How Strategic Banks Use Micro-innovation to Fuel New Growth

With digital financial experiences booming and young consumers flocking to app-focused banking, institutions are assessing which of their products and services will prove popular in the future and exploring how to ensure growth continues among a new demographic of consumers.

For the 65 million members of Generation Z in the U.S., “going to the bank” or “writing a check” are quickly becoming tasks from a bygone era. A 2021 survey underlined that 32% of these customers would prefer to do all their banking outside a physical branch, which presents banks with an opportunity for their digital products to take the lead.

If digital banking is the way of the future, why shouldn’t banks drop everything and go all-in? For most banks, that’s not feasible — or economically wise. It’s vital that banks understand the importance of solving problems while adding value for the customer. Former Apple co-founder CEO Steve Jobs explained, “when we created the iTunes music store, we did that because we thought it would be great to be able to buy music electronically, not because we had plans to redefine the music industry.” Solely focusing on innovation isn’t a practical strategy; the aim should be to make small bets that lead to big breakthroughs.

Most banks don’t need to adopt an “innovate or die” mindset toward the future to drive change. Not every bank will launch a groundbreaking app, and not every company can be Apple. Nor should there they be. Instead, leaders can look to micro-innovation: A scalable, stepwise growth model that supports agile technology integration and novel processes without a major overhaul to the bank’s core or existing infrastructure.

Flex and Expand the Core
A traditional full core conversion can take a bank five years or more to complete. The digital world won’t wait that long; it’s important that banks start implementing change now with micro-innovation. Rather than reinventing the essential processes that are working, micro-innovation allows institutions to launch services in a parallel run to test fresh ideas and offer new products. A micro-innovation approach allows core processes and revenue streams to remain intact while your institution welcomes the future.

Our partner, Holyoke, Massachusetts-based PeoplesBank, efficiently launched a compelling financial brand, ZYNLO, operating alongside its traditional offerings. The new digital bank is designed for younger customers and offers features to support financial health with tools like Zyng Roundup, Zyng matching and early access to paychecks. PeoplesBank is looking beyond the traditional realm of innovation and embrace new thinking by partnering with social media influencers to spread brand awareness and increase visibility.

Where to Begin?
The best incremental innovations are those that can be brought to market swiftly at an affordable cost. Consider leveraging your customer data to pluck low-hanging opportunities to serve groups of customers while providing valuable insights to improve their financial journey.

There’s an opportunity to start small by implementing a fresh onboarding experience. New customers are oriented to digital solutions; if it makes sense for your customers, consider building in-app account opening and educational tools to help them seamlessly engage with their financial future from their smartphone.

Get attention by testing out new product types and fine-tuning processes. Automatically rounding up transactions and deposit that change into savings, early access to paychecks with direct deposits, mobile-first initiatives and financial education tools like monthly spending reports are all popular among young consumers.

Ready to go further? By collaborating with a knowledgeable fintech partner, your institution can launch a own digital financial brand and deliver compelling hooks, such as invoice factoring, tax tools, credit builders and financial modeling, that better serve a niche group of individuals with shared financial needs and goals. Niche digital banks market to a wide range of geographically dispersed customers centered around identities (African Americans, LGBTQ), professions (doctors and lawyers), or shared life experiences and passions (individuals who have previously been incarcerated, pet owners, newly married couples).

In a time of economic uncertainty, organizations looking to win the moment should approach the future with a flexible and entrepreneurial mindset. Identify where your institutions wants to be, determine what’s required to get there and take the first steps in parallel to what’s already working. There’s no time like today.

Banking’s Netflix Problem

On April 19, Netflix reported its first loss in subscribers — 200,000 in the first quarter, with 2 million projected for the second — resulting in a steep decline in its stock price, as well as layoffs and budget cuts. Why the drop? Although the company blames consumers sharing passwords with each other, the legacy streamer also faces increased competition such as HBO Max and Disney Plus. That also creates more choice for the 85% of U.S. households that use a streaming service, according to the U.K. brand consulting firm Kantar. The average household subscribes to 4.7 of them.

Our financial lives are just as complicated — and there’s a lot more at stake when it comes to managing our money. A 2021 survey conducted by Plaid found that 88% of Americans use digital services to help manage their money, representing a 30-point increase from 2020. Americans use a lot of financial apps, and the majority want their bank to connect to these providers. Baby boomers use an average of 2.6 of these apps, which include digital banking and lending, payments, investments, budgeting and financial management. Gen Z consumers average 4.6 financial apps.

“Banks can be material to simplifying the complexity that’s causing everybody to struggle and not have clarity on their financial picture,” said Lee Wetherington, senior director of corporate strategy at the core provider Jack Henry & Associates. He described this fractured competitive landscape as “financial fragmentation,” which formed the focus of his presentation at Experience FinXTech, a tech-focused event that took place May 5 and 6 in Austin, Texas. Successful banks will figure out how to make their app the central hub for their customers, he said in an interview conducted in advance of the conference. “This is where I see the opportunity for community financial institutions to lever open banking rails to bring [those relationships] back home.”

