2 BANKING PERSPECTIVE QUARTER 1 2016

3BANKING PERSPECTIVE QUARTER 1 2016
TECHNOLOGY AND THE INTERNET are radically changing many industries, and the financial
market is no exception. According to CB Insights, more than $12 billion was invested in financial
technology startup companies (hereafter, FinTech) in 2014, up from $4 billion in 2013.1
These
non-banking firms threaten to reshape the status quo in the world’s financial markets by changing
the way customers and businesses consume financial services, including banking (Moven, Simple);
loans and credit to individuals and small businesses
(Lending Club, Kabbage); financing for small businesses
(BlueVine, Fundbox); wealth management (Betterment,
Robinhood); and, of course, payments (PayPal, Venmo).
Austrian economist Joseph Schumpeter dubbed the
process in which new, innovative products replace
outdated ones “creative destruction.” According to
Schumpeter, creative destruction results in richer and
more productive societies that enjoy higher living
standards. These rewards, however, come at a cost:
some firms and individuals, typically those that depend
on old or outdated products, might be worse off once
new products replace the old way of doing things. With
FinTech, the ones at risk are conventional banks.
The FinTech landscape has focused the development of
new products and services on two segments: individuals
(personal needs) and small businesses (see Figure 1). The
main vertical markets (ignoring Bitcoin, cryptocurrency,
and blockchain) under the individuals category are
mobile payments, banking, capital markets and investing,
lending, and wealth management. The main vertical
markets under the small businesses category are payments;
merchant services; and loans, financing, and credit.
Although there has been much activity and enormous
investment, in practice, how do FinTech companies create
value in the market? In general, when thinking about value
creation one should consider the benefits the product/
service offers to the consumer, which can be thought of as
the maximum the consumer will be willing to pay for the
product – the higher the benefit, the higher the consumer’s
willingness-to-pay (WTP) (B in Figure 2). The value the
firm creates in the market is then the difference between
the consumer’s WTP and the firm’s cost of providing
the product/service. The larger the difference between
these two, the more value the firm creates in the market.
Furthermore, the more consumers that want to consume
the product/service offered by the firm (Q in Figure 2),
the larger the value the firm creates in the market. Firms
can increase their value creation by increasing consumers’
WTP, decreasing their costs, or increasing the overall
size of the market (that is, the number of consumers that
consume their product/service).
Value creation is necessary for profitability; however,
firms must also consider their value capture strategy – the
share of the value created that the firm can capture as
profits. Specifically, the price a firm charges for its product
BY SARIT MARKOVICH
NORTHWESTERN KELLOGG SCHOOL OF MANAGEMENT

4 BANKING PERSPECTIVE QUARTER 1 2016
Creative Destruction in Banking
essentially divides the overall value created (B minus C,
where C is the average cost of production) between the
customers and the firm. The customer received B minus
P (where P is the price the customer pays) as consumer
surplus, while the firm takes P minus C as its profits. The
more competitive the market, the closer P is to C and
thus the lower the value the firm captures as profits. The
competitiveness of the market, however, is not necessarily
related to external factors. In particular, the better the
firm differentiates its product, the more unique the
product becomes, and consequently the less competitive
the environment the firm faces.
While firms can set the price in the market, the quantity
sold (Q) is determined by consumers’ choices. Given a
budget, consumers would choose the product that gives
them the largest consumer surpluses. That is, consumers’
product choice does not depend only on the price of the
product but also on the benefit that the product provides
to the consumers. The more value the firm creates in the
market, the more value to share between the firm and the
customer, and thus the easier it is to offer an attractive
amount of consumer surplus while still capturing a large
share of the value created as profits.
For example, take the introduction of MasterCard’s
PayPass in the early 2000s. PayPass lets customers tap
the card rather than swipe it, speeding up the checkout
process. Since the tapping action does not cut much of the
transaction time, specifically relative to the use of a debit
card, consumers did not feel that the PayPass technology
created more value than the alternatives available in the
market and, indeed, only a few adopted the technology.
