J.P. Morgan Chase and the Rise of the Machines

Retail banking on the surface seems to be a rather boring industry – an old-fashioned, people-oriented business slow to adapt to the changing technological landscape. But in reality, nothing could be further from the truth. Financial technology startups, collectively referred to as the fintech industry, are rapidly changing the way in which consumers interact with their banking institutions in an age of digital transformation. But while nimble startups are trying to disrupt the industry, the largest banks are fighting to hold onto their customer base by adapting to the times.

Take J.P Morgan Chase, the storied Wall Street giant. According to the company, Chase touches nearly half of all households in the United States with its 5,200 branches [1]. Dana Deasy, the company’s Chief Information Officer, says that 20 million of the bank’s customers conduct the majority of their business on a mobile device, with an additional 18 million banking on their computers rather than visiting a physical location [2]. Between now and 2020, the so-called Internet of Things, the network of smart devices becoming increasingly prevalent, is expected to increase at a compound annual growth rate of 35.2% to a whopping 25 billion devices [3]. As consumers become ever increasingly connected to the internet, they demand more services be provided in real time through their devices, and that digital experiences change frequently [4].

J.P. Morgan, like most banks, has responded to these demands by offering a host of online banking services to its consumers. But the lender has taken a somewhat more novel approach to staying relevant than some of its peers: it has outsourced large parts of its digital transformation. In 2015 alone, the bank met with the CEOs of 300 fintech startups to follow trends in the industry and to articulate the bank’s own transformation needs [5]. According to Deasy, the key challenge is fostering an environment of experimentation while not disrupting the $3 trillion of payments processed by J.P. Morgan daily [6]. By partnering with more agile startups, J.P. Morgan is able to continue adapting to its changing customer needs without interfering with its daily operations. At any given time, the bank is partnered with 60 to 70 startups working on innovative new solutions, the best of which will be implemented into J.P. Morgan’s core businesses [7].

But what innovations should a financial institution like J.P. Morgan be looking for from its fintech partners?

As with insurers which use sensors to assess driver’s safety, J.P. Morgan should use sensors (for instance, smart phones) to better discriminate interest rates on the loan portfolio it offers. If, say, a user frequently searches for home improvement projects on his or her phone, J.P. Morgan might infer that it could safely issue a mortgage against that person’s house at a more competitive rate. Additionally, banks could use sensors to monitor collateralized loans. If a sensor monitored a company’s inventory against which it borrowed, the bank could more accurately track covenants and issue margin calls as needed [8]. In theory, the reduction in information asymmetry would allow the bank to lower the interest rates it charges on loan.

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Indeed, the use of sensors in many applications will provide lenders such as J.P. Morgan with unprecedented visibility into borrowers’ behaviors, which will allow it to lower rates. Like insurance companies, lenders face the difficulty of trying to price risk under information asymmetry – that is, they cannot accurately predict who is a high risk consumer and who is low risk. By using sensors to provide better visibility, lenders will be able to lower rates to low risk borrowers and raise rates on high risk borrowers. By doing so, both the lender and borrower benefit (except, of course, the high risk borrower). But faced with increased rates, even high risk borrowers are incented to modify their behavior. As a result, a company like J.P. Morgan stands to create more business for itself by increasing the volume of its loan portfolio by attracting lower-spread loans to low risk customers, and more accurately pricing the interest on the loans it makes to less credit-worthy customers.

But of course, perhaps one of the most lucrative prospect for the mega-banks is its ability to better price the risk of consumer installment credit, such as credit cards. As the use of mobile payments increases, banks stand to learn even more about their consumers’ borrowing, purchasing, and repayment habits, reducing uncertainty in one of the bank’s key profit-driving segments.

With the increased visibility provided by mobile payments, banks could expand or contract credit at different rates in real time to consumers based on their behavior.  Like many service industries being disrupted by digital transformation, J.P. Morgan needs to integrate changing technologies into its operating model in order to survive.

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References:

[1] JP Morgan Chase & Co., https://www.chase.com/digital/resources/about-chase. Accessed November 12, 2016.

[2] Knowledge@Wharton http://knowledge.wharton.upenn.edu/article/jpmorgan-chase-cio-on-digital-transformation-and-the-4-ps-to-career-success/ Accessed November 12, 2016.

[3] Middleton, Peter. “Forecast: Internet of Things, Endpoints and Associated Services, 2014.” https://www.gartner.com/doc/2880717/forecast-internet-things-endpoints-associated Accessed November 12, 2016

[4] Knowledge@Wharton. Becoming Digital: Strategies for Business and Personal Transformation. Philadelphia, 2016. http://d1c25a6gwz7q5e.cloudfront.net/reports/2016-03-12-Becoming-Digital-Web.pdf

[5] Ibid.

[6] Ibid.

[7] Ibid.

[8] Hernces, Christopher. ”Banks Should Prepare for the Internet of Things.” https://techcrunch.com/2015/11/10/banks-should-prepare-for-the-internet-of-things/ Accessed November 17, 2016.