THE TECHNOLOGY MUDSLIDE HYPOTHESIS: SUSTAINING INNOVATION VS. DISRUPTIVE INNOVATION
You may have heard of the “technology mudslide hypothesis”: the struggle of established companies to keep up with technological change resembles an attempt to climb a mudslide that is accelerating down a hill.4 Just as the red queen in Lewis Carroll's Through the Looking Glass is running just to keep in the same place,5 companies need to keep up technologically with their competitors to avoid falling behind.
The technology mudslide hypothesis is widely accepted, yet author Clayton Christensen has challenged this hypothesis. He found the difficulty of adapting to technological change had little to do with the failure of leading firms. Instead, market leaders are often aware of innovations, but they fail to pursue them because they are not profitable enough in the short term.When refuting the technology mudslide hypothesis, Christensen introduced the distinction between sustaining innovation and disruptive innovation.6 While sustaining innovation aims at improving existing product performance, disruptive innovation brings a new value proposition to the market. Think about the example of vacuum tubes: sustaining innovation provided a better and more efficient vacuum tube. Conversely, disruptive innovation led to the introduction of the transistor. This has made smaller, cheaper devices possible, which revolutionized the electronics industry. Disruptive innovation may underperform today, but it will outperform tomorrow. Because disruptive products are usually first commercialized in insignificant markets, these products are simpler and cheaper by design. In contrast, most established companies are looking upward in the market, not downward. Their goal is to increase the complexity of their products and services to move their existing customers toward premium pricing, not to simplify their product palette and lower the price.
The most profitable customers of incumbent market leaders often have no use for disruptive products at the beginning, which gives the established companies the illusion that they may safely ignore disruptive technology at the onset and focus on the higher margin products or services instead. Christensen calls this the Innovator’s Dilemma in his eponymous book. It describes the inability of incumbent firms to recognize the significance of those technologies that eventually unseat them. It is called the Innovator’s Dilemma because many market leaders actually come up with the innovations that ultimately prove their own downfall; but it is the competition that commercializes the innovation for lack of interest by the incumbent.
When you look at the actions of today's banks, is it possible that they are conforming to the mudslide hypothesis? Most likely. Are they suffering from the Innovator's Dilemma? Let's see. Even though it wasn't banks that invented peer-to-peer lending, it makes sense to liken their current challenges with new FinTech companies to the Innovator's Dilemma. The symptoms of the dilemma are certainly the same: could a large incumbent bank roll out a payment solution such as Apple Pay? Certainly. Nevertheless, an incumbent either sees no point in doing so because of the small market size or feels it might better capitalize on its old business model as long as possible. Banks could have been the ones to create many FinTech innovations, but according to the Innovator's Dilemma, established companies protect their own profitable businesses and eschew small emerging niches. Established companies naturally shy away from disintermediating their own products and services.
Theodore Levitt mentions the railroads as an example of an industry that failed to see market opportunities. American railroads have lost market share with personal travelers not because others—cars, trucks, airplanes—filled the need to travel but because the railroads failed to fill this need themselves.
They let others siphon off their customers because they thought of themselves as being in the railroad business, not in the transportation business. They were “railroad-oriented,” not “transportation-oriented,” and their focus was on the product instead of the customer.7 It is easy to rewrite this scenario so it matches the situation with the banks. While the financial sector was recovering from a global financial crisis and catching up with new regulations, FinTech entrepreneurs found better solutions to problems that people cared about.When banks acquire FinTech companies or integrate their services, they do this to automate or streamline their existing operations, relative to those of their competitors. Especially in Big Data and analytics, banks enjoy an immediate payoff when deploying proven technology that external companies have developed. It is hard to identify the market potential of disruptive innovation. Large companies in need of big profits can rarely afford to take a long view. Online lending platforms, and marketplace lending in particular, show several characteristics of disruptive technology. For instance, they aim at small, unproven markets with low-margin products, and they require discovery-driven planning. The existence of this mismatch with the set of capabilities of established banks means that it's worth examining what this means in more detail.
