Last year, Entelos, a US medical simulation company, developed for Unilever a system to predict the effect of cosmetics on human skin, reducing the need for controversial animal testing. In the past few years, eBay, the internet auctioneer, has revolutionised shopping, while Apple’s iPod has overturned the profit model of the music industry. And in December, the Financial Times Innovate 2006 Summit included speakers from a host of industries, such as easyJet founder Stelios Haji-Ioannou, one of the radicals of the airline industry, and John Clarke, chief innovation officer at Nokia, the ground-breaking mobile phone company. Not one bank made an appearance.
That is far from surprising. Banks are abysmal at innovation. “Not a lot of innovation has gone on in banking over the past 1000 years,” says Andy Maguire, global head of asset management at Boston Consulting Group. He points out that one of the earliest known uses of paper money dates back to 650AD in China, while in the Middle Ages the Lombards of northern Italy had a form of what would now be called futures and options financial instruments.
Sticking points
There are a number of reasons for this lack of innovation. In retail banking, supervisors peering over the shoulders of bankers to ensure that they are treating their customers fairly make the risk-taking aspects of innovation unattractive. And innovation is less crucial to the existence of retail banks than it is to companies that make mobile phones, for instance. Banks have a basic business model that can deliver consistent profit: pay out less interest to depositors than is paid to them when they on-loan the money.
Banks rarely face the ‘burning platform’ metaphor of crises forcing change. In computing, for example, there is an imperative to innovate because market share and profitability can plummet (Dell, for instance, saw its shares go into freefall from a high of $58 in 2000 to $22 in 2006).
A smouldering platform, not a burning one, is facing banks in South Africa as, nudged by the government, they attempt to bring banking to the black majority. Nedbank, the third largest bank by assets, thus came up with the ‘branch-in-a-box’. This is a cost-effective branch in a container that can be erected at rural and peri-urban sites.
Banks benefit from customers who are notoriously sticky and loath to move. Furthermore, they conclude that they are satisfying customer needs because they sell a lot of certain products, such as mortgages. In fact, consultants say, sales are high only because consumers have no choice.
Banks are currently trying to figure out how to react to the community space – known as Web 2.0 or internet-only sites that emphasise collaboration among users – with new arrivals like Zopa providing a model, or perhaps a threat. The Zopa model, co-founded by James Alexander, formerly involved in internet banks Egg and Smile, cuts out banks by allowing anyone to lend any amount of money to anyone at a rate and in a time frame that is mutually beneficial – borrowers have credit ratings from low risk to higher risk.
The banks do not believe this represents much of a menace, however.
In investment banking, MBAs and traders earning millions scoff at the notion that investment banking is not innovative. “Each of our business units is very innovative,” says Jonathan Smart, innovation director for investment banking technology at Deutsche Bank. The bank is recognised among its peers for innovation in structured finance products.
That raises the issue of how to define innovation, a word that is as overused as the word passion in the business world. Non-bankers, including Mr Maguire, pour scorn on the notion that what he calls “constant, incremental change in the capital markets” qualifies as innovation.
Eric von Hippel, head of the Innovation and Entrepreneurship Group at the MIT Sloan School of Management, shares this view. “PhDs in investment banks are not doing research, they just design new financial instruments or are computer programme whizzes who are developing new trading programmes,” he says.
For example, prime brokerage, defined by the banks as a new business, is providing the same services that the banks did to classic institutional asset managers; the only difference is that their clients are hedge and private equity funds. And the Goldman Sachs of today, where trading and principal investments are now about two-thirds of pre-tax earnings, compared with 55% in 2001 (see The Banker, May 2006), is not a new model. It looks like the British merchant banks of yore.
Mr von Hippel, who has worked as a consultant for a number of companies like 3M – the third most innovative company in the world according to Business Week’s annual ranking – denigrates what investment bankers applaud as innovation: “automating systems they’ve got, processing loans more efficiently, designing new financial instruments and new trading programmes” are not innovation, he says. Naturally, the bankers disagree.
Little research and development
There is so much “low hanging fruit” in banking, says Mr von Hippel, that the banks have been able to get away with not having the research and development (R&D) departments that the most innovative companies have. “I am fascinated by the fact that banks don’t have R&D departments. I can’t imagine General Electric not having one,” he says. His advice to banks is, among other things, to set these up (see below).
Mr von Hippel’s judgement may sound harsh, but the sort of innovation that non-bankers talk about is that which breaks new ground, such as the advent of Windows or what Amy Radin, chief innovation officer for the global consumer group at Citigroup, calls “disruptive innovation” to create whole new businesses.
Amy Radin: ‘Every industry has regulatory challenges’
Some banks are starting to take note. Ms Radin ascribes this to the tailing off of the enormous growth that banks have realised during the past 10-to-15 years through mergers and acquisitions (M&A), and leveraging the internet. For many banks, however, M&A over the next few years looks rather promising. Cynics might note that Citigroup was barred by the US Federal Reserve from substantial takeovers for 12 months until April last year on the back of lapses in its compliance risk management systems and was thus forced to halt its highly takeover-dependent growth to focus on other profitable avenues.
Ms Radin, whose unit, coincidentally, was set up about 12 months ago, dismisses some of the oft-used reasons for the lack of innovation in banking, such as heavy supervision. “Every industry has regulatory challenges,” she says, using as an example the pharmaceutical business, which relies on innovation. She could just as easily have used the airline industry, another heavily regulated sector, revolutionised by the advent of low-cost carriers such as easyJet and Ryan Air.
