Innovative Challengers at the Gates

This is the text of a speech delivered April 16 at Crossroads 2015, an annual meeting of the Harvard Business School Club of the GCC.

The topic of today's conference is "disruptive innovation." In other words, the types of innovation that have significant impact on our core business - things that shake up the industry, things that reward one bank and punish another, things that drive dramatic growth.

Let's be absolutely clear, most innovations in financial services are NOT disruptive. Interest-bearing checking accounts, 24-hour call-centers, ATMs, and online banking are all relatively new offerings that have a huge benefit to consumers. Today they are available through virtually every bank, and are almost indistinguishable in form and function. These are the things that we spend most of our time on. And where we compete with each other all the time. They are things we have to do to remain competitive, but they rarely result in any sustainable competitive advantage.

I believe there is a fundamental reason for this frustrating phenomenon. At its core, as a regulated industry, stability is paramount -- and for all of the good reasons which we now know. New products, processes, customers are carefully assessed for approval by regulators, prudent bankers carefully roll them out to ensure risk-adjusted profitability, and any problems typically cause everyone to put things on "Pause" until we figure out what went wrong. Caution is in our DNA and this measured pace also makes it difficult to outrun our competitors.

Disruptive innovations shake things up. They de-stabilize the status quo - hopefully by offering something completely new to customers.

Within retail banking, there have been two standout, truly disruptive innovations in the last 20 years, where a few banks applied mass marketing techniques to create something unique.

First, Capital One in US credit cards created an entirely new business model based on massive direct marketing, tightly integrated with high-powered analytics and IT. For a number of years, Capital One was the largest customer of the US Postal Service, mailing over a million letters - per week! They had a centralized analytics group of several hundred technical PhDs to design and modify products, marketing campaigns, pricing, you name it.

The other major innovator was ING Direct. Instead of credit products, they innovated around deposits. At first by mail, but then online, they created a high-yield savings product that grew like wildfire - not just in one market but in seven different markets globally! ING Direct designed their product specifically to fix many of the things that customers hated about their traditional banks. They also utilized mass marketing tactics to attract their core customers in each market, at the expense of other banks. And they did it all without branches!

While we can look back on these examples of disruptive innovation as successes, we should also be mindful that we missed many great opportunities. For example, in the '80s, every US banker believed that consumers would only hold their savings in banks. After all, safety was paramount to customers, and besides, that is what they've always done. Then, along came mutual funds with firms like Vanguard, Fidelity, and a slew of others who offered better returns, more convenience and choice, and had almost the equivalent security from regulation via the SEC. Banks pretty much missed that boat. Today, over half of the US's retirement savings is with mutual funds.

With disruptive innovation, as with life, we win some and we lose some. But in this rich history of disruptive and non-disruptive innovations, we start to see a pattern. If an innovation enables a bank to do something it was already doing, but simply to do it better, other banks will not hesitate to follow along. In fact, there is an entire industry of supporting actors who will strategize, design and build any new product for the fast-follower bank. And the rest of the pack for that matter. Even if the innovation is something new, success will quickly attract copy-cats. But all of this has to take place behind the regulatory wall.

In contrast, real disruptive innovation - the kind that builds new markets, new products, or new customers - causes upheaval in the industry. Often, it leaves banks out of the game entirely. Stating this in more modern terms, banks are not too worried about the likes of an Uber, a company challenging the taxi industry globally in over 56 countries, coming in and wiping them out. The focus of the central banks on stability helps protect us against unregulated competitors sweeping in and threatening our core markets and businesses.

Rather, what we should be worried about is missing the boat on an Airbnb-style offering that opens up new markets that drive industry growth. Airbnb has created a new market completely separate from the hotel industry, without building one room! The app now offers 1 million rooms in 190 countries, and has housed 25 million people.

But is there an Airbnb-equivalent for financial services? I can't say for sure at this point - no one can. Besides, if I knew for sure, I would be investing in it and wouldn't be telling you.

But what I will say is there are things out there that strike me as particularly innovative, and that have the potential to be disruptive.

So let's start with one of the current "hot topics" in banking: mobile. As I said before, sometimes innovation happens without disruption, and that's true with mobile banking. Just like ATMs and online banking, they're great for customers but don't necessarily create any sustainable competitive advantage. Keeping customers will mean offering mobile banking - and doing it very well - but it won't drive much new business.

But we also know this about mobile - these devices are more closely connected to customers and their identities than almost anything else. More than their wallets, their home addresses or even their bank accounts, mobile devices tell us, on a truly granular level, exactly who our customers are: how they think, how they socialize; how they interact with the world - including how they bank. So if you follow that thread, understanding mobile ultimately means understanding our customers, and understanding our markets. That knowledge, at a level of detail and intimacy never seen before, could become the core of retail banking.

Consequently, we're seeing a lot of activity where mobile and financial services intersect. This is driven by the attractiveness of these two huge markets. And a tremendous opportunity for would-be attackers to compete with institutions that appear to be very slow-moving, as they operate behind their regulatory firewalls. In particular, mobile payments - Apple Pay, Google's Softcard, and Facebook Messenger - have the potential to shift brand value away from banks toward mobile devices, even though payments will most likely continue to be processed through banks. Consumers may not be aware or even care which bank is managing their mobile transactions. Their focus in that case would be less on the bank and more on the customer experience. Who would you expect to deliver a better payment app - Apple or your bank?

Innovations can also come from orthogonal directions. M-Pesa and other mobile payment operators in Africa have been rapidly expanding, and with this expansion are coming many next-generation innovations in financial services. These innovations include the development of third-party agent networks that offer a full suite of retail banking products, with mobile technology enabling the front-end payment systems. This business model separates the financial balance sheet from all forms of sales and service - including physical - challenging the core banking infrastructure as we know it today.

