The Bankwatch

When Matt wrote his post the other day about starting a bank it got me thinking about the effect of what he is saying relative to profitability when we introduce a policy to be safe and carry capital reserves of 2 – 3 times more than todays banks.

Assumptions:

- demand deposits = demand loans

- GIC (CD) = Mortgages

- incremental investment in higher returning mortgages is funded from cash

Relevance to Bankwatch:

• A $4 increase in gross profit results in a 15% higher Return on Equity when a lower capital ratio of 10% is accepted.  Note the stock market values ROE over absolute profits.
• the increase in gross profit is not so much in absolute dollars, especially when we consider the additional risk taken on
• the relative risk of Regular Bank is exponentially higher with $200 more in loans and $200 less in equity – thats a $400 differential
• a 12% ($84) loan write down in Safe Bank is absorbed within the $300 capital, leaving them still at a substantial 24% capital ratio versus original 30%.
• a 12% ($100) write down in Regular Bank eliminates their capital and requires FDIC takeover – THEY ARE GONE!

The basic question then is whether the Regular Bank can make up the absolute dollar shortfall relative to Regular Bank of $4 (20% of Regular Bank gross) by efficient operations, less /no branches etc.

A 20% improvement seems doeable.

This simplistic model is deliberately just that – simple.  It does suggest though that there is an opportunity to consider a different model that will still satisfy shareholders, but also satisfy common sense and a more conservative risk profile.  Which Bank will step up to this model?

Thoughts and critiques from the Basel experts welcome.  Note I ignored cost of capital for this exercise.

Alos here is the spreadsheet.  safe bank Note:  download, save, and change name to safe bank.xls – then you can open in Excel or OpenOffice.

The worlds safest banks are European, Canadian and Australian.

WORLD’S 50 SAFEST BANKS 2009 | Global Finance Magazine

New York, August 25, 2009 — With bank stability still high on corporate and investor agendas,Global Finance publishes its 18th annual list of the world’s safest banks. After two tumultuous years that saw many of the world’s most respected banks drop out of the top-50 safest banks list, the dust appears to be settling. Those banks that kept an iron grip on their risk exposure before the financial crisis blew up have consistently topped the table and maintain their standing among the top echelon in this year’s ranking. At the same time, the big name banks that lost their safest bank ranking during the credit crunch are still absent from the list as they struggle to rebuild their credit standing. The “World’s 50 Safest Banks” 2009 were selected through a comparison of the long-term credit ratings and total assets of the 500 largest banks around the world. Ratings from Moody’s, Standard & Poor’s and Fitch were used. Global Finance has published its “World’s Safest Banks” listing for 18 years and this ranking has become a recognized and trusted standard of creditworthiness for the entire financial world. “It’s been a bumpy two years for the rating agencies and many of the banks they evaluate,”says Global Finance publisher Joseph D. Giarraputo. “More than ever customers all around the world are viewing long term creditworthiness as the key feature of the banks with which they do business.”

Following up on the previous post covering the Bank of Canada’s view that Canadian Banks do not have a productivity gap [pdf 19 pages] relative to US Banks, here is the basis for that contention within a 2006 report.

The conclusion copied here in whole is in my view, woefully misleading and contradictory. It reads to me like someone with political motivations has turned facts into something that meets policy objectives. Analysis to follow.

This work examines the efficiency and productivity of Canadian and U.S. banks in three ways.

First, we compare key performance ratios and find that (i) the average Canadian bank employee produces more assets than the average U.S. bank employee, and (ii) in terms of producing net operating revenue, Canadian and U.S. bank workers are similarly productive.

Second, we investigate whether there are economies of scale in the cost functions of Canadian banks and a sample of U.S. BHCs. We find larger economies of scale for Canadian banks than for the U.S. BHCs. This suggests that Canadian banks are less efficient with regard to the scale of their operations and would have more to gain in terms of efficiency benefits from becoming larger.

Third, we measure cost-inefficiency in Canadian banks and in U.S. BHCs relative to the domestic efficient frontier in each country (the domestic
best-practice institution). We find that Canadian banks are closer to the domestic efficient frontier than are the U.S. BHCs, and that they have moved closer to that efficient frontier over time.

Overall, these results do not suggest relative efficiency or productivity gaps in the Canadian banking industry. On the contrary, Canadian banks compare generally favourably.

Finally, as noted above, legislative and regulatory changes have benefited efficiency in Canadian financial services. This shows the importance of removing any remaining restrictions that inhibit competition and efficiency, but provide little (or no) benefit in terms of financial soundness.

