Quarantine time for the past few months has given me plenty of time to reflect on bargaining power quite a bit. Between two toddlers (customers), my mother (a supplier), and my wife (both a customer and a supplier), the bargaining power of suppliers has become something I ponder daily. The toddlers have plenty of options for whom they can get to fulfill their playtime needs. The two working adults have a limited supply of time and are in a weak position to bargain. The negotiations are intense, especially at nap time.
I’ve covered the first three of Porter’s Five Forces, including The Misunderstood Threat of Substitutes, last time. But bargaining power — both of suppliers and customers — is the most overlooked. Bargaining power is often treated as fixed, especially in financial services; but what happens when there is a shift in the ecosystem and a bank doesn’t update its strategy?
Half-Baked Technology
If thinking about who is considered a supplier to a bank has you scratching your head, let me add clarity by using a baking (no, that’s not a typo) example. A baker has clearly defined suppliers and the baker also has a clear role in adding value to the end product. The baker converts raw ingredients like flour and yeast into the delicious carbohydrate treats that we’re all probably over-indulging in during quarantine.
Now, let’s look at banks. Who are a bank’s suppliers? Is it the people providing the pens with the snazzy bank logo? Is it the check manufacturers and payment card producers? Is it the toaster and frisbee makers that used to lure new customers in with the promise of a shiny new prize?
To answer that, we have to look at a bank’s competitive advantage. Most banks have always defined their competitive advantages as customer relationships and service. Considering that both of those elements are interpersonal and largely based on in-person interactions, banks have often focused on investing in assets that support these strategies. These strategies are based on proximity, so investments were funneled into branch networks and the in-branch experience. Banks invested in people that could run front of house services and execute back office processes.
Historically, financial service firms did not behave as technology powerhouses — nor did they need to. Technology to execute back-office tasks added little value, so banks didn’t invest in that area. The systems that banks have traditionally operated on are connected to vast networks and have two main requirements:
High fidelity - they are accurate. The systems and processes are exact. “Pretty close” doesn't cut it when it comes to interest calculations or ensuring a deposit is processed.
High reliability - they always work. Payment systems like Visa, Mastercard, and First Data process millions of transactions per minute. Even a small hiccup in the system can result in the fintech equivalent of a 100-car pileup. They need 99.999% uptime.
Enabling high fidelity and reliability requires large amounts of processing power via mainframe computers that sit in special rooms. These systems are closed systems by nature, to comply with security requirements and to ensure that neither customers nor partners couldn’t break the high-fidelity, high-reliability systems they were running.
Developing technology offered little upside and little differentiation for banks, so they avoided building their own technology. What’s more, the hyperfocus on human interactions to provide outstanding service also served as a buffer to internal technology development. At the end of the day, most banks buy, rather than build, their technology.
Bargaining Power of Suppliers
Over time, this reality has spawned into the perfect storm of consolidation for technology providers. The products that banks provide are relatively similar and there are significant economies of scale to maintain these complex, high-fidelity systems. So the original providers of technology to banks consolidated. The “big 3” now hold roughly 80% of the US market for core processing.
Here’s where it starts to get interesting: banks have increasingly found it easier to purchase more bells and whistles from these providers. These massive, high-fidelity systems are incredibly difficult to integrate, making banks more and more dependent on their supplier.
Add to that the fact that there is little value in switching providers and you have a merry-go-round of technological stagnation dressed up as progress.
One of our member banks has said the single riskiest thing they can do is core conversion. What’s the point if the product hasn’t really changed?
The technology core providers have significant bargaining power which they have used to further entrench their position. They do this via long-term contracts, obscuring the pricing so it is difficult to make an apples-to-apples comparison, and charging costly fees to change platforms. This bargaining power allows technology providers to increase fees, keep profits as they increase efficiencies, and spend little on innovation or enhancements.
High bargaining power from suppliers means banks are stuck. As the supplier of storytime for the toddlers, I’d like to quote Pinkaliscious: “you get what you get and you don’t throw a fit.”
Enter the fintechs, which have shaken up the industry as startups, technology companies like Google & Facebook, and banks that have shaken off the shackles of the core providers in favor of technological independence. Fintechs like these are not beholden to their suppliers’ innovation strategy (or lack thereof).
Fintechs have the ability to write their own code that is hosted on commoditized providers of computing power and that can be ported, exported, or translated via a few keystrokes thanks to APIs. This factor alone dramatically lowers the bargaining power of technology providers to these companies. As a result, they are free to innovate, have substantially lower costs, and can integrate with other best of breed providers that continue to emerge over time.
Some concentrated technology providers, like the card networks and ACH rails, still exist. The former is relatively commoditized and because they never exerted duopoly, have lower bargaining power. The latter (being government-run) promoted competition and intentionally leveled the playing field.
While gutting existing technology relationships isn’t a viable strategy, banks need to come up with solutions that address the bargaining power of suppliers. If they don’t, they will cede to those who have addressed it — and who hold a significant advantage.