During the event, Wetherington revealed results from a new Jack Henry survey finding that more than 90% of community financial institutions plan to embed fintech — integrating innovative, third-party products and services into banks’ own product offerings and processes — over the next two years.

Put simply, open banking acknowledges today’s fractured banking ecosystem and leverages application programming interfaces (APIs) that allow different applications or systems to exchange data.

Chad Davison, director of client solutions consulting at Fiserv, creates “balance sheet leakage” reports to inform his strategic discussions with bank executives. “We’ve been trying to understand from an organization perspective where the dollars are leaving the bank,” said Davison in a pre-conference interview. Some of these dollars are going to other financial providers outside the bank, including cryptocurrency exchanges like Coinbase Global and investment platforms like Robinhood Markets. This awareness of where customer dollars are going could provide insights on the products and services the bank could offer to keep those deposits in the organization. “[Banks] have to partner and integrate with someone to keep those dollars in house,” said Davison, in advance of a panel discussion focused on technology investment at the Experience FinXTech event.

Increasingly, core providers — which banks rely on to fuel their technological capabilities — are working to provide more choice for their bank clients. Fiserv launched a developer studio in late 2021 to let developers from fintechs and financial institutions access multiple APIs from a single location, said Davison, and recently launched an app market where financial institutions can access solutions. “We want to allow the simple, easy connectivity that our clients are looking for,” he said. “We’re excited about the next evolution of open banking.”

Jack Henry has also responded to its clients’ demand for an open banking ecosystem. Around 850 fintechs and third parties use APIs to integrate with Jack Henry, said Wetherington, who doesn’t view these providers as competitive threats. “It’s a flywheel,” he said. “Competitors actually add value to our ecosystem, and they add value for all the other players in the ecosystem.” That gives banks the choice to partner and integrate with the fintechs that will deliver value to the bank and its customers.

As fractured as the financial landscape may be today for consumers, bank leaders may feel similarly overwhelmed by the number of technologies available for their bank to adopt. In response, bank leaders should rethink their strategy and business opportunities, and then identify “the different fintech partners to help them drive strategy around that,” said Benjamin Wallace, CEO at Summit Technology Group. Wallace joined Davison on the panel at Experience FinXTech and was interviewed before the conference.

The Federal Reserve published a resource guide for partnering with fintech providers in September 2021, and found three broad areas of technology adoption: operational technology to improve back-end processes and infrastructure; customer-oriented partnerships to enhance interactions and experiences with the bank; and front-end fintech partnerships where the provider interacts directly with the customer — otherwise known as banking as a service (BaaS) relationships.

Banks will need to rely on their competitive strengths, honing niches in key areas, Wallace believes. That could be anything from building a BaaS franchise or a niche lending vertical like equipment finance. “Community-oriented banks that do everything for everyone, it’s really difficult to do” because of the competition coming from a handful of large institutions. “Picking a couple of verticals that you can be uniquely good at, and orient[ing] a strategy and then a tech plan and then a team around it — I think that’s always going to be a winning recipe.”

Using Modern Compliance to Serve Niche Audiences

Financial institutions are increasingly looking beyond their zip code to target niche populations who are demanding better financial services. These forward-thinking institutions recognize the importance of providing the right products and tools to meet the needs of underrepresented and underbanked segments.

By definition, niche banking is intended to serve a unique population of individuals brought together by a commonality that extends beyond location. A big opportunity exists for these banks to create new relationships, resulting in higher returns on investment and increased customer loyalty. But some worry that target marketing and segmentation could bring about new regulatory headaches and increase compliance burdens overall.

“The traditional community bank mindset is to think about the opportunity within a defined geography,” explains Nymbus CEO Jeffery Kendall. “However, the definition of what makes a community has evolved from a geographic term to an identity or affinity to a common cause, brand or goal.”

Distinguishing the defining commonality and building a unique banking experience requires a bank to have in-depth knowledge of the end user, including hobbies, habits, likes, dislikes and a true understanding of what makes them who they are.

Niche concepts are designed to fill a gap. Some examples of niche concepts geared toward specific communities or market segments include:

  • Banking services for immigrant employees and international students who may lack a Social Security number.
  • Banking services geared toward new couples managing their funds together for the first time, like Hitched.
  • Payment and money-management services for long-haul truck drivers or gig economy workers, like Gig Money or Convoy.
  • Banking platforms that provide capital, access and resources to Black-owned businesses.

Targeting prospective niche communities in the digital age is an increasingly complex and risk-driven proposition — not just as a result of financial advertising regulations but also because of new ad requirements from Facebook parent Meta Platforms and Alphabet’s Google. Niche offerings pose a unique opportunity for banks to serve individuals and businesses based on what matters most to them, rather than solely based on where they live. This could impact a bank’s compliance with the Community Reinvestment Act and Home Mortgage Disclosure Acts. The lack of geography challenges compliance teams to ensure that marketing and services catering to specific concepts or customers do not inadvertently fall afoul of CRA, HMDA or other unfair, deceptive or abusive acts or practices.

