Journey to the Center of the Matrix Nigel Morris Managing Partner, QED Investors
QED Investors has invested in 40+ FinTech disrupters over 9 years I’ve been blessed with four distinct stops in We began QED Investors over nine years ago retail financial services to help the disrupters 1985 • Leverage over 120 years of collective Strategic Planning Associates Principal experience in building financial services 1988 businesses Signet Bank Card • Invest in breakthrough disrupters attacking Executive Vice President the incumbents and leveraging next generation 1994 propositions in retail financial services ( 40+ FinTechs to date ) Capital One Co-Founder, President, COO • Play active, hands-on consigliore roles with leaders leveraging our operating, credit, and marketing experiences to profitably scale 2004 quickly and soundly QED Investors Managing Partner 2
We contemplated what a blank slate bank might look like… ü Delight your customers in service and product design ü Embrace digital channels and avoid creating technical debt ü Develop a culture of discipline and consistency ü Attract and retain top talent ü Don’t get sideways with the regulators ü Manage out rogue employee behaviors ü Don’t try to be all things to all people all the time All of this is true but obvious – and doesn’t provide a roadmap for existing companies 3
How must new and existing institutions evolve? • We propose that the answer requires striking the right balance along two dimensions: – Resilience – Flexibility • While important, this is devilishly difficult to do… – “Extremes” create vulnerability, while balance allows institutions to reap the best of all models – Organizational change is challenging and slow – and typically faces multiple sources of resistance 4
The basic retail banking model has been the same for decades Retail banks have engaged in a largely similar Even the execution of this model is not business model for decades dramatically different today Circa 1930 Protection, Deposits interest Interest Loan Today 5
That model worked when banks averaged ~15% ROE… 18% 18% 16% 16% Return on average equity (%) 14% 14% 12% 12% Post-crisis cost of equity 10% 10% 8% 8% 6% 6% 4% 4% 2% 2% 0% 0% 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 -2% -2% Source: Federal Reserve Economic Data. Return on Average Equity for all U.S. Banks, Percent, Quarterly, Not Seasonally Adjusted. Shareholder value shading assumes constant cost of equity 6
…but banking economics have weakened since the crisis 18% 18% 16% 16% Return on average equity (%) Shareholder value 14% 14% destruction 12% 12% Post-crisis cost of equity 10% 10% 8% 8% 6% 6% 4% 4% 2% 2% 0% 0% 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 -2% -2% Source: Federal Reserve Economic Data. Return on Average Equity for all U.S. Banks, Percent, Quarterly, Not Seasonally Adjusted. Shareholder value shading assumes constant cost of equity 7
Banks have not focused on what the key profit pools are, attempting to be all things for all people… Annual post-tax economic profit, 2015 35 30 2.4 0.3 2.6 25 0.4 20 9.0 $BN 0.3 15 29.7 3.1 0.1 0.2 3.1 10 5 9.2 0 Checking Savings Online Online MMDA CDs Credit Retail Charge Auto HELOC/ Total checking savings cards cards cards loans HE loans Deposits Cards Lending Source: Oliver Wyman analysis 8
…while disrupters have attacked deep profit pools and atomized the retail banking model FinTech disruptors Consumer loanDepot has funded $100 lending Bn in loans since 2010 Square’s $50 Bn in 2016 Payments transaction volumes marks a 39% increase from 2015 Wealth Betterment and Wealthfront management manage over $10Bn in assets Chase, BBVA Compass, and Small business CommBank (Australia) have lending partnered with OnDeck Atom works with 800 Deposits mortgage providers to provide digital mortgages 9
Regulatory pressure, low rates, and evolving technology have squeezed bank profitability… High costs of technical debt that burden traditional banks Reduced value of bank branch + footprint due to mobile Cheap computing that lowers barriers for new entrants 10
…and much of the talent arriving at these disrupters has come from banks Many FinTech founders left leading banks… …and grow their teams with bank talent CEO, Co-Founder 1,363 employees on LinkedIn 213 employees on LinkedIn Mike Cagney Past employers Past employers 94 Wells Fargo 22 Northern Rock 48 Capital One 19 Barclays CEO, Co-Founder Justin Basini 45 Bank of America 18 Virgin Money 41 JP Morgan 18 Lloyds 36 Charles Schwab 10 HSBC 264 87 CEO, Co-Founder Sasha Orloff Source: LinkedIn 11
