Disaggregation: the springboard for lending innovation

Immediately after the global financial crisis our industry experienced a period of existential threat. The good news is – we still exist!

The good news is – we still exist! However, developments in consumer behaviour, technology, regulation and investor sentiment mean that the outlook for financial services has changed utterly. There is much debate about who will be the winners and what will be the enduring innovations.

History can bring a helpful perspective to future predictions. The Great Depression prompted one of the greatest innovations our industry has ever seen – the introduction of wholesale funding through Fannie Mae and Freddie Mac. Mortgages had been short term, up to five years in duration, meaning that borrowers were exposed to refinancing risk. The innovation of wholesale funding enabled the introduction of 20+ year mortgages and decades of structurally lower financing costs, transforming home ownership.

My thesis is that the winners post the 2008 financial crisis will be those who pursue value chain disaggregation.

Financial services has lagged behind other industries in value chain disaggregation

We can see examples of business and industries that employ disaggregated business models. Apple is a good example. It is clear on the capabilities where it wants to excel – R&D, packaging, marketing, user experience – and focuses relentlessly on them. These functions are kept in-house, controlled tightly and run by genuine market leaders. All other capabilities are outsourced to expert providers who produce any new product the firm needs. As a result, Apple minimises Capex and has very low unit cost from the start. Many other tech firms use similar disaggregated models successfully.

Intercontinental Hotel Group is one of the main players in leisure with almost 750,000 rooms. IHG pursues a disaggregated model, owning less than 1% of these rooms with the rest secured through either franchising or management of other investors’ properties. However, Airbnb has taken disaggregation to a totally new level, with over two million rooms and circa 10% of the headcount of IHG.

Even in the automotive world, the likes of BMW use partners for a substantial proportion of its capabilities. Interestingly, as Apple and Google look to develop driver-less cars they will use some of BMW’s suppliers. BMW is comfortable with this because it is confident that it has an unbeatable capability in judging the confluence of technological capability and consumer demand.

Forces driving fundamental change in the provision of financial services

Technology is now enabling tremendous progress in very specific areas of the value chain. These solutions are challenging the longstanding advantage of the market leaders by enabling specialists to be the best at key elements of the value chain, within specific customer segments and within specific product markets.

Simple is a good example of this. Established in 2009, Simple had a compelling vision for a new kind of retail bank, a virtual bank. Simple’s proposition was based on providing effective software which users could use to manage their own finances. It empowered customers and produced significant commercial benefits for them. By the time it was sold to BBVA in 2014, Simple had 100,000 customers with just 92 staff – an impressive indication of what banks can do with a disaggregated operating model. Equally, with £2.7 billion of assets managed by less than 600 staff Shawbrook, a client of Target, stands as a great example of how this model can work in the context of UK lending.

In today’s climate of rapidly increasing consumer power, providers want to be able to enter and exit products and markets more rapidly whilst minimising Capex and operating costs. In many instances building in-house takes longer, costs more and introduces execution risk. Also, with increased investor focus on return on equity, many providers seek to access economies of scale that cannot be achieved on a standalone basis.

The increased burden of regulatory compliance is important too. Firms cannot abdicate accountability by getting another party to perform certain activities for them. However, third parties who do a similar activity for multiple providers are typically able to meet regulatory requirements more reliably and cost effectively.

All of these factors create a compelling argument for disaggregating business models. But where do lenders begin? First, they need to identify where in the value chain they want to be truly world class. However, in order to achieve this, lenders need to have confidence in their partners’ ongoing capabilities. Enlightened providers increasingly want to understand the plans for evolution of the technology they are buying, as well as the servicing capability, in order to build strong and lasting relationships.

Who will be the winners in business model innovation?

Business model innovation may turn out to be the greatest innovation of all. Ultimately, the winners will be those who see supplier selection and management as a core competency. Firms need to choose where they want to excel – and then find providers who are great at the rest. Getting this right can enable the business to be more flexible, more innovative and, ultimately, lead to superior and sustainable profitability.