In contrast, Venmo allows consumers to easily split bills
and offers peer-to-peer payment and thus creates value
in the market. The availability of similar free alternatives
(e.g., PayPal or cash), however, makes it hard for Venmo
to capture value (see Figure 3). Since consumers choose
products based on consumer surplus, charging too
high of a price may make consumers switch back to the
alternatives they were using before adopting Venmo.
In order to consider a FinTech’s value creation, it is
useful to think about the six main functions financial
systems perform (as defined by Robert C. Merton and Zvi
INDIVIDUALS SMALL BUSINESSES
Mobile Payments
Dwolla MCX Venmo PayNearMe Mozido Square
Payments
Simple Moven Bluebird
Banking
Bill.com Wave Zuora
Merchants’ services
Our Crowd Circle Up Crowdcube
Capital markets and investing
Lending Club Affirm
Lending
Robinhood Betterment Wealthfront
Wealth Management
BlueVine OnDeck FundBox Lendio
Loans, financing and credit
FIGURE 1: THE GROWING FINTECH LANDSCAPE

5BANKING PERSPECTIVE QUARTER 1 2016
Bodie): 1) clear and settle payments; 2) transfer resources
across time and space (e.g., loans, saving accounts,
currency exchange); 3) pool resources and subdivide
shares (e.g., mutual funds, stock market); 4) provide
information (market data); 5) manage risk (insurance or
derivatives); and 6) deal with asymmetric information and
incentive problems between different parties.2
While traditional banks perform many or even all of
the functions, FinTech companies pick and choose the
functions they can perform. For example, the lending
platform Kabbage provides working capital to small online
merchants and sellers on marketplaces like eBay, Etsy,
and Amazon. That is, Kabbage chooses to provide only a
few of the functions typically offered by traditional banks
– transfer resources across time, manage risk, and deal
with asymmetric information. Kabbage and other FinTech
alternative lenders are not the first non-banking firms to
enter the alternative lending market and focus on these
specific functions.
The distinction between alternative lenders and their
predecessors comes from the technology-based approach
these newer companies take to automate the process
of analyzing borrowers’ data. This allows these lenders
to offer the financial functions of managing risk and
dealing with asymmetric information at a lower cost than
traditional lenders. Some of these cost savings can then be
shared with borrowers (and, in the case of crowdfunding,
investors), increasing consumers’ surplus for borrowers.
Kabbage, for example, uses dozens of data sources,
including sales and credit history, customer reviews, and
prices and inventory to assess the risk of a specific loan.
This data-driven approach helps Kabbage mitigate two
main challenges facing lenders that offer loans to small
business: idiosyncrasy and asymmetric information.
The traditional underwriting process of giving a loan
to a small business is encumbered by the heterogeneity of
small firms, making it hard to develop general standards
for assessing applicants’ risk of default. Kabbage, in
contrast, mines vast amounts of data to successfully rewrite
the rules on how credit is evaluated. For example, a small
business seeking a loan through Kabbage must grant access
to e-commerce sites, such as Amazon or eBay, so Kabbage
can access credit worthiness. Kabbage looks at customer
feedback, reviews, and ratings to determine if the small
business has good products and customer service. SoFi, a
marketplace lender with over $7 billion in loans (student
loan refinancing, mortgages, mortgage refinancing, and
personal loans), doesn’t rely solely on FICO scores because
many millennials don’t have credit cards. Instead, SoFi
also looks at data such as a borrower’s cash flow, course of
study, university, and postgraduate employment.
Established financial institutions are just beginning to
tap into social media to evaluate risk. Insurance companies
use social media to investigate claims, such as for a car
accident. They also use it to uncover fraud by looking at
social media connections to see if the claimant knows
other parties in a motor vehicle accident, for instance.
Leveraging this information for data analytics and
machine learning guides the value creation strategy of
The distinction between FinTech
alternative lenders and their predecessors
comes from the technology-based
approach these newer companies take to
automate the process of collecting
and analyzing borrowers’ data.