Proactive global banks
Most banks do not have chief innovation officers. Citigroup’s Ms Radin is one of the few. Deutsche Bank’s innovation officer is on a more junior level: Mr Smart was appointed to the new post in January 2006. Placing innovation in a technology ghetto is more usual for banks, which appear to have a problem seeing innovation in wider terms.
Both the US and the German bank – the former on the retail side, the latter on the investment banking side – appear to have reached a few similar conclusions. One is that a proactive rather than a reactive impulse is needed.
Mr Smart, who came from the equity side of the investment banking business, uses as an example Deutsche’s strategic transactions team, which each year produces about 100 tailored transactions for large companies in the $100m range. Traditionally, they then came to the technology department to have their vision translated into reality, which is a reactive model. Now, with support from board level, a formalised innovation push is leading to a more proactive stance. This might include interviewing and filming clients like hedge funds or corporates to find out their unarticulated needs.
After all, as legendary car manufacturer Henry Ford reportedly said, if he had asked people what they wanted, they would have said faster horses.
Ms Radin also refers to the use of ethnographic studies, which use tools developed from how anthropologists work, to understand people’s unarticulated needs. Both banks emphasise that the innovation should be customer-driven, albeit leveraging technology.
Both banks also insist that the size of their departments is immaterial. Ms Radin refuses to reveal how many staff she directs, insisting that innovation “does not take a lot of people, it takes the right people”, and points out that she works on projects with people in many different departments. At Deutsche Bank, Mr Smart has three members of staff in his department plus 167 innovation ‘champions’ around the business, who have volunteered to spend about 10% of their time on workshops and training.
Mr Smart’s aim is to break down the silo mentality of the bank to help businesses work across regions and divisions, and service customers better. He believes that the advent of the Market in Financial Instruments Directive (MiFID) this year will lead to ever narrower margins; thus a client’s decision about which bank to trade with will be based on service and other differentiating factors.
On the retail front, Ms Radin uses last year’s trial of a contactless payment system in a selected number of New York subway stations as an example of what her department produces. However, this appears to be anything but innovative: Hong Kong has the public transport and convenience store Octopus card, launched a decade ago, while in London the Oyster Card, launched in 2003, is similar.
Awareness
Some banks are more aware of the opportunities from innovation than others.
Spanish bank BBVA has an R&D department that came up with Dinero Express, a separate division aimed at capitalising on the opportunities offered by the four million immigrants in the country. The brightly coloured offices do not look like banks and offer subsidised phone calls home and packaging services through partners like DHL. Those are the magnets for the immigrants who then send remittances home and, as they move up the social scale, take out small loans and mortgages.
BBVA chairman and CEO Francisco González sees that as only a small step. “What would BBVA be like if you could build it from scratch?” he asks. His vision is of the walls between sectors disappearing, not just from the side of the retailers that have ventured into banking, but from banks moving into other sectors so that their revenue mix will be from more than financial services.
“How can we break down a person’s needs from when they wake up to when they go to bed? We need to see how we can have more contacts with them, what might be profitable for both sides, for instance in health and education. Or, why can’t we give them the information on what is the best TV in the market? We need to become managers of information. We know what clients save and spend money on and we have to get closer to our clients,” he says.
Mr González notes that banks have an advantage in that for a tiny marginal cost they can carry out numerous tests to see what customers want. He is also adamant that multidisciplinary teams are needed, including non-bankers – he began his career in 1964 as a programmer in an IT company.
He admits that implementation of this vision may be complicated, but expects to deliver concrete plans this year. He is, at least, sounding the right notes when it comes to innovation.
But the record so far for most banks is less than impressive. Banks are absent from Business Week’s annual ranking of the Top 25 Most Innovative Companies. And, realistically, the chance of that changing over the next few years is small.
SEVEN RULES FOR INNOVATION
- Formalise the procedure. Creativity is not automatically stifled by process. Last year, Deutsche Bank started a pipeline for ideas from anyone in the firm, even accepting submissions from fresh-faced university graduates. A regional peer review panel sifts through them and, ultimately, the best ideas are passed on to the management team. There are about 3500 ideas in the pipeline and the expectation is that one in every 1000 might work. By systemising the process, Deutsche hopes to avoid the duplication and re-inventing of the wheel endemic to its historically silo-like business model.
- Measure time to market and return on investment. Measure how many ideas are killed. You need to kill a lot to allow only quality ideas through.
- Customers are the key. Figuring out what customers need is crucial. Companies such as Victoria’s Secret, the US lingerie company, which researches what makes women feel comfortable and what makes them feel sexy, is a model of the sort of customer focus banks should have.
- Adopt lead-user theory. This is essentially piggybacking on the most advanced customers in order to innovate. Eric von Hippel, head of the innovation and entrepreneurship group at the MIT Sloan School of Management, ran a study on electronic home banking in which he discovered that so-called ‘lead users’ – those that are more advanced than the average – were far ahead of what the banks were offering them, perhaps balancing multiple mortgages and their cashflow. The banks could then offer an automated budgeting process. Lead user research, used by companies such as 3M, is crucial to innovation.
- Set up a research and development (R&D) department staffed by holders of PhDs. Investment banks already recruit them, but they need to be allowed free rein through a separate unit, even though its overhead status may grate. That is, after all, exactly what the most innovative companies in the world do. Nokia had an annual R&D budget of $3bn a few years ago, and most of its business units have at least three R&D sites, located in 15 countries and generally nearby top universities and relevant industry clusters.
- Diversity is crucial. Banks need thought leaders from different industries, with different degrees and different ethnicity, who have lived in different countries.
- Create an environment where change is encouraged and failure is not punished. On the reward side, Procter & Gamble, the world’s largest manufacturer of household goods, gives out gift certificates and stock to staff who innovate.
