Second Law of Digital Transformation in FSIs: Entropy of Operating Model Increases Over Time
Even the best fintechs go soft and do large layoffs, the unfortunate nature of FSI evolution, organizational entropy's impact on scale advantage, how to stop the decay without wild gyrations
Second Law of Digital Transformation in FSIs: Entropy of Operating Model Increases Over Time
"Monthly results just came in - we would need to cut 20% of headcount instead of 10%,” the Head of Division of a top-3 US bank gave our consulting team a new marching order in the summer of 2001. As the US was heading deeper into the recession, the division revenues were collapsing, so it had to drastically reduce its size to a much smaller client footprint.
This is a normal reaction to big macro surprises in financial services, insurance, and other industries. One of the best-known examples is Yahoo’s CEO email announcing the firing of 10% of employees during the 2008 recession, all in a low case:
A more puzzling situation arises when a successful brand announces large top-down cuts without any seismic shifts in the macro environment. We have been hearing about a lot of such cases recently across financial services firms like Citi and Block and among the Digital Natives.
In every instance, the CEO perceives that the company has become too burdened with organizational silos, levels, and intermediaries, necessitating a drastic reset to a leaner structure. How did they allow the company to devolve, and what are the proven practices to prevent organizational entropy?
Even the West's Best Fintechs Go Soft
We are not surprised by collapsing empires or industry colossi (US Steel was just sold to a Japanese firm). Even one of the world’s best investment conglomerates, Berkshire Hathaway, led by the legendary Warren Buffett, stopped overperforming the market in the last 5 years. Should the best fintechs have an indefinite advantage in operating effectiveness?
No, even they appear destined to confront organizational entropy. For fintechs, the bureaucracy of superficial outcomes tends to spread around the decade mark after the founding. Another decade elapses, and it permeates most of the enterprise.
When Stripe laid off 14% of its staff in 2022, its founders, the Collison brothers, had the fortitude to take responsibility in a way that few fintechs would, and it would be unheard of in a traditional FSI:
“In our view, we made two very consequential mistakes, and we want to highlight them here since they’re important:
We were much too optimistic about the internet economy’s near-term growth in 2022 and 2023 and underestimated both the likelihood and impact of a broader slowdown.
We grew operating costs too quickly. Buoyed by the success we’re seeing in some of our new product areas, we allowed coordination costs to grow and operational inefficiencies to seep in.”
Jack Dorsey, one of the most brilliant fintech founders of this century, decided to reduce Block's workforce by 8% more recently with a similar rationale:
“… number of people has far outpaced our growth and performance. In fact, I believe it's slowing us down and frustrating everyone… we’ve created structural duplication and redundancy that would better serve us by being more centralized.”
Will it work? In the short term, cost-cutting for Stripe or Block is likely to be as effective as it is for Citi. However, it might not be a lasting change because there doesn't seem to be a deep analysis of what caused their organizational entropy: the elements of talent, incentives, and organizational design.
For example, among a host of changes, Jack Dorsey recently introduced a switch from bureaucratic employee review cycles to at-manager-will termination, which seems great in theory. But why would the same managers who enable overhiring suddenly make sound decisions about whom to terminate?
Another "red flag" is the desire to improve operating effectiveness through the creation of new enterprise-level roles rather than replacing ineffective managers in divisions and functions. Jack created a new Enterprise CTO role responsible for engineering accelerators (culture, tools, strategy), but not having all engineering reporting to him:
It is understandable, given Jack's penchant for meditation retreats and famous hands-off style, that he prefers to have other people improve "culture," but adding enterprise executives is designed to lead to more buffer roles, not fewer.
The Unfortunate Nature of FSI Evolution
After completing an Agile transformation workshop for a divisional CIO of a global life insurer, I noticed that his team was energized, but he looked sad. I asked for a reason after everyone left. “We did all of this already 10 years ago, but it fell apart after a few years. I wonder how long it will last this time.”
Our newsletter often discusses the reasons why digital transformation is so challenging despite plenty of resources and general excitement. I call it the First Law of Digital Transformation: “Evolution cannot be achieved without abnormal behavior from FSI executives.” Achieving digital transformation in FSIs is an aberration from how most people prefer to operate, running counter to their deeply ingrained preferences:
Ownership mindset: humans enjoy frivolous spending of other people's money on more initiatives and resources with unclear ROI, which they would never do if they owned the same FSI;
Embrace of complexity: humans generally prefer simplicity, with a default reductive tendency to a one-size-fits-all approach, no matter a massive difference in digital needs and operating maturity across FSI’s departments;
Enabling autonomy: humans strive for the stability of higher status, and this can make it difficult to share power with less senior employees and vigorously debate ideas with peers; and
Muscle development: individuals are more interested in asserting their own voice and complaining than in asking insightful questions and learning from others.
But the hope was, at least, that once an FSI executive brings its group to the next level of digital maturity, it could recuperate there for a while before the next grueling evolution. Unfortunately, not - organizational entropy increases over time, pushing an FSI backward:
This is akin to getting into much better shape or losing a lot of extra weight and then maintaining it. While achieving that is much harder than maintaining, the maintenance effort is not trivial.
A year ago, Michael Rhodes announced a real agile transformation of his Personal Banking division at TD. Our newsletter in early 2023 profiled his attempt because it included many often missing elements. But we also had concerns about whether Michael would stick around to see it through:
He did not. As often happens, Michael recently left TD, in a surprising move to Discover Financial Services. Without his leadership, the gains in digital maturity are likely to reverse due to entropy forces.
Organizational Entropy Diminishes Scale Advantage
As we discussed in another newsletter, most of what one needs to understand about the target states of digital transformation comes from three firms: Amazon, Netflix, and Spotify. These companies wrote operating playbooks that the rest of the world is trying to follow, but they are also learning how to minimize and reverse organizational entropy.
Spotify recently announced a 17% layoff. This massive cut wasn’t due to some macro calamity or bad business performance but the founder's realization that the company had deviated far away from what made it uniquely effective in the first place:
“As we’ve grown, we’ve moved too far away from this core principle of resourcefulness… we still have too many people dedicated to supporting work and even doing work around the work rather than contributing to opportunities with real impact.”
With Jeff Bezos spending more time paddleboarding in Florida and flying in space, his previously notoriously lean Amazon has succumbed to the same natural forces. Middle managers are now incentivized to grow headcount rather than maximize impact. In other words, their career ascent is driven by the ability to grab a bigger budget rather than by the P&L impact a manager can generate from given resources.
A former Amazon's General Manager illustrated that promotions were determined by the size of a manager’s team rather than by repeated demonstrations of competence.
Due to such self-propagating bureaucracy, larger FSIs surprisingly exhibit mediocre effectiveness. Instead of leveraging a bigger scale to create advantages in efficiency and revenues, these FSIs negate it by adding a proportional volume of filler roles:
How to Stop Organizational Entropy?
The good news is that some FSI executives have learned how not to cede ground to organizational entropy. The best approach is to limit the pause between evolution phases to 3-6 months before embarking on the journey to new heights.
If there is no business reason or capabilities for another phase of digital evolution, FSI executives put in place three elements to preserve the gain in the meantime:
Management incentives: Update incentives across managers to focus on either the scalability of their resources or business impact
Organizational layers: Collapse management layers to a minimum, so executives are working as doers, personally observing front-line performance.
HR role: Ensure that the HR team is minimized and has no decision-making role in promotions.
