The Bankwatch

This from the World Economic Forum as it opens tomorrow.  Major systemic financial failure remains at the top in terms of impact, but less likely than water or food shortages.  Click the pic for the full pdf.

This piece from Douglas J. Elliott, Fellow, Economic Studies, Initiative on Business and Public Policy at Brookings does an excellent job at highlighting what it is that investment bankers just do not get about life in the real (banking) world.

The Volcker Rule and its Impact on the U.S. Economy

First off I like the Glass Steagall/ Volker Rule approach to banking.  I believe it provides clarity and lucidity to people and allows them to frame their lending and investment approaches within their own personal context.  It also allows governments to quantify their contingent liability associated with deposit guarantees through vehicles such as FDIC and CDIC.   It further allows them to allocate money outside the ‘basic banking’ construct for additional return if they wish.

L ets look at Elliott’s arguments.  (He rightly notes that the opinions are his and his alone, not those of Brookings).

He begins with a macro point:

My core problem with the Volcker Rule is that it seems to me to be trying to eliminate excessive investment risk at our core financial institutions without measuring either the level of investment risk or the capacity of the institutions to handle the risk, which would tell us whether the risk was excessive. Instead, the rule focuses on the intent of the investment rather than its risk characteristics.

To this I say he is absolutely correct and actually makes my point for me.  Why should a Granny or a 28 year older saver need to consider “capacity of the institutions to handle the risk” when they make their monthly deposit to their savings account?  The Elliott argument to this point follows his general thread here that he looks at banking as securities/ risk oriented industry.  I say go back to Bedford Falls, New York if you want to see what banking really is.  Investment bankers have never seen this and that is not their fault.  Basic banking is taking peoples money/ savings and carefully lending it, but maintaining adequate capital to handle downside.

Lets move on to his four arguments:

Argument 1:  The globally-agreed Basel rules on bank capital take a more intelligent approach, by explicitly measuring both investment risk and the adequacy of capital to absorb those risks.

Yes of course.  But that does not make it right.  Nor is it backed by any evidence that regulators or risk managers have any competence in evaluating risk.  A 10% chance of something going south means little when it goes south and 100% is lost.  The issue with back to basics banking is to isolate undue risk from basic local and understandable risk.  More on this to come.

Argument 2:  Many supporters of the rule seem to be particularly concerned about investments made by banks which are funded with depositor money and on which the shareholders collect any gain.

At the core of this argument is the reality that ‘basic bankers’ are willing to live with low returns and do not wish to be concerned with risk/ reward calculations.  This concept is foreign to investment bankers.

Argument 3:  There is no reason to believe that regulators will be better at this than bankers, even recognizing the mistakes made by bankers in the run-up to the financial crisis.

I accept this point.  There is an arbitrariness involved in the implementation of the Volker rule.  But this argument is not enough to not pursue it.

Argument 4:  As a public policy matter, we want banks, even small ones, to hold substantial portfolios of safe and highly liquid securities so that they can meet sudden demands for cash …  A large portion of the investment losses at commercial banks in the crisis were on their holdings of securities purchased for liquidity purposes. They bought mortgage-backed and asset-backed securities that were rated “AAA” and which were quite liquid until the financial crisis struck and rendered them illiquid.

The best for last.  I cannot believe that the argument to hold MBS is held up as an argument against Volker.  Good grief.  Those toxic bonds and the promotion of them is precisely what caused the 2008 debacle.  Surely the writer cannot be making the argument that because some new fangled bond is liquid right now, that it is appropriate?  Surely not?  

Relevance to Bankwatch:

How far have we drifted from the traditional concept with the unfortunate title of ‘widows and orphans’ (look it up Mr Investment Banker).  If it seems unknown it is probably risky.  Implementation of Volker is being totally confused with modern concepts such as ‘weighted average risk’, beta, and a bunch of other investment jargon.  A good test for inclusion/ exclusion for Volker would be just that … jargon based /no jargon required. 

Lets bring some common sense back to financial services.  There is a need for utility banking whereby people have low expectations on return and high expectations on safety.  This is not a difficult concept.