Some facts from their report:

• Expense ratio Canada – 67 cents per dollar of revenue
• Expense ratio US – 59 cents per dollar of revenue
• Assets per employee Canada – $6.1M
• Assets per employee US – $4.1M
• operating revenue per employee US/ Canada same at $0.3M

This from the report:

Our analysis indicates that the difference in the expense ratios can be currently attributed to a higher labour cost component (wages and benefits) at Canadian banks. However, this differential does not imply disparities in productivity, which concerns how much output is produced per unit of input (typically, labour).

Relevance to Bankwatch:
Translation. Bank of Canada views Canadian Banks as productive by taking the narrow view of relative employee output. However that view excludes the overall budget of banks that includes real estate, and technology. The latter points explain the overall expense disparity per dollar of revenue earned at a significant 8 cents.

In other words productivity is a measure of investment not of employees. That is the entire point of automation. This further explains the contradictory point in he Tim Lane Kingston speech that wrote off StatsCan concerns for Canadian Bank productivity.

Productivity is a measure of inputs (expenses) and outputs (revenue). Any narrower view does a disservice to the country and the Banks, covering over potential areas for concern. Banks in Canada cover a large geography with relatively small population and while internet adoption is high the related savings in real estate and technology efficiency have yet to be achieved.

In this talk at Kingston last Tuesday, Tim Lane, Deputy Governor Bank of Canada lays out a quite lucid view [ 9 pages] of the opportunities and challenges facing Canada in recovery.

Highlights:

• labour productivity and output is the fundamental challenge that existed before and will continue post recession
• the size of the working population is to decrease significantly for demographic reasons, and neither immigration nor baby boomers remaining longer in the workforce will significantly alter that prediction
• the financial services industry is critical to Canada at 20% of the economy
• Canadian producivity has been dropping because of insifficient investment in technology and lack of innovation. Productivity is further hampered by por re-allocation of capital and labour across industries and this is exacerbated by the recession. Think auto employees in Oshawa having to move to mining in the prairies.
• The financial services sector productivity is described as particularly worrisome:

How productive is the Canadian financial services sector? Data from Statistics Canada point to a possibly worrisome trend. Productivity growth in this sector has declined from an average of 2.8 per cent per year in the 1990s to just over one-half per cent in this decade.

• Lane goes on to effectivley dismiss that StatsCan assessment with based on a BofC 2006 survey. I located the referenced BoC paper, and will review that later. It is also attached below. I note it is 3 years old, and thats an odd comparison to a 2009 StatsCan survey.

That said, if we compare Canada with the United States, our own research suggests that generally, the productivity of Canadian banks compares favourably with the productivity of U.S. banks.

Relevance to Bankwatch:
All in all the main concerns are the labour market, overall productivity, the financial services sector, and potential for inflation; he counters the latter with the Banks capability for Quantitative Easing which Canada has largely not employed yet.

recovery canada aug 2009 tim lane kingston r090828e.pdf
canadian bank productivity 2006 research_1206.pdf

A debate ensues in UK and to some extent in France, on the issue whether the financial sector is an underpinning of the economy, or a destabilising factor to the economy.

The debate is quickly moving to new taxes on transactions, but its unclear to me why that would solve either side of the debate, rather than merely be passed on to customers.

City regulator seeks to deflate financial sector with global tax | FT

… … a “swollen” financial sector paying excessive salaries has grown too big for society

If you are interested, there is an excellent debate on P2P Lending going on over a few blogs now. The general theme is whether P2P Lending (otherwise known as Social Lending) will make a difference to Banks.

It began here with this post at Zopa.

The problem is that unlike so many other far healthier industries, the banks have no effective competition. Microsoft is kept in check by Apple and increasingly Google. Warner, EMI and Sony are battling it out with the digital download phenomena. Tesco has to watch out for Sainsburys, M&S and Waitrose. Even the BBC has to keep something of an eye on ITV and Channel 4.

Banks don’t have the self-righting mechanism of genuine competition. It’s become a cosy club where customers are simply the supplier of money for banks to punt in their casino operations, politely called ‘investment banking’

Then James ex of Lloyds kicked in at Bankervision.

If Zopa were to have a material effect on bank lending, and its competitive differentiation is price, it will not win. It does not have pockets deep enough to win a price war with a major bank, let along the whole market. This much is simple market forces at play. The only reason this isn’t happening now is that, as Martin says, Zopa is not having a material effect on the market at present.

Then ‘always up for an argument’ Chris Skinner ratcheted up the volume here. [disclaimer - I am 100% with Chris on this one]

The real point is that, assuming there is a need for these new businesses which I believe there is, the only thing that undermines their business model is access to ongoing capital to get to the point of success. This is the challenge of any new business, and this is the real challenge to these new entrants: can they fund the business long enough to be successful?

