companies that hope to be survivors.

The Leadership Challenge

Survival requires adaptation and change. For businesses, there are always technical and financial obstacles to be overcome to make the changes needed to ensure their survival. But often the first challenge to be surmounted often lies in the leadership area.

Management teams tend to be dominated by people with a wealth of experience in banking as it has traditionally been conducted. Many spent their formative years mastering a business model that was focused on customers coming into their offices and interacting with bank staff at times and on terms the bank got to define. The past achievements of these leaders led them to their current positions of authority and respect. But it can often be hard to look beyond the lessons of past successes to really understand what needs to change for today’s reality.

This is complicated by the fact that many people in middle- and upper-management ranks lack a strong understanding of technology. They may also view the industry through a generational lens, and think that customer preferences on how to do business with a bank are the same as their own.

Change also involves risks. Rather than trying something new with an uncertain outcome, traditional managers prefer to stick with what has worked before in order to avoid the stigma of potential failure. They may get caught in a ‘paralysis by analysis’ trap, where they are unwilling to move forward with any investment that doesn’t promise a strong return on investment with a reasonably high level of certainty. But it is notoriously hard to measure the ROI on many digital transformation investments since by their nature they involve doing something new and often untried.

Banking is also a highly regulated industry, which puts a damping effect on change for fear of examiner criticism. This has historically created a disincentive for innovation and experimentation. But there is growing evidence that the regulatory agencies understand the challenges faced by the industry and the need for it to change. As this attitude continues to filter down from the national level to the regional offices, regulatory receptiveness to new ideas and methods will improve and will likely even be encouraged.

Adapting to the changing business environment requires leaders willing to embrace change and who are prepared to take risks in the pursuit of disruptive new processes and technologies. It requires strong leadership starting at the executive management and Board of Directors levels – people who can articulate a vision for the future, allocate the resources needed to make it happen, and provide continuous support and encouragement throughout the transformation process.

Moving Forward

Survival in a changing environment is a challenging task that requires creating a shared vision of the future, a plan to address the challenges to achieving the vision, and commitment from people from all levels of the company to execute the plan. The key steps are:

Assess where you are today. Review how well your company is currently meeting the needs of key stakeholders, including customers, employees, and the communities you serve. What is your purpose? How is it different from competitors? What does your institution mean to your customers and communities? Also carefully consider how you stack up relative to the competition – both traditional institutions and FinTech companies.

Envision where you need to be in the next 1-3 years. Visualize what the company needs to achieve in important areas including the quality of the customer experience, efficiency levels, deployment of new technology, employee skill levels, and growth paths, and community support.
Create a plan that will move the company from where it is today to where it needs to be to remain competitive.
Identify and prioritize needed investments. It’s often best to start small to try to achieve quick wins to bolster confidence and gain support for additional initiatives
Develop a culture of innovation and experimentation. It’s important to move beyond the notion that failure must be avoided at all costs. Not everything will succeed on the first try – it’s better to learn to fail fast and iterate based on lessons learned.
Make sure you have the people/skillsets that you need. Many companies may not have a critical mass of employees with the necessary technical skills. Community banks are not an employer of choice for many, making recruiting the necessary talent more challenging. Retraining or ‘up-skilling’ existing employees will be important.
Assign transformation responsibilities to specific individuals or teams. It is also critical to identify change agents (individuals or teams) with the authority and responsibility to reach across organizational silos to execute the plan
Create benchmarks, timeframes, and institute an ongoing tracking/review process. Monitor, celebrate, and reward achievements as they occur.

It’s likely that there will be extensive consolidation in the banking industry over the next few years as a result of either financial pressures or an inability to make the necessary investments to remain competitive. The companies that survive will be the ones who are able to both successfully navigate the current recession and adapt to the longer-term challenges of the digital transformation.