6 BANKING PERSPECTIVE QUARTER 1 2016
Creative Destruction in Banking
FinTech companies not only to predict bad loans and
build credit risk models, as Kabbage does, but also to
detect fraud, build trading algorithms, offer robo-advisers,
etc. That is, essentially, the same trends that dominate
technology (big data and networking, social media,
data analytics, and machine learning) also dominate
the FinTech revolution. As this happens, the traditional
revenue streams that traditional banks have enjoyed for
years (account management fees, loan origination fees,
interest on loans, and more) will be challenged.
One must wonder how much of FinTech threatens
traditional banks. According to Lending Club’s CEO,
Renaud Laplanche, the company’s operating cost is 2%
of assets, compared with 7% at a typical bank. What is
the source of these lower costs? According to Laplanche,
the main advantage of FinTech companies is their
independence from expensive, older systems and their
freedom from regulatory overheads. As FinTechs grow
and mature, however, they will likely start to attract the
attention of regulators, which would increase compliance
and operating costs.
The FinTech revolution, however, is not only cost
driven. Technology provides FinTech companies with a
cost advantage but, more importantly, it allows them to
create value by more effectively solving the asymmetric
information problem and better aligning incentives.
FinTech companies empower their customers with ample
information to be more responsible with their money
and make informed decisions, increasing the benefits to
consumers.
For example, Simple offers its customers the Safe-to-
Spend feature, which takes their current balance and
subtracts upcoming bill payments, pending transactions,
and any saving goals. This gives customers a clearer view
of what they can actually spend without affecting future
plans. Furthermore, the extensive data FinTech companies
collect and mine provides them with a rich overview of
their customers’ behavior. In lending, information about
borrowers’ social network, consumption, and spending
behavior, etc., can reduce the information asymmetry
between the lender and the borrower.
Clearly, many banks have similar and, at times, more
comprehensive data on their customers; after all, banks
have very long relationships with their customers.
Nevertheless, unlike most banks, FinTech companies rely
mostly on data analytics and machine learning to assess
the risk of default. This decreases the cost of providing
these functions and thus increases the value created; this,
in turn, allows FinTech lenders to offer more attractive
loans to customers, thereby increasing the overall market
for loans (e.g., increasing Q in Figure 2).
FinTech companies also create value by enhancing the
alignment of incentives of the company and the investor.
A case in point is the equity-based crowdfunding platform
OurCrowd, which identifies early-stage startups that
it finds to be appropriate investment candidates for its
clients. To enhance the alignment of the incentives of the
platform and its investors, OurCrowd itself invests around
$50,000 of the funding target. While this helps to better
align incentives, OurCrowd and its investors’ incentives
still are not well aligned. While most of its investors invest
in only one investment opportunity, OurCrowd is more
Established financial
institutions are just beginning to tap
into social media and nontraditional
data sources to evaluate risk.

UNITS SOLD
$/UNIT
B
Q
P
C
Benefit of product
to customer;
willingness-to-pay
Price customer pays
Units sold, or number of customers who purchase
Value created
Value that goes
to customers as
CONSUMER SURPLUS
Value that goes
to firms as
PROFITS
Average (per unit)
cost of production
7BANKING PERSPECTIVE QUARTER 1 2016
diversified than its customers by being invested in all the
investment opportunities it identifies for its investors.
To address this issue, OurCrowd offers its investors its
Portfolio Reserve product, which automatically chooses
investment opportunities for investors from the next 10 or
more financing opportunities that OurCrowd identifies.
OurCrowd is not alone in offering such products; Lending
Club and Prosper, also offer similar services.
Finally, FinTech companies create value by
democratizing financial markets, giving unsophisticated
consumers access to financial products that previously
were out of their reach. For example, peer-to-peer
lending gives mass-market investors access to make
loans to individuals and small businesses. Equity-based
crowdfunding gives unsophisticated investors access to
investment in early-stage startups, and also gives startup
companies and seed-stage venture capital funds access
to money from a larger network of investors, enabling
startups to pitch their ideas directly to millions of
accredited investors.