Separate the high risk/ potential high return into a separate organization outside of Volker and let people who wish to play there do so.  Its very simple.  The volume of argument from the Elliotts and the Diamonds makes me wonder if they are afraid the savers will restrict their money to the utility bank and cut off cheap investment capital.

This is a seminal article and one that western companies and governments should study.  The general assumption is that manufacturing work is outsourced overseas due to lower wages.  Not so.

How the U.S. Lost Out on iPhone Work | NY Times

Apple executives say that going overseas, at this point, is their only option. One former executive described how the company relied upon a Chinese factory to revamp iPhone manufacturing just weeks before the device was due on shelves. Apple had redesigned the iPhone’s screen at the last minute, forcing an assembly line overhaul. New screens began arriving at the plant near midnight.

A foreman immediately roused 8,000 workers inside the company’s dormitories, according to the executive. Each employee was given a biscuit and a cup of tea, guided to a workstation and within half an hour started a 12-hour shift fitting glass screens into beveled frames. Within 96 hours, the plant was producing over 10,000 iPhones a day.

“The speed and flexibility is breathtaking,” the executive said. “There’s no American plant that can match that.”

This story developed following a question last year from President Obama to Steve Jobs.  The backstory is that Apple has 40,000 employees in the US and up to 700,000 people worldwide engaged in making Apple products.  This in contrast to the US Auto sector, or GE, that each had at one time several hundred thousand US workers.

Obama to Jobs:

Why can’t that work come home? Mr. Obama asked.

Mr. Jobs’s reply was unambiguous. “Those jobs aren’t coming back,” he said, according to another dinner guest.

The president’s question touched upon a central conviction at Apple. It isn’t just that workers are cheaper abroad. Rather, Apple’s executives believe the vast scale of overseas factories as well as the flexibility, diligence and industrial skills of foreign workers have so outpaced their American counterparts that “Made in the U.S.A.” is no longer a viable option for most Apple products.

It begs the question.  Why does someone not try to build a manufacturing facility in the US that goes head to head with the Foxconns of the East?  To say it cannot be done is too easy an answer.

As it became clear in 2009 the influence of Government on banks that the took control of that year had to become a consequential factor in how those banks operate.  My hypothesis at the time was that those banks would lose the innovation incentive and in effect become utilities that provide a basic banking service.

I am surprised it took this long, but David Cameron has made the first consequential step by setting a very low limit on bank bonuses on RBS and it appears to also impact all government owned banks so Lloyds and HBOS too.  The piece is headlined in reference to the Knighthood Gordon Brown gave to Sir Fred, but while amusing that is not the point here. 

PM signals ‘Fred the Shred’ could be stripped of knighthood | The Times (subscription)

He also said that the cash element of bonuses paid this year to staff at RBS, which is 83 per cent owned by the taxpayer, would be restricted to £2,000, the same as last year.

Relevance to Bankwatch:

The larger point is that this signals a sea change in how banks operate and the first consequential change since the banking crisis.  I firmly believe there needs to be a solid banking system available for those who are risk averse.  This used to be provided not just by banks, but by Trustee Savings Banks and those days are well gone.  A shift that encourages utility banking will bring that back.

Wells Fargo is doing a great job and has publicly announced getting back to basics, as has Lloyds Bank.

This will result in natural competition which will arise from newcomers and prospective customers can make their own educated estimates of the risk and reward with those newcomers.  In fact there is no reason newcomers cannot re-use utility banks as their safe and secure ‘engine’ for access to bank accounts, and payments systems, while they provide innovative and flexible front ends.  We are already seeing beta testing of such operations (Movenbank).

In any event things are not the same following the intervention of Government, but it might just germinate the customer focussed creativity that never came from the big banks.

This piece in the FT talks about the FSB (Financial Stability Board).  I had to remind myself that the FSB is the G20 designate to fix the banking system, and not the KGB successor. 

The quote in the title indicates the goal of the group but the reality of the need for this piece indicates that it is not being taken too seriously yet, hence we must remember … FSB.  The good news is that the FSB has one of the better and clear thinking Central Bank governors in Mark Carney.  The challenge that is faces is critical for the world.

There are several hints that the mobile payment acquiring space is getting interesting. 

