The Great Fintech Convergence leading to partnerships with small banks

Small Banks

During the Global Financial Crisis in 2008 it became clear that Big Banks had become unmanageable and dangerous. The behemoths were crumbling before our eyes. Since then, Banks have cleaned up a lot of the financial leverage that was the precipitate cause of the crisis. The unwinding of leverage was only the first wave of change. The much bigger wave that came later was digitization and that is what we track on Daily Fintech. This research note looks at how digitization is undermining the advantages of traditional scale and replacing it with the advantages of digital scale, not just in banking but also across all sectors of the economy. This will lead to the renaissance of small banks and the small businesses that they serve best and the Fintech ventures that serve small banks. 

What is the point of large companies? 

In 1954, Fortune 500 companies accounted for around 1/3 of GDP in America. By 2000, that share had doubled to 2/3.

Hidden in those numbers are the countless family farms that could not withstand the onslaught of Agribusiness and the Mom & Pop shops that closed when Wall Mart came to town.

Imagine a world where that cycle reversed. Imagine that small businesses got back the 1/3 of the economy that they lost in the last 50 years.

This may be about to happen. This shift will have dramatic implications for investors, entrepreneurs and employees.

Big companies took a bigger chunk of the economy during the last 50 years because they served a very real historical purpose. That purpose was to turn scarcity into abundance by manufacturing mass-produced products and selling them through mass-market distributors to retailers through warehouses and road/rail/air freight logistics.

Surrounded as we are today by an abundance of mass produced products, it is hard to remember a time when people were concerned about scarcity of basic things such as food and cars. Big companies solved that problem. Small companies could not solve that problem. The job required economies of scale, vertical integration and large amounts of capital.

Digitization erodes the value of traditional economies of scale. This is what tilts the playing field in favor of small business.

Professor Coase, Please Explain

Ronald Coase won the Nobel Prize for Economics in 1991, but his key work was done in the 1930s.

His main theory, described in his 1937 essay The Nature Of The Firm, is that a company exists because it is cheaper to do transactions within a company than outside the company.

The Internet has resurfaced this theory as a practical consideration.

Coase’s theory about transaction costs was pretty much ignored by business executives because it was only theoretical.

The Internet now enables transactions of all types to be managed more efficiently externally than internally. Start-ups outsource everything that is not the one thing that they have to excel at.

Too big to manage

During the early stages of the Global Credit Crisis, back in March 2008 when this looked like a distant soap opera being played out on Wall Street, the Spiegel asked:

“Raise your hand if you don’t quite understand this whole financial crisis.”

The point of the article was, don’t feel bad about not understanding the financial crisis, because the guys who are paid $ millions to run Wall Street firms do not understand it either.

“Robert Rubin, the former Treasury secretary and current Citigroup executive, has said that he hadn’t heard of “liquidity puts,” an obscure kind of financial contract, until they started causing big problems for Citigroup.”

Too big to fail has been replaced by a deeper problem of too big to manage. Ronald Coase has more to say of relevance than all the regulators. Digitization will break up the big banks before the regulators do.

Platforms with digital economies of scale

Digital platforms such as Google, Facebook, Amazon and Alibaba have reached tremendous scale. Scale is not dead. It is just that digital scale based on network effects has replaced analog scale based on purchasing power and physical world logistical depth.

Small Business likes Small Banks and vice versa

Small business is such a huge opportunity for Fintech entrepreneurs for a simple reason. The big banks don’t like the complexity of dealing with small business, preferring the simple scale of serving Consumers and Large Companies. So the Banks leave a big white open space for entrepreneurs.

Small banks, scrabbling for relevance in a world of mega banks, continued to serve small business, using old-fashioned ways to know your customer based on local knowledge and personal relationships. Their patience may be about to pay off.

The leveling of the playing field for small business

When small businesses were being crushed by large businesses, from 1950 to 2000, focusing on serving small business would have been Quixotic at best. Now the playing field is getting more level in three key areas:

  • Finance.  Real time supply chains are getting rid of the curse of inventory and new low cost on demand financing networks are emerging (tracked by Jessica Ellerm every Wednesday on Daily Fintech).
  • IT. Cloud technology is replacing expensive complex IT. Big companies now want the agility of a small business using this Cloud technology and the innovation is flowing from small business IT to big business IT (a reversal of the historic trend).
  • Sales & Marketing. Selling online (via B2B or B2C networks) is replacing those highways and distributors as the key to success.

With this leveling of the playing field, serving small business might be the smartest thing to do. This is especially true if you want to take advantage of the fast growth economies through globalization.

First the Rest then the West

In the post war era in the West, the economy was dominated by big companies – and their employees who were referred to as consumers once their 9-5 gig was done.  There were very few Entrepreneurs, even though the media hype disguised this statistical reality. Entrepreneurs were much lauded in the media, but only if they later became big companies; Mark Zuckerberg is story that sells pixels, but another restaurant or gift shop is not.

