Banking on the Rise of Fintech Startups to Take Over

How are startups creeping into the financial services sector, where incumbents continue to stick up for their established positions? One of my favorite partners and a great presenter from a16z - Alex Rampell - walks us through how a fintech space can largely open up to the startup underlings.

1. Psychology

The biggest difference between financial services companies and other industries lies in the fact that more number of customers is not necessarily profitable for financial services. Think about insurance companies. More number of customers mean you will have more coin-flips between healthy customers vs. unhealthy customers. It's essentially a 50-50 chance, with more customers not necessarily leading to more profit. However, when you think about Ford or Apple, for instance, more customers 100% leads to more profitability.

Another aspect that is unique from a customer standpoint is that loss-making customers are being 'subsidized' by profit-making customers. Healthy people who will rarely die early of chronic diseases will be funding the insurance policies of people who have unhealthy diet or poor workout habits. Those people will then say 'this insurance policy is "unfair" for me!'.

These customers then proactively move out of the traditional insurance platform to move into a new one that will offer them a more equitable result. That 'positive selection' - good customers proactively moving out of the incumbent system and selecting a new system - helps the startups to collect only the profitable customers.

So what ends up happening is, companies are attracting customers who are going to be profitable and customers are getting repriced at a more fair value than what they're currently paying in the pool mixed with customers with riskier profiles.

2. Data Sources

Correlation between different attributes and default can be found out via machine learning, but in the US, it is illegal to use the correlation result to determine default likeliness if that will yield adverse impact. For instance, if you used 'zip code' to determine the default risk, and it appears that 'zip code' was somewhat correlated to a specific race, gender, etc., then you can't use that criteria to determine default risk.

So the type of data source that fintech companies are garnering are nontraditional in a sense that you will not guess these features predict your default risk. Things like battery runout, # of apps, or how many times you text a day, are new sources of data that Branch is collecting to better determine which customers are going to be less likely to default.

3. Changing customer behaviors

Now comes the last wedge that startups are using to better profit. The last wedge is really a supplement to the 1st and the 2nd wedges, because they are picking the cream of the crop, the best in class customers as they are. But what some startups are doing is to nudge some of the bottom quartile customers to become better ones, using tactics like social pressure.

So now, WHAT can incumbents do to respond these startup strategies?

It is important to segment your customers and create sub-brands. A catchall strategy from large bulge bracket banks will not be efficient in fighting off the specific targeting / marketing of these startups. By sending off the customers that the big incumbents turned down on, you can also seek a partnership with startups.

Source: https://www.youtube.com/watch?v=3KYM6JdW9d8