What Banks Can Learn from VCs

I often give venture capital firms a hard time. It’s partly because with their crummy performance that they deserve it, partly because with their humorlessness and hubris that they need it, and partly because I know more VCs than bankers — and it’s always more fun to fight with people you know than with people you don’t.

But there is a flip side to this.  Financial services industry is in upheaval like at no other time since the previous depression. From banks to brokers to, yes, VCs, financial services is seeing major changes in how and whether it makes money.

So, which part of the industry is changing fastest? Venture capital. More venture firms, as a percentage of the total extant, will have failed over the current period than is the case with banks in the U.S., but with no need for a government-led bailout. We can have widespread VC financial failures without societal consequences.

At the same time, the nature of the VC industry is changing rapidly, with new entrants (micro-VCs and super-angels, but also larger funds), new partners and new brands, and even a change in sectoral & stage emphasis. The industry a couple of years out will look very different from what it did a few years ago, let alone what it looked like a decade ago.  This change is not being driven by regulators, but by the individual actions of new entrants and competitors, trying to respond to changes in the funding market, as well as to changes in their customers — entrepreneurs.

The result: Radical change in a sector of the otherwise wasted financial services industry. New people, new companies, new markets, new providers of capital, all in the space of a few years. Will it produce higher returns? I hope so, but if it doesn’t, rest assured more VC firms will fail, and there will be no talk of a safety net, or a bailout.

Why is venture different? Why is this rapid failure/speciation/innovation sequence not playing out in banking? In part, and not to get all deregulatory about it, because we don’t let it. The most important difference between venture and other parts of the financial services system, especially banking, is that the former isn’t regulated (okay, regulated very, very lightly), while the latter is highly regulated. That regulation, while well-intended, has the effect of straightjacketing the industry, meanwhile preventing usurpers and change and innovation, and making banks that are already too big to fail, too bigger to fail.

It is wrong and simplistic to say that if we just deregulated banks that all would be well. But it is also true that the path to having half of the banking industry (in assets and firms) shrink away, with no societal consequences (as is happening in venture), could be at least informed by what is happening right now in U.S. venture capital. [-]