4.1.1 Small unproven markets with low-margin products
Banks have phased out low-profit customers since the financial crisis and have focused on those operations with high profit margins. Multinational banks with hundreds of billions of dollars in assets can hardly afford to experiment with low-margin products in nascent markets that will cost a lot of money without foreseeable potential. Most new niche markets are too small to satisfy banks' requirements for growth. As a result, large companies adopt the strategy of waiting until new markets are “large enough to be interesting.” When it comes to buying other companies that have developed technology that banks can use in their operations, they will only be interested in those innovations with an established track record so banks can monetize their acquisitions quickly. Nurturing technology innovators, let alone giving them space to experiment with unproven ideas, is out of the question.
However, just like the railroads in Levitt's example, the hands-off approach of banks to innovation allows new entrants to develop new markets. This might have come with few risks when technology was a natural boundary to entry in the financial sector. But today, cheap and ubiquitous computing power allows anyone with a good idea and modest seed capital to rival banking services.Even though several banks and other multinational companies fund FinTech accelerator programs, such as the FinTech Innovation Lab in New York, London, and Hong Kong,8 they are largely on the sidelines when it comes to disruptive innovation. By their own account, in their programs, they “give early and growth-stage companies a platform to develop, trial and prove their ideas alongside the world's leading banks in a 12-week mentorship program.”9 There are several issues with this approach to innovation: some products that underperform today, relative to customer expectations in mainstream markets, will become those that dominate markets tomorrow. By “tomorrow” we mean five to ten years, not twelve weeks. At the same time, the business model of banks allows no margin for error. Disruptive innovation requires launching into untested, unproven markets where little confirmation exists. Any entrepreneur will cringe when a mentor asks him to develop, trial and prove an innovation in twelve weeks, and such a program will only attract those entrepreneurs that have already been in the market for a while. As a result, FinTech innovation labs will vet sustaining innovation, pass on the disruptive ideas, and not even attract those entrepreneurs with the biggest potential in the first place. The notion that disruptive innovation happens “alongside the world's leading banks” also raises eyebrows. As we will discover later in this chapter, innovation happens best in a secluded pocket, far away from the bureaucracy of a big company.
It makes sense for banks to keep their eye on the ball for another reason: small niches at the onset can grow into respectable markets and threats over time.
Christensen describes the humble beginnings of minimills—small-scale steel mills that use scrap metal as raw material— that only produced low quality rebar in the beginning, a business the large steel manufacturers were more than happy to get out of. Regardless, the minimills invested their profits in new processes for angle iron, then structural steel, and eventually high-quality sheet metal, which in the end disrupted the entire steel industry.10Christensen himself couldn't have picked a better example than FinTech as an exemplar for the Innovator's Dilemma. Most FinTech startups are unprofitable or barely profitable for a long time, which includes many of the large online lenders. It is rarely those startups that large multinationals agree with that will make waves in the long term. The world's leading banks and financial firms have no use for disruptive innovation because their existing customers and shareholders have no interest in it. As a result, by definition, the innovation they are promoting is at best the incremental improvement of their existing operations. To align themselves more closely with disruptive innovators, banks must incorporate fresh approaches to new business development. Discovery-driven planning is one of them.
4.1.2 The need for discovery-driven planning
Discovery-driven planning is a tool that acknowledges the difference between planning for a new venture and planning for a more conventional line of business. Conventional planning (or platform-based planning) requires that managers extrapolate future results from well- understood past experience. One expects predictions to be accurate because they spring from solid knowledge about the past rather than from wild assumptions about the future. In conventional planning, a project's deviation from a plan is a bad thing. Conversely, in discovery-driven planning, we know little and assume much. Instead of treating assumptions as facts, they serve as best-guess estimates that we frequently test and question.
This systematically converts assumptions into knowledge while a venture unfolds. When new data emerge, they become part of the evolving plan, which helps managers discover the potential of the venture piece by piece as it develops. This approach needs different disciplines to those used in conventional planning, but they can be just as precise as established practices.11Discovery-driven planning is the modus operandi of every startup. Several FinTech companies have modified their course over time. The robo-advisor Wealthfront, for example, started out as KaChing in 2008, which allowed users to replicate the trades of successful amateur investors.12 It then pivoted to provide professional account management in 2010 and now boasts over $1 billion assets under management.13 Discovery-driven planning only works in small companies with a relatively flat hierarchy and a quick product and release cycle. This kind of thinking is squarely at odds with the current practices of established banks and credit institutions. However, in order to play the FinTech game successfully, banks need to learn how to use discovery-driven planning.
4.2