Last month, a group of innovative bankers and fintech founders converged in Nashville to discuss the next era of banking. As part of our Annual Member Meeting, the Alloy Labs Ventures Team led a broader discussion on how like-minded banks can leverage strategic investing to complement their own efforts, minimize their risk, and maximize their operational and financial output.
Innovating within a bank is hard. Innovation isn’t a core tenant of banking. These institutions are naturally conservative, not progressive nor aggressive. The business model has relied on minimizing credit losses and, critically, avoiding catastrophic losses that will sink the institution. After all, banks didn’t survive for over 100 years by being irresponsible.
If a bank does try to grow quickly or stretch its business beyond the current structural bounds, its regulator will ding it. And if the bank takes a loss or receives a regulatory action, that experience will stick within the organization’s psyche and brand for a long time, hanging like a dark cloud over any future action it may want to take.
“When investing in a project, the culture piece is so critical because if it doesn’t work, you’re tainted with failure…I haven’t worked yet at a FI that doesn’t have a long memory around that.” – Alloy Labs Member Bank COO
Unfortunately, investments in innovation aren’t as predictable as credit underwriting. Innovation is expensive, risky, and the returns may not come for a LONG time; if you’re lucky enough for them to come at all. How can banks be expected to innovate with their structural, regulatory, and cultural barriers?
The solution lies in risk transference.
Approaches to Innovation
There are four common approaches to deploying your innovation budget: Internal Innovation, Corporate Venture Capital, Traditional Venture Capital, and Strategic Venture Capital. These categories differ on a few ranges, including the amount of cost, control, risk, return expectations, and strategic applicability of the investment approach to the core business. Let’s examine each option and their trade-offs:
1. Internal Innovation
Build the solutions to your problems. Building things yourself is the highest cost option, requiring the largest collection of technical resources, taking the longest time to materialize, and presenting the maximum amount of risk if you are unable to realize the gain internally. Even if you’re operating at JPMorgan’s scale, you can’t build and implement everything you need in the moment to maximize your effectiveness. You’ll be perpetually under-resourced to achieve everything you desire.
Many banks that build have latent intent on selling these services to other institutions or fintechs. There are instances where this has happened successfully, but it is extremely rare. Banks aren’t set up to build and sell at this sort of scale nor continue investing resources in “completed” software in a manner that allows them to compete against venture-backed companies whose sole focus is this problem area. High costs, low chance of external return, and capacity for very few projects make internal innovation a risky long-term bet.
2. Corporate Venture Capital
Invest in the solutions to your problems and help bring them into the bank. The CVC model requires less technical talent but requires specialized human capital to execute. A strong team requires a skillset inclusive of understanding the bank’s needs, technology, startup culture, the venture ecosystem, and how to find, attract, select, and cultivate winners. Every investment that CVC makes should have an immediate or near-term direct application to the core business and must be a good venture bet. In many cases these two things are not aligned – strange, I know. Put simply, some products worth buying are not worth investing in.
A product may be worth buying because it solves your problem… But is that solution going to grow efficiently and at a fast enough pace to capture and hold a meaningful piece of the market that is going to lead to a return on the equity you purchased? Does it have potential to produce a return that justifies the existence of the entire CVC program? That’s the bet that is made when venture investing and is often overlooked when banks directly invest in their exciting new startup partners.
3. Venture Capital
Invest in a venture capital fund and transfer risk to an outside party. Investing in venture funds provides a more efficient opportunity to invest in technological innovation. You don’t have the fixed costs of operating an innovation group or CVC team*. Investing via a venture capital fund will lead to a portfolio of solutions, hopefully attacking different problems and utilizing different frontier technologies across different industries and markets. That portfolio will assuredly have several losers that will get written down, as is the norm for startups and venture funds. But if constructed well, the diverse portfolio should generate more consistent, higher returns than internal approaches to innovation.
*Efficiency still comes with a cost, typically the 2/20 fund model or some variation of it.
4. Strategic Venture Capital
Invest in a venture capital fund with a strategic focus, aligned with your institution’s innovation needs, goals, and vision. Rather than investing in a generalist fund, you can invest in a fund that only deploys capital in solutions that are directly applicable to your business and industry. A strategic venture capital fund should still deliver that same risk transference and return performance. If executed well, a strategic fund will also generate more opportunities and insights to benefit your business. A strategic fund should act as a complement to an innovative bank, expanding their team’s surface area of engagement with the fintech community. The fund should operate as an extension of the bank, understanding their specific needs as well as those across the market.
Wholly owned, internal innovation efforts, either by building direct or through corporate venture capital, is extremely risky with no certainty of financial gain. That capital will be deployed to address the problems that are most meaningful to your bank today, in projects tailored to your organization’s roadmap, but at a significant cost. Strategic investing offers banks the chance to be active innovators without incurring overwhelming costs. Outside partners can take the risk away from the bank and can collaborate closely with startups to help the bank generate strong business impacts and strong returns.
Innovative banks, consider your strategy, your risk appetite, your roadmap, your culture, and then consider what the right investment approaches are for you. In this next era, you will need one.
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