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The Misunderstood Threat of Substitutes

Updated: Oct 31, 2023

Three of Michael Porter's Five Forces deal with competition: 1) industry rivalry, 2) threat of new entrants, and 3) threat of substitutes. This article will explore the third, and perhaps most misunderstood, of these three: the threat of substitutes.

The word “substitute” brings to mind sweeteners and teachers. Both serve the same stated purpose as the original but achieve the results in different ways and with different features. Substitute sweeteners allow people to sweeten their coffee in the same way as sugar but come in no- or low-calorie versions and sometimes solve for certain allergies. Substitute teachers help children to learn, but they come with a new teaching style and a lack of preconceptions about who the “smart kid” is and who will misbehave. The best substitute teachers come with more movies, especially on Fridays.

When we look at the role of substitutes in banking, it’s a popular misconception that a credit union is a substitute for a community bank or that an online account is a substitute for a branch bank. When we drill down to the capabilities between each, however, they appear to be more similar than dissimilar. In other words, credit unions and online accounts are not really offering novel mechanisms or features in delivering similar products and services to community banks. Ipso facto, they aren’t truly substitutes.

What is a Real Substitute?

Consider the argument that Coke is a substitute for Diet Coke. In reality, a 5-hour Energy drink more accurately befits a substitute. It really boils down to how you define the problem. Looking at the drink example, If the goal is to stay awake while imbibing as few calories as possible, then a true substitute should tick all the same boxes.

If you purport to solve the problem of people needing a local bank account (a problem no one has, by the way), then your competition only includes other branch banks in your geographic location. If you broaden that problem ever so slightly to just “bank account,” including savings accounts or checking accounts (still not a real problem), then the competitive pool begins to broaden, too. You’ve now introduced fintech startups that brand themselves as a new type of checking account into the mix. Even so, these competitors are still operating on a level playing field when it comes to features offered to customers.

What happens when you define the problem slightly differently, such as people who need a “transaction account”? Now, you’ve broadened the playing field so that the threat of substitution includes both startup and incumbent brokerage accounts. Let’s dissect the actual threat: customers that have an existing investing relationship with a brokerage can now access (through that brokerage) a companion account for paying bills, a new debit card, or a new line of credit. All of these options — from home equity loans, credit cards, or other credit products — can layer on top of that customer’s existing investment relationship. This bundling can be very powerful for the utility it provides customers.

Inaccurate Threat Maps Lead to Failure

Understanding the threat of substitution is critical to benchmarking and developing effective strategies to outplay the competition. If you are benchmarking your features, functionality, and products against other community banks or credit unions only, you are probably going to get an artificially high grade. You’ve narrowed the competitive pool too far. In other words, that benchmark will not be a relevant predictor of success in the marketplace.

Here’s a more personal example: relative to other six foot one fintech influencers in the Minnesota area that recently broke their right hand, I score exceedingly well. Do those descriptors factor into the likelihood that you’ll make it to the end of this article? Probably not.

Building a competitive strategy with the wrong competitors in mind will set you up for failure. It leads to ill-informed investments or no investments at all because your competitive analysis shows that your (inaccurate pool of) direct competitors are not investing. You will build (or choose not to build) products and features because your (inaccurate pool of) direct competitors are or are not doing those things. In the meantime, new entrants and substitutes are acquiring customers, gaining share, extending their lead, and, most importantly, learning. If your strategy does not have an accurate threat map, you are doomed to fail — slowly at first, then quickly.

Other Banks Are Not the Only Threat

The threat of substitutes is particularly challenging for the financial services industry. Amazon has stated several times it does not intend to become a bank; yet customers, quite commonly, opt to have any refunds issued to their Amazon account, where they hold them for a period of time. Amazon also has a track record of actively lending to its best small merchants.

Outside of jokes from industry keynotes, no one seriously refers to Starbucks as a bank; yet the coffee retailer stores billions of consumer dollars on its balance sheet from the Starbucks app. Pop quiz: guess one of the leading payment sources within the Starbucks store. That's right. The Starbucks app.

These examples are not banks. They don't aspire to be banks. They don't think of you as their competition. However, when we look at the behavior of customers, they are your competition. The million-dollar question then becomes “What value and functionality do you provide that will keep you relevant with these substitutes over time?”

Never Underestimate the Breadth of Possible Substitutes

The threat matrix of most competitive strategies over-emphasizes industry rivalry. Banks tend to set their sites on near-term threats. They look warily at visible threats like the competitor across the street or the competitor that is advertising a similar rate. Banks also tend to underestimate the threat of new entrants. It’s easy to draw assumptions about the challenges new entrants will face. It’s easy to point the finger at risk, compliance, and regulatory hurdles and how those elements will hamstring new entrants. Banks focus on all of the reasons why new entrants won’t have an impact on business and none of the reasons why they will.

Worse yet, the threat of substitutes goes completely ignored due to mischaracterization. We think of a substitute as someone using a savings account instead of a money market account or a money market account instead of a checking account. We look at it as someone drawing on their home equity line of credit rather than using a high yield C.D. We’re missing the most important qualifier of all: customer impetus.

We think of substitutes as square pegs, assuming most won’t fit through the round hole of our “unique” products and services. In reality, the opposite is true. Most substitutes are round pegs and the customer problems we’re trying to solve are wide squares. Most substitutes will fit or fill the customer problem in some way, though it often doesn’t look the way we expect it to. Banks must abandon their flawed descriptions of substitutes and look at them through the framework of how a customer problem is solved.

When we think about the threat of substitutes, it's vital we step back and think about the problem from the customer's perspective. Very rarely does a customer wake up and say “I need a new mortgage” or “I need a new checking account” out of the blue. These asks come at the tail end of a much broader storyline — a storyline that substitutes are becoming exceedingly gifted at creating. It’s a storyline that presents substitute offerings as a relevant, convenient, and personalized way for customers to live the life they want.

We're seeing these substitutes come up more frequently and more powerfully in the world of financial services. Banks beware: these substitutes aren’t coming from the other financial service players; they're more likely to come from technology companies or commerce players. When assessing the threat of substitutes, banks should think broadly and consider the real problems customers are aiming to solve. Only then will they be able to accurately assess real threats and create an effective strategy against the full breadth of competition.


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