Show me the incentive and I will show you the outcome.
— Charlie Munger

Have you ever thought about how much better some products are than the same version ten years ago?

My iPhone 12 is 8,000% faster than my iPhone 4. On 5G it can download at 4,000 Mbps versus my iPhone 4's top speed of 2 Mbps. And it's the same price. Meanwhile, countless physical products have become just apps on the phone.

In 2010, I had 7 Mbps Internet at home. Today I have 1,000 Mbps Internet. For the same price. And our children do live online video school while my wife and I run live Zoom meetings. Without even a hiccup.

Let's compare this to financial services.

If my Internet is 142 times better today than in 2010, how much better is my mortgage? Zero. My checking and savings accounts? Zero. My insurance? Zero. My investment services? OK, not zero. But not even a fraction of 142x.

Why?

One reason is that phone and Internet have exponential tailwinds from Moore's Law and digitalization. Digital is different, as we discussed in detail in how software eats money.

But that's not the only reason. Many financial services haven't improved in decades. How can that be?

Incentives

Charlie Munger, the vice-chairman of Berkshire Hathaway, wrote in the Psychology of Human Misjudgment:

I think I’ve been in the top five percent of my age cohorts almost all my adult life in understanding the power of incentives, and yet I’ve always underestimated that power. Never a year passes but I get some surprise that pushes a little further my appreciation of incentive superpower.

One of my favorite cases about the power of incentives is the Federal Express case. The integrity of the Federal Express system requires that all packages be shifted rapidly among airplanes in one central airport each night. The system has no integrity for the customers if the night work shift can’t accomplish its assignment fast.

Federal Express had one hell of a time getting the night shift to do the right thing. They tried moral suasion. They tried everything in the world without luck. And, finally, somebody got the happy thought that it was foolish to pay the night shift by the hour when what the employer wanted was not maximized billable hours of employee service but fault-free, rapid performance of a particular task. Maybe, this person thought, if they paid the employees per shift and let all night shift employees go home when all the planes were loaded, the system would work better. And, lo and behold, that solution worked.

Incentives matter. And if you know the incentive, you can know the outcome. The reason financial services have not improved in decades is a problem of incentives.

All good organizations pick metrics to measure success. But because measuring actual human behavior is difficult, we typically choose a proxy metric to represent it. In education, we use test scores as a proxy for aptitude. In media, we use attention as a proxy for customer value. In consumer internet, we use clicks as a proxy for 'looked at this' and time spent as a proxy for 'enjoyed this.'

What do we use in financial services?

What metric is used to measure the amount of value being delivered to a customer? Is there one?

If a student has a higher test score, we can infer a higher aptitude. If someone spends more time watching a video, we can infer more entertainment or information value.

What is the equivalent in finance?

If a customer has more loans, are they getting more value? If a customer paid more fees, are they getting more value? If a customer trades more or has more insurance, are they getting more value?

The truth is most financial services companies do not think about customer value when measuring success. Assets under management, accounts opened, loans per loan officer and the countless other current KPIs are all inward facing. They measure bank value, not customer value.

If no one is measuring customer value, it's no surprise customer value isn't improving. There's no incentive.

Optimizing for the wrong metric is why Wells Fargo employees opened millions of fake customer accounts. Even after the consent order, employees report the culture still hasn't changed. Have the metrics changed? Show me the incentive, and I will show you the outcome.

If optimizing for the wrong metric isn't bad enough, there's a second problem. Proxy metrics are imperfect measures of human behavior and often have second-order consequences that system designers didn't want or anticipate.

There are situations where using a product encourages more use of the product. This creates a feedback mechanism where not only the production side of the system is optimizing for the metric, but the consumption side is as well. This flywheel effect can cause an epidemic, like when the media industry optimizes for content designed to trigger a dopamine response (like a newsfeed filled with fake news or baby photos) or when the food industry optimizes for empty calories (like sugar).

How different are the feedback loops in media and food from the feedback loop in consumer loans? How many loans is too many loans?

Charles Schwab has quietly become one of America's biggest banks and plans to focus on loans since interest rates are so low and trading commissions have gone to zero. Increasingly, all financial services companies are in all lines of financial services. And competition is only going to increase as bank platform as a service offerings enable every company to be a fintech.

What happens if loans are one of the few places left in financial services to make money, but now they're available from literally everyone? The same old product. A commodity.

And what if Gen Z decides they don't want as many loans, as the evidence suggests?

What do you do?

Build something no one else can measure

The prevailing wisdom in media is to maximize engagement. This means you want people to spend as long as possible on your website. Google, by contrast, is optimized to minimize the time you spend on their website:

We know your time is valuable, so when you’re seeking an answer on the web you want it right away–and we aim to please. We may be the only people in the world who can say our goal is to have people leave our website as quickly as possible.

Uber and Lyft show public transportation options for users in their app even though they make no money if a user chooses them. Why? They are optimizing for the best way to get a user from point A to point B. They know that in many cases Uber or Lyft are the best option. Their goal is to be the starting point for all a user's trips, so they can measure and optimize them. Something public transit operators cannot do.

In a world where most retailers want to minimize returns, Zappos has optimized to maximize them. They made returns a delight and part of shopping, noting that the more goods their customers returned, the better they were for business:

Our best customers have the highest returns rates, but they are also the ones that spend the most money with us and are our most profitable customers.
-Craig Adkins, VP of services and operations, Zappos

Sriram Krishnan, who's worked on the product teams at Twitter, Snap and Facebook, said one of his theories on how to compete with major platform companies is to "build something that optimizes for a metric they can't measure."

This is also true in financial services.

It's not enough for financial services companies to evolve from sales organizations into software companies. You cannot win by optimizing for today's inward looking metrics. They result in incrementalism and local maxima.

Tomorrow's winners will optimize for a metric that measures customer value.

Perhaps it's wealth generated per customer. Or percent of monthly income saved. Or even average improvement in credit score.

Whatever the metric is, it will reflect the fact that financial services will soon improve at the rate of phones or Internet service. Just like all digital products do.

This may sound unimaginable today.

So was iPhone upending the value chain in wireless and claiming the majority of profits. Or Craigslist taking every US telecom provider's yellow pages business from $10 billion to zero. The list goes on and on.

It won't be easy. And there will be many failures. But companies that win will optimize for a metric that makes customers feel awesome. Like they have a superpower. In the same way that using Google or iPhone feels like a superpower.

They'll be loved by customers. And bigger businesses than ever seen before.

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  1. Cover photo by Felix Mittermeier