The Banking Industry's Value Chain Is Unbundling: Future Winners & Losers Are Emerging

The way the digital economy works is rewriting everything we know about service businesses. Most have no idea what is going on behind the scenes.

It's already happened to physical goods. Now, it's about to unfold in services.

Let's take a look at a traditional service-based business: the bank.

100 years ago, banks were local and intimate to their community. Let's say you lived in Nebraska and banked with First National Bank of Omaha (founded in 1857). Back in the early 20th century, what did the bank do?

They did everything! They did all of their own underwriting, all of their own marketing, their own customer service, etc.

Why did they do everything? Because outsourcing processes did not work well in the last century.

Let's say you walked into the bank for a home loan:

• You went to Bank of Omaha because everything was done in person.

• This was your local bank. Your only option was banks within a short travel distance.

• Phone service was rare, and there was no internet.

Thus, you banked local, and not with a bank a far distance away.

Bank of Omaha was the only one capable of underwriting your home loan because:

• The community knew you best.

• Your job was a local job. The local bank knew your role in the community and job security, therefore they knew your ability to pay the loan better than anyone else in other parts of the country.

• They were privy to local specialized information that others did not have. There were no digital databases to easily access.

The local bank had more access to your local deposit history and habits. It wasn't something easy for other banks to verify if you didn't bank with them. Fraud would be hard to catch.

Overall, limited communication technology, lack of standardized data, undeveloped specialized service providers, and the high transaction costs of coordinating external parties made most business functions operate locally.

This is why banking was local, and almost all of the value chain was exclusively local as well, from deposits to underwriting.

Things, however, are much different today. Particularly in the last decade since all businesses started moving toward a full digital tech stack.

How is the Banking Value Chain Changing Today?

Banks have a few notable functions for creating value for customers. Two significant functions are:

Customer & service aggregation: Banks can provide a single location to do financial services and manage money, such as through a banking app.

Underwriting: This is the process of determining an individual's risk and the appropriate APR and loan terms for maximum profit and risk assessment.

In the fully digital economy, these two different value creation activities do not need to be performed by the same business.

This Will Result in Two Big Changes:

1. Customer aggregation can be done by businesses who do not need to do underwriting. For instance, Robinhood can enter banking by being a customer aggregator. They can simply pass off underwriting to another bank or financial services company. This lets them further monetize their customer aggregation ability by being a single place for people to manage their money.

2. Underwriters no longer need to be banks. This means a business can focus entirely on the underwriting process and assessing risk for APR without having to aggregate customers. New examples include fintechs like Upstart, whose staff is over 50% devoted to the technical part of the organization to determine the optimum financial modeling, machine learning, and AI techniques in pricing risk to rate and identifying fraudulent customers beforehand.

The further we move forward in time, the greater the separation will become between the customer aggregators and the underwriters.

We're currently living in a time where some businesses attempt to do both, but are increasingly discovering the benefits of becoming specialized in one.

For instance, Upstart now works with over 100 financial institutions (banks and credit union networks) who have realized that they are best as customer aggregators. These credit unions know that they are attractive hubs for their community to do all their banking activities.

But they also recognize that Upstart has better underwriting than they do because Upstart employs many of the best machine learning minds in the world to solve complex problems and improve their underwriting abilities. These credit union networks use Upstart to price loans to their customers. It improves their profitability versus using their own models alone.

The reverse is true for customer aggregators like Robinhood. Why do they need to devote time and energy to figuring out how to underwrite when they can let someone else do it? Instead, they can profit simply by being the best UI, interface, and brand that attracts customers.

The end result is that businesses can now focus on their core competency. Instead of trying to do everything "okay," they can do one thing exceptionally well.

This is exactly what we saw previously happen when it came to physical products in the real world. Thanks to globalization, the value chain separated.

For instance, in a complex product like semiconductors, virtually every part of the semiconductor value chain is created by a different player. For instance:

• Semiconductor design software by Synopsys

• Semiconductor design by NVIDIA

• Semiconductor manufacturing by TSMC

Each company has its specialty in the value chain. The same will happen to services, such as banking, and this specialization and decoupling is currently in process.

The Bottom Line for the Future of Digital Banking and Services

As investors, we must be aware of how this decoupling will reverberate through the financial industry.

It means there is danger for businesses that are average in all parts of the value chain and exceptional in none.

For banking, as the value chain splits, those that survive best will be ones that are amazing aggregators and amazing underwriters. Whereas those that are simply average at both will eventually lose their aggregation market share to competitors, and their customers to those businesses that also have better underwriting.

It also means there is an opportunity. Those that are the best and world-class in each have potential for immense scale.

How big will Robinhood banking be in 10 years? How big will Upstart's underwriting services be? The potential is massive.

ALSO READ: How Information Overload Leads Investors Astray

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