1. Square
2. Intuit GoPayment
3. SimplyTap

These new offerings bypass traditional payment networks and thus eliminate (or replace) merchant discount charges for those accepting credit cards.

While we await banks being disrupted, this payment space could just be the next big thing.

A nice summary from McKinsey of the fundamental problem facing banks in any country, that reflects the zero appreciation in bank stock value over the last 20 years.  McKinsey state that banks need a new model.

Why US banks need a new business model

Many commentators blame Europe’s sovereign-debt crisis and fears of a double-dip recession. But three additional factors also weigh heavily on investors: the new bank capital requirements introduced under the Basel III international-banking regulations, the impact of new US banking regulations responding to the financial crisis, the Dodd–Frank Act, and the unwinding of consumer debt. All three undermine banking’s traditional business model.

This is an obvious point despite investors lack of appreciation of it. 

This next point is my favourite.

By business model, we mean how banks actually operate—how work is done, the degree of automation, the pricing and design of products, and underlying compensation systems. In the market’s view, the threats are so strong that it won’t be enough to trim the sails, refocus investment, or cut costs a bit here and there.

There has been an unfortunate mixing of what I would call banking, that is accepting deposits and making loans; mixing with investment banking that is far removed from traditional banking.  But that is a self made problem so no excuse.

Lets break this down using the McKinsey model approach:

1. how work is done,
2. the degree of automation,
3. the pricing and design of products, and
4. underlying compensation systems

1. How work is done:

Banks approach the market with a sales force that generally speaking has no idea about products or technology.  I don’t mean this to sound as harsh as it does but it is not the fault of the front line. 

The technology and product people (I am generalising here) are generally not allowed to speak directly to customers.  The model is designed to provide features and benefits descriptions to front line staff.  This is a good design for selling but a bad design for quality service and answering questions.

2. The degree of automation:

If you ask a bank technologist they will describe an amazing amount of automation, with incredible sophistication of system integration.  However the very statement is evidence of the degree of internal focus required to make the systems work together at all.  This in contrast to what customers need. 

3.  The pricing and design of products:

Pricing and product design for banks generally follows the telco and airline models by creating complexity with a host of extra fees embedded in that complexity.  There are some standouts such as ING who try to break through that but not a lot of innovation here. 

5. Underlying compensation systems

Not much to be said here.  Many bank employees have made a lot of money, yet the value to shareholders over the last 20 or 30 years for the average bank is zero.

The title says it all in this McKinsey piece from earlier in the year.  While it is fashionable, expected and admired to multitask the reality is that it is counterproductive.  The piece expands into a personal strategy to focus, filter and forget.  It’s a welcome reminder for time management principles.  It underlies the thinking with a new aspect to multi-tasking that is addictive and physiological. 

This drug like effect generates company inefficiency, errors and missed opportunities.

Always-on, multitasking work environments are killing productivity, dampening creativity, and making us unhappy | McKinsey

We tend to believe that by doing several things at the same time we can better handle the information rushing toward us and get more done. What’s more, multitasking—interrupting one task with another—can sometimes be fun. Each vibration of our favorite high-tech e-mail device carries the promise of potential rewards. Checking it may provide a welcome distraction from more difficult and challenging tasks. It helps us feel, at least briefly, that we’ve accomplished something—even if only pruning our e-mail in-boxes. Unfortunately, current research indicates the opposite: multitasking unequivocally damages productivity.

An increasingly obvious observation from this Economist piece on the value of social media for commerce.  In particular the original promise was that social media would allow companies to infer and interpret customer preferences in a particularly granular and specific way, by associating customers buying preferences with their friends and their buying behaviors.

Too much buzz – Social media provides huge opportunities, but will bring huge problems | Economist

Most commentary on social media ignores an obvious truth—that the value of things is largely determined by their rarity. The more people tweet, the less attention people will pay to any individual tweet. The more people “friend” even passing acquaintances, the less meaning such connections have. As communication grows ever easier, the important thing is detecting whispers of useful information in a howling hurricane of noise. For speakers, the new world will be expensive. Companies will have to invest in ever more channels to capture the same number of ears. For listeners, it will be baffling. Everyone will need better filters—editors, analysts, middle managers and so on—to help them extract meaning from the blizzard of buzz.