Traditional banks and FinTechs operate at fragile extremes - - Slow adoption of digital channels Monoline / narrow product suite - - Legacy technology infrastructure Lack of built-in physical distribution - - Conservative use of alternative data Scarcity of customer data - - Organizational inflexibility Sub-scale, millennially-focused business - - Culture of “no” and regulatory overhead Struggle to scale new businesses - - Struggle to launch new businesses High cost of capital and debt - - Weak talent attraction/retention Lack of capital reserves - - Poor net promoter scores Minimal compliance / capital mkts. infrastructure Risk of being a utility Risk of extinction for numerous reasons 12
Similar to BCG’s framework for analyzing business units, we need a framework to discuss banking model trade-offs BCG Growth-Share Matrix (1970) QED Matrix (2017) Stars Question marks Mountains Trees High High Market growth rate Resilience Cash cows Dogs Boulders Leaves Low Low $ High Low Low High Relative market share Flexibility 13
Each quadrant has its shortcomings, so institutions close to the center tend to be best positioned QED Matrix • Distinguishing between banks and FinTechs on a single dimension is insufficient Mountains Trees • The QED Matrix reflects trade-offs in the design of High financial services institutions – Resilience is a function of factors like brand, Resilience capitalization, and product suite diversification – Flexibility concerns both infrastructure and decision-making – and spans organizational Boulders Leaves design, technology, culture, talent, and more Low • Each quadrant has strengths and drawbacks, so our thesis is that entities should move towards the center of the matrix Low High Flexibility 14
QED Matrix: Mountains QED Matrix Characteristics • High resilience due to product diversity, brand, capital Mountains Trees reserves, distribution networks, and low cost of capital High • Low flexibility due to institutional inertia, low growth, technical debt, & focus on regulation and cost reduction Resilience Pros / Cons • + Very strong distribution, including massive physical networks and more investment in digital than Boulders Boulders Leaves + • Efficient at competing in “national” businesses Low • + Able to test new models easily on existing customers through partnerships with and acquisitions of Leaves • - Decision-making process, infrastructure, and regulatory pressures lead to poor ROE and limited innovation • - Sourcing and retaining talent remains challenging Low High 15 15 Flexibility
QED Matrix: Boulders QED Matrix Characteristics • Low resilience due to lack of capital reserves or Mountains Trees product diversification of larger banks (Mountains) High • Low flexibility due to legacy infrastructure, weak talent pipeline, and dearth of ideas or comparative advantage Resilience Pros / Cons + • Low cost of capital and strong advantage in “local” businesses (e.g., deposits, CRE) Boulders Leaves • + Partnerships with Leaves and even Mountains can be Regional banks particularly material due to smaller size Low + • Developed risk and compliance capabilities • - Vulnerable due to more limited capital reserves and capacity to innovate (given talent, digital capabilities) Community banks / CUs • - Sub-scale operations force a trade-off between Low High profitability and proper resourcing 16 16 Flexibility
QED Matrix: Leaves QED Matrix Characteristics • Low resilience due to product concentration (often Mountains Trees monoline) and lack of stable, low cost capital (deposits) High • High flexibility due to simple organizational structure and technology infrastructure, access to talent, etc. Resilience Pros / Cons + • High degree of focus makes it easier to excel in a specific part of the market (e.g., franchise lending) Boulders Leaves • + Focus facilitates partnerships with Mountains/Boulders Low • + Very flexible model with minimal regulatory and organizational overhead, good talent, etc. • - High cost of capital and customer acquisition • - Too much flexibility can lead to oversight of edge cases and compliance issues that create extinction risks Low High Flexibility 17
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