Luckily there are plenty of financers out there who do believe in these new businesses however to fund them through their fledgling beginnings, including Red McCoombs for SmartyPig and Zopa’s investors range from Bessemer Venture Partners and Balderton Capital to the Rowland Family.

Even so, in Zopa’s case where they are creating a new market in P2P lending, the issue and challenge has always been getting enough people placing money into Zopa to enable them to meet the demands of those who want to borrow. Without funders, there is no marketplace.

So the challenge is to maintain investment and manage operating costs long enough during this start-up phase to get to the tipping point of growth. And, based upon a 40% increase in total loans just in the last year, maybe that tipping point has finally arrived.

And now the debate has made the FT blog …

But what we at Money Matters want to know is whether UK individuals who have used Zopa have got a good deal. At the start of the year, Matthew Vincent wrote a piece about a new online auction site for fixed-term deposits – and although he found that online lending exchanges such as Zopa were offering higher rates of interest, he suggested that these rates could come down as the number of lenders using Zopa increased.

… and the House of Commons through Tom Watson MP blog.

I wrote to the Chancellor in front of me but essentially I suggested three things:

1. Change the tax regime so that people who make loans – investors – can aggregate their total ‘wins’ and ‘losses’ for the purposes of tax. So, if you make 10 loans and nine of them fail, you should be allowed to offset them again the tenth loan that made you money.
2. Consider allowing people to use P2P within their ISA allowances.
3. Bring P2P within the remit of the small loans guarantee scheme. It is this area that I think could have a great impact in the small business sector. If people are prepared to bet their own cash on a business, then they are likely to conduct as much, if not more due diligence on the company as any bank. And when the banks make silly, greedy, short term risk averse decisions, groups of small private investors can step in.

Relevance to Bankwatch:
Thats a lot of debate for something that doesn’t matter.

[another disclaimer; I am involved with CommunityLend in Canada, a P2P Lending company]

Most of us here are of the mind that there is a consequential change going on, and that change is driven by internet. Part of the reason that Banks have issues dealing with internet is that it is viewed as an add-on … a new access channel that is additive to the others such as branches and telephone.

The change is more fundamental however. The way that a company acts, and implements online activities increasingly defines that company, and that includes Banks. In banking language we refer to self service however this is limiting and tends to place internet within the traditional context of banking.

McKinsey have reactivated a 1997 study that is even more pertinent for Banks today, and it reflects the belief that there is a larger more fundamental shift occurring, and it is consequential that it comes from them.

A revolution in interaction | McKinsey 1997

The modern world economy is in the early stages of a profound change in the shape of business activity. Two centuries ago, dramatic shifts in the economics of transformation—of production and transportation—precipitated the Industrial Revolution. An upheaval of equal proportions is about to be triggered by unprecedented changes in the economics of interaction.

Interactions—the searching, coordinating, and monitoring that people and firms do when they exchange goods, services, or ideas—pervade all economies, particularly those of modern developed nations. They account for over a third of economic activity in the United States, for example. More than that, interactions exert a potent but little understood influence on how industries are structured, how firms are organized, and how customers behave. Any major change in their level or nature would trigger a new dynamic in economic activity.

Interactivity is simply defined as the need for interaction between people in order for economic activity to take place.

The article makes the point that interactions account for a large part of economic activity and more than 50% of economic activity within financial services. The relative efficiency of managing interactivity therefore accounts for a significant proportion of the profitability of financial services.

The next step in the logic is that technology will revolutionize interactions, yet company’s have yet to lever that benefit.

The past couple of decades have brought remarkable innovations in these fields, but modern economies have yet to exploit opportunities to increase the quantity and quality of interactions and reduce their cost.

Until now, our ability to manipulate and process data has far outstripped our ability to communicate and interact. However, a number of converging factors are set to change this situation. New networking capabilities, technologies that enhance connectivity and bandwidth, and standards that drive new applications are coming together in an environment of spiraling processing power and deepening technological penetration. This potent combination heralds a new age of abundant interactive capability.

In other words computing power has been levered to transmit and manipulate data. It has not been levered to improve interactions. If we look at the typical bank employee desktop this is abundantly clear. Across the 10′s of thousands of employees at a typical bank it is no exaggeration to note they have limited interaction capability. Web mail and IM are frowned on or in some cases disallowed. MS Exchange / Outlook is available to some, but often only HQ staff, and management and not all front line personnel. In fact as an outcome of typical bank policies and management approach, employee interaction is viewed as a hindrance to customer service. Quite the antithesis of the conclusions in the this McKinsey piece.