In the Rest of the World (China, India, Africa, Latin America etc) it is a very different story. Most people there are self-employed entrepreneurs. Most of these micro entrepreneurs make less than a minimum wage employee in the West, but in aggregate these billions of micro entrepreneurs is one of the biggest market opportunities around – but don’t try serving them with traditional Western consumer models.

The same dynamic is playing out in the West where we see the Underbanked stitching together a living from multiple gig economy and online networks such as Uber, AirBnB, Amazon, Alibaba, eBay etc. Most micro entrepreneurs won’t graduate to become small business (let alone big business), but in aggregate they will remain a great market for those entrepreneurs and banks who see them as they really are and not as degraded versions of what they have historically served – a consumer with a paycheck from a big company. The digital success stories such as Uber, AirBnB, Amazon, Alibaba & eBay understand this very well.

Traditional Fintech Version 3 meets Emergent Fintech

I earned my stripes in what is now called Traditional Fintech, which is now considered boring. Today the exciting space is Emergent Fintech aka the disrupters; this is a story that sells conference tickets and unlocks early stage financing.

In 2016 we are witnessing the Great Fintech Convergence, which Daily Fintech first wrote about here from the perspective of the Emergent Fintech ventures and the Banks. At the end of this Convergence, we won’t be able to tell the difference between:

  • A Fintech upstart that matured and became regulated and added some people into the service delivery process (because that is what customers wanted).


  • An incumbent Financial Institution that automated enough of the service delivery process to be cost competitive with Fintech upstarts and learned to deliver digital first.

In today’s research note we look at the Great Fintech Convergence from the perspective of traditional Fintech where we see three levels of maturity:

  • Version 1: perpetual licensing for in house data centers. Vendor gets a big fee upfront plus some Annual Maintenance Fees. Buyer has all the risk & all the upside. It was a great way for vendors to bootstrap a business (essential before VC became mainstream). Now these businesses get low valuations and become rolled up into conglomerate structures designed to squeeze out cash flow.
  • Version 2: Cloud & SAAS. This is now happening in every vertical niche. It is simply a better model for both vendor (greater revenue visibility) and buyer (less implementation risk).
  • Version 3: This takes Cloud & SAAS to the next level by offering shared revenue pricing. Cloud & SAAS took away the data center cost & risk, but still left business outcome risk. Shared revenue pricing can be better for both vendor (greater revenue scalability) and buyer (less business outcome risk and greater skin in the game alignment of interest).

Those Version 3 Fintech ventures can no longer be neatly divided into Traditional and Emergent Fintech. They don’t proclaim disruption (a silly marketing tactic as customers don’t care about disruption) so they sound more like Traditional Fintech making nice with the Banks, but they have scalable revenue models that we associate with Emergent Fintech. This is the other side of the Great Fintech Convergence. If a Fintech grows with each financial transaction in partnership with incumbent regulated Banks are they traditional or emergent? The distinction is irrelevant; investors will look at them as they will look at most businesses on metrics such as CAC/LTV or revenue per employee.

Think beyond the big names to build enduring partnerships

In the Great Fintech Convergence, we defined three levels of maturity in the relationship between Fintech ventures and Banks:

  • Level 1: Incomprehension. The other party just looks strange and it is hard to imagine a productive conversation. Whether the emotion is fear or disdain, the reaction is the same – inertia. Banks seek to overcome the incomprehension problem by funding Accelerators and Hackathons.
  • Level 2: Funding. Banks take minority equity stakes in Fintech ventures through their Corporate Venture Capital (CVC) unit. This is the level that most relationships have reached. (Funding while still in Incomprehension mode is clearly dangerous).
  • Level 3: Strategic. This is where the relationship drives needle-moving revenues and profits for both parties. This may or may not include an equity relationship; the strategic relationship comes first.  Creating these win/win strategic relationships is one of our core skills at Daily Fintech Advisers because we understand enough about both parties to “know what makes them tick”.

As Fintech entrepreneurs and Banks seek strategic win/win relationships, they will move beyond Level 2. The Corporate VC wave of funding into late stage Fintech that we saw in 2015 is a classic sign of an overheated market. The real win/win deals will be at Level 3 and equity will not be a primary feature of those deals; they will be straightforward revenue share deals. Big Banks will have to gain the trust of entrepreneurs who might worry that Big Banks want to learn from them and then build in house or buy a struggling competitor. In other words, Big Banks could be competitors or partners. Small Banks don’t have an option to be competitors; they are partners that entrepreneurs can feel comfortable with.

Two stocks in the Daily Fintech Index that prove this theory

When we looked at 6 stocks in the Daily Fintech Index that outperformed during the downturn, two jumped to the top – Fiserv and Jack Henry.

What both have in common is a focus on serving small banks rather than big banks. This seems to be a winning strategy.

Daily Fintech Advisers provide strategic consulting to organizations with business and investment interests in Fintech. Bernard Lunn is a Fintech thought-leader.




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