Why Fintech Has Failed to Supplant Big Banks - So Far

Since going public, Lending Club's CEO and several management team members have been let go or resigned. Prosper is laying off a large share of its employees. Avant Financial is also dealing with workforce cuts and increased regulatory scrutiny. SoFi is thinking about getting a bank charter. The turmoil in financial technology -- fintech -- does not stop there.

While many try to diagnose what has gone wrong within the industry, no one is talking about the single biggest reason it is faltering: fintech companies have consistently failed to use technology to offer truly differentiated underwriting or gain access to the low-cost capital easily attainable for banks.

Why hasn’t fintech replaced the banks?

After all, banking is now largely a software business. Banking products are just data. Your checking and savings accounts, your loans, your investments are actually all just information stored on a server.

Despite moving from physical to digital services, the core of the banking business model has not changed. Bankers still collect low-cost retail deposits and lend that capital out to collect interest and earn a spread. Major banks also have online lending programs and bid for the same customers as fintech companies, increasing the cost of customer acquisition for the latter.

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As a result of failing to discover materially better risk splitting based on unique data, fintech players have ended up focusing on unsecured consumer lending products with relatively high interest rates and the higher risk lending associated with them. Others have recognized that they are ultimately competing on cost of capital and, like SoFi, are becoming the banks they ostensibly set out to destroy.

Haven't we seen this syndrome before?

In the late 1980s and 1990s, a host of monoline credit card companies sprung up with a mission similar to that of the fintech lenders. They successfully used alternative channels like direct mail and the early internet to acquire customers without all the branch infrastructure of traditional banks. But, following the dotcom boom monoline credit card companies disappeared: some to insolvency, others to acquisition by larger banks like Providian and MBNA. The few that remain as stand-alone companies, like Capital One and Discover, acquired or became banks themselves.

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The good news: the hope of disrupting traditional banking remains. A second, more informed, wave of fintech companies will find the right recipe. These next generation startups will use two approaches that will prove key to success.

What will new firms do better?

First, companies like Square Capital will create products that give them advantaged data for lending and/or proprietary access to customers. In Square’s case, they have direct access to the small businesses using their Square credit card processing, giving them the unique ability to see which businesses are successfully making money and are credit worthy. Future fintech lenders will succeed by using technology to create unique troves of digital data and customer access that traditional banks simply can’t replicate.

Second, fintech companies will transform the deposit taking space by creating differentiated offerings to help people to better manage their money. Fintech providers, like newcomer Zero, will build upon the model of Simple (unfortunately bought by BBVA early in its product journey) to develop differentiated banking experiences for customers using software.

Related: Regulation Is Strangling Fintech Startups: 4 Ways VCs Can Help

Think Google-like algorithms that track your income and spending, identify high-cost debt to pay off, and move your savings into investments to create wealth -- all at a fraction of the cost of traditional banks. These fintech companies will compete with banks on a cost-of-capital basis by doing lending themselves, or through partnerships with fellow alternative lenders who create unique access and data.

Will fintech 2.0 get it right?

While the potential of technology to transform the banking industry is real, the first generation of fintech companies has not fulfilled that promise. The opportunity for the next generation is to succeed by delivering a reinvented customer experience using digital technology, unique data and access to the capital base needed to survive. Hopefully, this second wave will not have to break away from the central promise of fintech to do it.