Digital Transformation: Not Always Essential for FSIs to Meet Customer Demands
Also in this issue: How Can FSIs Strategically Limit Digital Transformation to Profitable Areas?
Digital Transformation: Not Always Essential for FSIs to Meet Customer Demands
What is the most important feature for a consumer selecting a primary bank? After the start of the war in Ukraine, Raiffeisen Bank deliberately imposed unattractive savings rates to exit Russia organically. However, as the only Western bank left in the country, depositors continued to keep their money there due to its superior perception of safety. This resulted in Raiffeisen unwillingly generating about half of its profits in Russia out of 24 countries.
Safety is not the only traditional feature that still wins customer business in financial services and insurance. Local banks continue to thrive by offering lending products to nearby small businesses and consumers. When my friend recently needed a mortgage, his large financial providers couldn’t offer competitive pricing despite the billions spent on data analytics. A local bank did because they knew the community and had a surprisingly more accurate understanding of the risk involved.
Understanding customer needs could make FSIs more money, even if those needs are irrational. Selling overpriced ESG funds was a lucrative business specifically because affluent clients didn’t care about snazzy digital features. They wanted to believe they were helping to reverse global warming. Similarly, rather than worrying about crypto’s ultimate use cases or volatility, FSIs overcame their reluctance and have been selling well-margined products. Morgan Stanley recently took it one step further and began proactively offering bitcoin ETFs:
To ensure the right client fit, Morgan Stanley has defined a narrow segment for advising on investments in the "numbers go up" asset class. Their criteria include:
Net worth: Clients with at least $1.5 million.
Investment profile: Clients with aggressive risk tolerance and a desire for speculative investments.
Account type: Taxable brokerage accounts, not retirement accounts.
Some FSIs might be tempted to violate the first rule of capitalism, "give people what they want," when attempting to nudge clients into healthier behaviors using novel digital tools. For instance, around 10% of traffic accidents are caused by drivers using cell phones, so Progressive Insurance helped conduct a study to see how to reduce that behavior. Not only did tools and training make no difference, but even with gamification and incentives, over 70% of the usage persisted in the first couple of months—and this was among an opt-in audience.
The worst mistake that FSIs and fintechs can make is to develop a digital solution for a problem that doesn’t exist or, worse, one that alienates target customers. Victimbanks are a primary example of this phenomenon, consistently failing to scale within narrow groups based on ethnicity or sex. The most recent casualty of the "You are a victim. Now, give me your money" strategy is the challenger bank, Totem. How come it failed to resonate despite such an exciting headline:
The funniest example of such customer mistargeting is the attempt to create products that cater to the perceived plight of Gen Z in the U.S. Based on a never-ending stream of media articles and expert opinions, many FSIs began to believe that Gen Z faces unprecedented challenges and thus requires a fundamentally new acquisition and portfolio management approach. In reality, American Zoomers are earning more than previous generations and have higher homeownership rates than millennials did at the same age.
Being customer-centric means satisfying customers' needs and wants, not inventing new ones or trying to change them. Digital transformation makes it easier to attempt the latter, so FSIs and startups have increasingly pursued these strategies. However, sometimes the most customer-centric act is simply leaving customers alone.
How Can FSIs Strategically Limit Digital Transformation to Profitable Areas?
Digital transformation aims to build sustainable digital capabilities that can differentiate FSIs through a uniquely lucrative business model or a superior cost structure. The potential for value creation is immense—Revolut reached a valuation of $45 billion in less than a decade, while Nubank hit $60 billion after 11 years. Consequently, FSIs now allocate around a trillion dollars annually to technology, with many top institutions spending over $10 billion each year. "Digital transformation" remains so hot among FSIs that it's now being used to justify investing in trendy fintechs with direct Board access:
Moreover, many well-known fintechs are now profitable, and others are nearing profitability, largely due to significantly lower customer acquisition costs. For instance, TymeBank in South Africa amassed 8.5 million customers and achieved profitability within its first five years, with an acquisition cost of under $5 per customer. That includes in-store kiosks where new applicants can open a bank account in under five minutes.
A major factor in these low acquisition costs is the substantial portion of new accounts generated through word of mouth. Outside of China, Nubank, Revolut, and Wise are arguably the world's three most effective consumer fintechs, with each enjoying 70-80% of new customers through referrals. However, Revolut’s advertising and marketing spending has grown proportionally with its revenues, while Nubank and Wise have achieved more scalable growth:
These differences arise because Revolut's expansion into complex bundles in highly competitive markets is significantly more costly. In contrast, Nubank currently focuses on three Latin American countries, where its product bundle remains superior to competitors. Wise, on the other hand, primarily offers an easy-to-switch product with a volume growth rate of less than 20%, which is behind Nubank and Revolut.
For traditional FSIs in competitive markets like the US, this should prompt a reassessment of whether to compete with such fintechs or potentially withdraw from certain target segments or regions. Even if traditional FSIs master digital transformation and their executives adopt a fintech mindset, the question remains: is the target market lucrative enough to justify years—or even decades—of investment? For instance, Wise is successfully outperforming Western Union with minimal acquisition spend. However, Western Union's stock has performed relatively better year-to-date:
Behind this trend is investor apprehension about the future of digital money transfers. The scaling of fintechs for some financial products often leads to a substantial revenue decrease in that industry. For instance, if a low-cost provider like Wise were to eliminate all global competitors in cross-border C2C transfers, its revenue might peak at only $10 billion—less than 20% of the current industry total. Hence, investors are concerned that the investment required for Wise and its peers to lead in such a digital “death match” may not justify the potential returns.
Such concerns should be assessed before embarking on digital transformation in any specific client segment, product, or region. For instance, Citadel Securities already controls 25-35% of various stock trading segments. Its revenue in Q1 was only $2.3 billion.
Avoiding markets with bleak prospects requires finesse, rather than simply exiting tough ones. A recent article by surveillance technology expert Albert Fox Cahn provides a perfect anecdote about how digital capabilities can backfire when applied top-down to home insurance. The industry has been notorious for huge losses over the past four years, so it is expected that players like Travelers would apply AI drones to detect any potential property risks such as moss on roofs which could lead to large claims.
After detecting moss on Albert's roof, Travelers canceled his home insurance coverage, revealing three problems:
1. The moss was treated by the time the drone captured the image, but the drone didn't detect this.
2. The customer wasn’t offered an option to fix the issue or pay a higher insurance premium.
3. The billing software lacked rules to send prior cancellation notices to customers in certain states.
Is it worth Travelers trying to digitally transform a business that is, at best, only breaking even? Avoiding digital transformation in markets already or likely to be disrupted, while gradually exiting them without losing profitable customers, will help FSIs preserve cash for investing in areas where they can develop a competitive advantage. This nuanced approach might seem excessive in today’s environment of lavish technology spending, but these advanced operational muscles will come in handy during the next cost-cutting cycle.