I remain skeptical about how social media might create value for commerce, beyond advertising and awareness.  The original promise (above) has faded.  It has largely been replaced for now by attention to social media for advertising and negative customer opinion awareness.

I would cite two large problems within the data problem that The Economist mentions above:

1. If any commercial value did appear, it would be instantly gamed by advertisers using fake users
2. Beyond the ubiquitous ‘like’ or ‘+1” buttons, people generally focus on the negative rather than promote the positive.  The qualitative product comments are definitely something to be closely monitored.

Don’t get me wrong.  Trends and new stuff will surface in social media.  In fact one study quoted here in Quora suggests that 71% of tweets are original and ignored, with 6% being retweeted.  This suggests that the 71% may well hold some new knowledge and startups are frantically working to assess that data from Twitters feeds.  Mind you, what percentage of those original tweets are ‘what I had for dinner’ or ‘links to web news’.  There is clearly an emerging value around the immediacy of news that is game changing for media.  There is also value in keeping family and friends updated on news.  There might be some user social and personal behaviour inferences that can be inferred.

Time will tell what other value might appear from that data.  But for now, Social Media’s value to commerce is becoming just another media buy to generate awareness and promote purchasing.

There is a brilliant collection of essays in the Jan/Feb issue of Foreign Affairs.  There is one lead piece from Francis Fukuyama entitled the Future of History (premium) which borrows from the title of his earlier book The End of History. 

The broad theme is the failure of politics and the problem with the rise of economics over politics that has led (his words) to the end of left wing idealism as a counterweight to the right. 

Foreign Affairs:  He closes with this statement on what is needed:

It would have to have at least two components, political and economic. Politically, the new ideology would need to reassert the supremacy of democratic politics over economics and legitimate anew government as an expression of the public interest. But the agenda it put forward to protect middle-class life could not simply rely on the existing mechanisms of the welfare state. The ideology would need to somehow redesign the public sector, freeing it from its dependence on existing stakeholders and using new, technology-empowered approaches to delivering services. It would have to argue forthrightly for more redistribution and present a realistic route to ending interest groups’ domination of politics.

He got there by reviewing a host of historic movements and how they arrived. 

• the introduction of the rights of property owners
• the concept that government can only tax when voters agree
• the power to vote for non property owners (an American invention – Andrew Jackson)
• that technology carries some of the blame for driving efficiency that requires fewer workers and provides for greater income generation for well educated, something that supported the growth of middle class.

He moves us quickly through the history of democratic movements which he notes fall out of demographic movements.

• socialism and rise of unions
• communism and its failure
• rise of middle class which through passing of relative wealth to people in large numbers that displaced the earlier two movements
• latterly the flattening of middle class incomes over the past 40 years, and finally
• more recently the rise of a new group of culturally disenfranchised (immigrants, gay, less/uneducated, etc) which has itself displaced the power of the middle class, and further displacing the worker power of unions, by creation of a large third franchise.

Even the Arab Spring he notes can be rooted in a new Arab group that is better off, better educated, that can clearly comprehend the Dictators are firmly between them and a better life.  See this in Russia too now.

But he ends on a note of pessimism that with inequality and friction between these broad groups, each of whose opposing needs broadens, the solutions and endgame are not clear.  In the US, the top 1% of families take home 23.5% of income he notes.

Relevance to Bankwatch:

With this backdrop, we can see clues in the political quagmires we see in the Euro zone and in the US.  The governments are torn about which franchise to follow because it is just not clear.  In fact the structures of governments was designed for a different time and place with much different citizen structure.

We have the additional shift from demographic aging in western countries.

These factors exacerbate the mismatch of the structure of government to the requirements of the population.

This blog is not about politics, but I believe requirements for the design of banks is as dependent on the requirements of the population.  One thing we can see from the last 4 years, is that banks’ design are based on a different set of requirements and not around making them inherently useful and of value to the broad base of people.  Unfortunately, all people cannot successfully claim to be in the top 1% that make 23.5% of income.