Niche banking enables financial institutions to innovate beyond the boundaries of traditional banking with minimal risk. Banks can unlock new revenue streams and obtain new growth by acquiring new customers segments and providing the right services at the right time. When developing or evaluating a niche banking concept, compliance officers should consider:

  • Performing a product and services risk assessment to understand how the niche banking concept deviates from existing banking operations.
  • Identifying process, procedure or system enhancements that can be implemented to mitigate any additional compliance risk incurred by offering new solutions to customers.
  • Presenting its overarching risk analysis to cross-functional leads within the organization to obtain alignment and a path forward.

Now is the time for financial institutions to start asking “Did I serve my consumers?” and stop asking, “Did I break any rules?” When I led a risk and compliance team for a small financial institution, these were questions we asked ourselves every day. I now challenge financial institutions to reassess their current models and have open conversations with regulators and compliance leaders about meeting in the middle when it comes to niche banking. With the appropriate safeguards, banks can capitalize on the opportunity to deliver innovative, stable and affordable financial services.

Before Digital Banking Was Cool, There Was Live Oak

As James “Chip” Mahan III tells it, Live Oak Bancshares was everything a regulator would hate when it started up in 2008. The Wilmington, North Carolina-based banking company would go branchless, lend on a national scale to only one industry, and raise deposits by paying top rates.  “They fundamentally hated all that,” Mahan, one of the founders, says.

Nowadays, Mahan and his team say the $8.2 billion banking company’s relationship with the regulators has improved. On top of that, niche lending on a national platform isn’t a new concept anymore. Investors, in particular, seem drawn to the bank lately. As of Sept. 22, Live Oak was trading at 385% of tangible book value and 22.8 times price to forward earnings, according to S&P Capital IQ.

Why?

The market views Live Oak as a successful cultivator of technology companies, with a venture capital arm currently invested in growth companies such as digital banking platform Greenlight and core provider Finxact, says Christopher Donat, an analyst and managing director at Piper Sandler & Co.

There may be other reasons, too. Investors think Live Oak is a niche bank like a SVB Financial Group or First Republic Bank, both based in California, says Jennifer Demba, managing director at Truist Securities, who follows the bank. “Niche banks growing faster than their peers tend to trade at premiums,” she says. And growing it is. Live Oak’s compound annual growth rate for noninterest and interest income from 2011 to 2020 was 25.9%, according to its 2020 annual report.

The Live Oak team’s journey to niche, digital bank started out with a simple enough concept. Vice Chairman Lee Williams III and Mahan had previous experience with Small Business Administration lending and banking, and wanted to start a bank focused on it. They worked with a company in Cleveland called Government Loan Solutions, which gathered loan performance data from the SBA by filing public records requests. Live Oak scoured this data to find out which industries had the best loan performance. Guess who did? Veterinarians. Not only did they have love animals, but they loved paying their loans on time.

As Live Oak grew, it expanded to more small businesses the team felt were overlooked by banks: smaller businesses that many banks didn’t focus on, usually with less than $5 million in annual revenues. Live Oak created a digital lending platform that would deliver those customers a decision on their loan approval quicker.

Live Oak eventually bought Government Loan Solutions, but it’s not only focused on technology. It’s also focused on talent, recruiting top SBA lenders from other banks. While other banks tend to offer SBA lenders complicated compensation structures based on commission, Live Oak doesn’t pay commissions. Instead, it offers lenders their total pay at their current jobs as a base pay, plus 100% coverage of family health care costs. “They are the bank of choice for an SBA lender to work at,” Demba says.

Among banks in the SBA’s signature 7(a) program for fiscal year 2021, Live Oak was the No. 1 lender in terms of dollar volume. When the coronavirus pandemic hit, Live Oak was vulnerable to risky sectors of the economy, including restaurants, hotels and entertainment businesses, says Donat. The bank took $19.4 million in net charge offs in 2020 related to the pandemic and hotel loans it chose to sell, according to its 2020 annual report. Its profitability also took a hit in 2019 and 2020 as it transitions to holding more SBA loans on its balance sheet; previously it had generated fees selling SBA loans, according to Demba. Moving forward, that may make Live Oak’s profitability less volatile.

Despite the pandemic, the bank’s credit quality has been good and its opportunities to grow are numerous, Demba says. It could improve future profitability by generating more noninterest bearing deposits through more attractive deposit products for small businesses. Mahan describes a future where the bank is “embedded” in small business operations, from payroll to cash management to accounting software. “We’re going to create, in every industry that we lend to, everything that that business needs to operate,” Mahan says. That’s part of the reason why investors are willing to make their bets on Live Oak.

“It’s a unique company, and they are very forward thinking, and I think they are more nimble than their traditional bank peers,” Demba says.