Given the various ways in which FinTech companies
create value, the threat to traditional banks depends on
whether the advantages FinTech companies have are
sustainable. Specifically, while many of these direct-to-
consumer products are likely here to stay, it’s unclear
whether we should expect these products to be offered
mainly by non-banking FinTech companies a few years
from now or if traditional banks will enter the market.
In general, there are several strategic responses
incumbents (in this case, traditional banks) can take
when facing a disruptive innovation. The first question to
ask when considering a response to disruptive innovation
is: Does the innovation threaten our products/customers?
The biggest misconception about innovations is that
the new way of doing things will grow and eventually
overtake traditional methods. Appreciating that the new
way of doing things is not necessarily superior to existing
methods is important when considering the response.
For example, online banking, which was viewed as a
promising innovation in the early 1990s, still has not
disrupted the market as initially expected. Similarly,
E*Trade and Ameritrade were heralded during that same
time as foretelling the death of traditional broker dealers,
a prediction that never panned out.
Assuming the innovation threatens profitability,
another issue to consider is whether the main effect on
consumers’ behavior is substitution or augmentation
of volume. Under substitution, consumers migrate
transactions from the current product/service to the new
product/service (e.g., consumers substitute investment
in the stock market with investment in peer-to-peer
lending). The augmentation effect suggests that the new
products and the current products are complements such
that consumption of the new product/service increases
the consumption of current services (for example,
data provided by Simple may increase the number of
transactions consumers make between their different
savings and deposit accounts).
Finally, adopting the new innovation may increase
the benefits or decrease consumers’ implicit costs of
FIGURE 2: VALUE CREATION AND CAPTURE

8 BANKING PERSPECTIVE QUARTER 1 2016
Creative Destruction in Banking
consuming the current product/service and thus may
result in an overall increase in its overall consumption
(i.e., the use of peer-to-peer mobile payments may
increase the overall number of payment transactions).
The relative magnitude of the substitution,
augmentation, and volume effects should then guide
incumbents with their strategic response. Specifically, if
the substitution or volume effects dominate, incumbents
should either embrace the innovation (migrate to the
new business model and scale up) or go on the offensive,
developing an even more compelling value proposition.
If the innovation introduces a complementary product/
service, incumbents can either offer both products or
keep focusing on their existing products/services and
customers while trying to differentiate themselves in the
market, guaranteeing they benefit from the increase in the
consumption of the current product/service.
Looking at the banking market, the analysis above
seems to suggest that many of the new products/services
offered by FinTech companies create value in the market
and are here to stay. So the answer to the question “Does
the innovation threaten our products/customers?” is
“Yes.” Therefore, “do nothing” is not an optimal response
strategy for traditional banks. With that in mind,
how should traditional banks respond to the FinTech
revolution? It depends on the different vertical markets
(payments, lending, wealth management, etc.) and
how these innovations create value. While the verticals
determine whether the new innovation offers products
that are substitutes or complements, the way technology
creates value determines whether traditional banks would
be able to adopt the innovation as well.
For example, merchant services and some of the loans,
financing, and credit services to small businesses are
complementary products that banks may choose to leave
to non-financial FinTech companies. As long as banks
keep strong relationships with small businesses, these
innovative products and services complement the banks’
activity and help small businesses stay profitable and grow.
This, in turn, may increase banks’ profitability.
In contrast, mobile payment, banking, wealth
management, and lending are substitute products.
Could banks adopt these innovations to offer better or
comparable services? Most of the FinTech lending and
credit products create value by having lower costs and by
utilizing data analytics and machine learning. Traditional
banks could adopt these innovations (and in fact many
already do) by either developing these activities in-house
(e.g., Chase QuickPay), acquiring a FinTech company
that performs these activities (e.g., BBVA’s acquisition of
Simple), or by outsourcing or partnering with FinTech
companies (e.g., Lending Club’s partnership with
BankNewport, as well as other small banks). This trend
creates opportunities for software companies to service the
traditional bank community with capabilities such as big
data, data analytics, and machine learning.