Over 12 billion US dollars were invested in financial technologies last year - a 200% increase! Venture capital firms like Kleiner Perkins, most major telecoms companies, financial services giants like MasterCard and Visa - are all jumping in. And you can bet that enterprising students at Stanford, MIT and Harvard, are starting up their own businesses, often with a focus on mobile. The low barriers to developing innovative apps, coupled with companies, hungry for the "big win", has created thousands of new financial service offerings, from Palo Alto to Berlin to Shanghai. As Jamie Dimon of JP Morgan Chase said, "Silicon Valley is coming...they all want to eat our lunch...every single one of them is going to try."

On the credit side, Peer2Peer lending through firms like Lending Club are disintermediating banks by connecting retail borrowers directly to lenders. Any individual can post a request to borrow almost any amount for any purpose, and get rated and priced by Lending Club. Anybody, including individuals can review the application and fund any portion of it that they want. At this point, quality borrowers are funded in seconds! In fact, hedge funds have built apps that scan new borrowers to make sure they are the first ones to lend! Scary stuff for a bank. So how successful has Lending Club been? Try "the biggest US IPO of 2014." Try a current market cap of 7 billion dollars.

And where will this go next? Lending circles have been around for a long time in traditional communities in East Asia, India, and here in the Middle East. Communities like families, villages, and schools. What happens when they get re-invented with modern communities like Facebook, or even personalized circles that can be set up with a mere Twitter blast?

How about something completely new - and old at the same time? Combining successful trends in managing risk in micro-lending with traditional supply chain financing, Alibaba recently committed to deliver 160 billion dollars in financing to small businesses in China by linking borrowers directly to investors. This brilliant approach to financing exploits Alibaba's unique asset: Purchasing and sales data on both suppliers and customers, to ensure creditworthiness. Extending this idea beyond China, Alibaba has partnered with Lending Club to offer unsecured financing with near-instant approval. And at 50% of the cost to U.S. companies purchasing Chinese goods. This complete integration of the SME supply chain and its financing is a real and direct threat to one of the core businesses of banking.

I recently had the opportunity to speak with Jack Ma, the founder of Alibaba, over lunch. Apparently Alibaba's offer of working capital to their massive customer base is only his most recent foray into banking. There is AliPay, his version of PayPal, with twice the users and four times the transaction volume. And last year, Yu'e Bao, Alibaba's money market fund, grew from nothing to 92 billion dollars in one year, by offering a credible alternative to Chinese banks' core deposit products!

But, do these things matter here in the Gulf? After all, we always tell ourselves that customers are more traditional, regulators more conservative, competition less fierce. I say, we need to look at the innovations that threaten to take away our most profitable customers and businesses. According to Bain, as much as 30% of traditional bank revenues could be at risk. Just look at our customers. We have a young population with an appetite for new and innovative products and services and a high penetration of technology, which has huge disruptive potential. We have smaller markets, where cost-of-entry would be lower. And we have profitable customers - which would be prime targets for attackers looking to edge-in on our business.

To get a sense of how vulnerable we might be to a "digital disruption" in banking, we, at Gulf Bank did some research and asked over 2,700 individuals across the GCC a few questions. First, we wanted to know how comfortable they were using digital channels. 76% are using online or mobile banking. Around 50% are already using their phone for payments. One-third interact with their bank via social media. And, what's more worrying, more than one-third are using PayPal or similar payment products. Bottom-line, our customers are tech-savvy and already exploring new products.

Second, customers said that for "new and innovative products" they would look to their current bank first. But if they were to switch out: 1) they would prefer an Apple or a Google over a bank for payments; 2) they wouldn't care who it is if they are borrowing money; and 3) they would only slightly prefer a bank for their savings. In other words, a new competitor, even for traditional banking products, does not have to be a bank.

Finally, 57% of the respondents said that they expect innovations to come from the tech giants like Apple, Google, or Facebook - not from the banks.

So we should beware that our customers are fertile ground for innovation from outsiders.

So what do we do now? Where do we go from here? As a regional player in the GCC, we have usually been dedicated fast followers of innovations that are developed elsewhere. We usually don't expect to be creating innovations. We also tend to lean on regulatory safeguards to protect us against too much disruption. For our core businesses, I believe that these strategies may be adequate - but are certainly not enough.

We cannot, should not merely rely on regulatory walls to protect our businesses. We need to figure out how to better serve our customers, how to bring them new products that excite them. We need to make sure that when the boat leaves the dock - when disruptive innovation opens new markets, customers, or value propositions outside of traditional banking - we are on board for growth. And finally, we need to work with regulators to make sure that disruption does not mean instability. There is no reason why the two should be the same.

As it has always been, those who are able to innovate and adapt will be rewarded with success. They learn how to identify and exploit the opportunities that are created by disruptions, and compete with new as well as traditional competitors.

Charles Darwin, the English naturalist, perhaps said it best: "Adapt or die." Darwin was referring to the evolution of species of course, but his famous insight is also true here: Adapt to changing market conditions and you can build a path for future success; stand idle and refuse to budge, and you are destined to become a financial footnote to history.

How do we best prepare for what's to come? How do we ensure stability and success in light of future disruptions?

At Gulf Bank this is something we think about all the time. We are working hard to embrace innovation at all levels - both conventional and disruptive - and we're building a culture that seeks to keep us ahead of the game. We believe innovation is not only a critical part of our business, but the key to future growth and success.

Thank you for your time today.