So will traditional banks adopt all the value-created
opportunities FinTech companies brought into financial
markets? The one value-creation category that remains
a challenge to a traditional bank’s profitability is the
UNITS
SOLD
$/UNIT $/UNIT
B
P
C
B
P
C
WTP increases but costs go up a little and Venmo must offer consumer surplus that is
at least as high as the alternatives. As a result, profit opportunities are quite limited
Alternative to Venmo:
Cash, PayPal
Venmo
CONSUMER
SURPLUS
PROFITS
CONSUMER
SURPLUS
PROFITS
FIGURE 3: VALUE CREATION AND CAPTURE – VENMO

9BANKING PERSPECTIVE QUARTER 1 2016
democratization of financial markets. As discussed earlier,
FinTech companies such as Affirm and Kabbage offer
personal and small-business loans by committing their
own funds, creating value mainly by the usage of data
analytics and machine learning. However, many FinTech
platforms, such as Lending Club, Fundera, and CircleUp,
disrupt financial markets by giving a broader range of
consumers access to individual and small-business loans.
Others FinTechs do the same for startups, by offering
access to capital (e.g., Crowdcube) or even exchange
currency (e.g., TransferWise). Under this category of value
creation, innovation is aimed at replacing investment
banks, for example, with the crowd. While some of these
products are aimed at market segments that banks so far
have chosen to ignore (e.g., loans to very small businesses),
the scale and growth in these markets suggest that these
segments may offer a profitable opportunity. Indeed,
traditional banks may choose to participate in these
markets by either providing the platform or simply by
partnering with FinTech companies to help facilitate the
transaction. Still, democratization by definition implies
that some of the value created will be captured by the
mass market. That is, unlike in the case where value
creation relies on information, data analytics, and machine
learning, under democratization of financial markets,
banks will not be able to keep all the value created for
themselves. Rather, the value will be shared.
This approach to the provisioning of financial services
by the crowd changes the way risk is allocated in the
market. Specifically when it comes to democratization,
the crowd, rather than the intermediary, bears the risk.
This change in risk allocation brings up possibly the
most important point to consider: regulation. Regulators
are concerned by the mass-market investor’s ability
to understand the underlying risk in the investment
opportunities offered by FinTech companies. Moreover, as
suggested by Stephen G. Cecchetti in his recent Banking
Perspective article “Shining a Light on Shadow Banking,”
non-bank financial markets create systemic risk in the
system.3
For example, peer-to-peer lending and equity-
based crowdfunding suffer from both adverse selection
and moral hazard. Cecchetti suggests that regulators
should take a functional regulation approach where all
banking activities, regardless of how and by whom they
are provided, should be under the same regulation terms.
CONCLUSION
There is no doubt that FinTech is “creatively disrupting”
financial markets by changing the way financial services
are accessed, delivered, and experienced. It is unclear,
however, whether banks will be worse off from this
round of creative disruption. While FinTech challenges
the banks’ traditional revenue stream, banks will likely
remain the dominant players in the market. Banks have
ample information on their customers, which they can
use to imitate and eventually improve upon FinTech
companies’ data approach. Furthermore, banks have
strong relationships with their customers and have
already earned their trust to handle their finances. Banks
must quickly take advantage of these assets to adapt
to the new environment before FinTech companies are
able to build large networks and gain consumers’ trust.
That being said, the FinTech revolution has also brought
innovation that requires banks to share some of the value
created in the market with the crowd. The future of this
democratization of financial markets, however, crucially
depends on FinTech companies’ skills (and incentives) to
manage the risk of investments on their platforms safely
and responsibly. n
ENDNOTES
1 https://www.cbinsights.com/blog/fintech-and-banking-
accenture/
2 Merton, Robert C., and Zvi Bodie. 2005. “Design of Financial
Systems: Towards a Synthesis of Function and Structure,” Journal
of Investment Management 3(1): 1-23.
3 Cecchetti, Stephen G. 2015.“Shining a Light on Shadow Banking,”
Banking Perspective 3(4): 42-48.