There will be new ways to configure business.

New ways to configure business.

Vertical integration will become less valuable and disaggregation, outsourcing, and the use of external markets will increase. Whether a company makes or buys depends on the comparative costs of transformation (production and transportation) and interaction. While outsourcing or purchasing from a market allows buyers to benefit from the superior economics of specialized suppliers, it tends to involve substantial interaction costs. As these costs fall, the relative attractiveness of arm’s-length purchases will rise. ….

In textiles, for example, EDI has allowed players to disaggregate procurement, spinning, weaving, finishing, logistics, and retailing, and contract them out to specialists along the industry chain.

In contrast, horizontal integration and cooperation will become more economically attractive. Horizontal integration brings benefits when carrying out a set of activities jointly rather than separately yields economies of scope in the form of higher returns or lower costs. As falling interaction costs allow companies better to coordinate the marketing and distribution of a wider variety of products and services, the value of horizontal integration should increase.

In practical terms they suggest ways to lever a core competence of interaction:

The strategic value of scale is likely to decline in many industries, although it will rise for networked businesses. In businesses where distribution or logistics originally made scale essential, falling interaction costs will reduce its importance. Outsourcing, alternative delivery channels, and the ability to variablize inputs will grow, reducing fixed costs. As a result, smaller firms will proliferate in such industries as consumer goods manufacturing, applications software, specialty retailing, and design services.

By contrast, in networked businesses, where the number of possible interactions increases exponentially with the addition of each node, interaction efficiency is the key to competitive advantage. As recent acquisitions and mergers in telecommunications, transportation, banking, and mass retailing suggest, scale expansion is likely to take place in such businesses.

And at the most obvious level, it means less supervision necessary,. which means smaller HQ.

In general, there will be a shift toward more networked forms of business configuration. At its simplest, this means that companies will be able to devolve decision making from corporate headquarters as interactions become easier and cheaper.

The punch line. The ease of interaction that is available will produce players that are efficient, and online markets and connections will replace intermediaries. Banks are intermediaries.

Some businesses, like banking, are by definition intermediary in nature. In time, their foundations will be threatened. If electronic cash comes of age, it is difficult to imagine consumers being willing to pay for the high-cost infrastructure they currently have to use when they interact with banks. Similarly, if consumers could obtain information directly from content providers at low cost, many areas of information publishing might lose their distinctive value.

It finishes with predictions about how the direct to consumer model will win and “Digital and Internet-based approaches will provide the next leap forward in the sales and delivery of goods and services. Using the Internet as a transaction channel, customers will be able to obtain a range of goods from wine to winterwear … “

Relevance to Bankwatch:
This is a refreshing piece and while it states the obvious to many of us it is not obvious to Banks. Banks are stuck in the conundrum of decreasing revenue growth patterns as consumers de-leverage alongside enormous cost infrastructures associated with personnel and physical locations. As has been evident recently there is a shift to close branches, but that is not the answer.

First the Bank must decide what its future business model looks like and it should be an ‘internet first’ model as opposed to a ‘branch first’ model. The design of that new model is crucial. Only then can strategies be designed to get there from the current state.

[update:  this actually fits nicely with the theme of a presentation I have for tomorrow night at Ignite Toronto]

a revolution in interaction.pdf

Daniel notes good practices in managmenent of a merger using web media.

Alfa follows a good internet media strategy – covering its merger with Kazna | Retail Banking in Russia

An absolute majority of posts at this blog deals with operational aspects of banks business – but recent coverage of Alfa-Bank and Severnaya Kazna merger gives good examples on how a Web-media strategy of a bank can be formulated to better suit the wavering clients of the banks, and convey a positive image of banks in merger.

By co-incidence here is yet another chink in the armour of the branch network. Long ago Jim had the foresight to write what others could not admit to at that time, with the 40 year view of The Demise of Branches. Iin that far-sighted piece Jim aimed at the core raison d’etre amongst traditionalists, account acquisition, and developed potential approaches to offer a better value proposition than ‘just being there’.

In 2006, Banks were in major branch build out mode, to support their market share objectives. The payback period on those branches is extended to say the least. On the other hand, the payback period on branch elimination is almost immediate, but it has to be managed. It is a strategy that is aimed at the growing majority, but services must be made available online for that new majority.

BofA are aiming at a particularly work intensive branch activity – wires – I know and have done them – its a pain, and its work and time intensive. Its the ideal application to automate. Time to knock off those labour intensive branch apps that serve as an excuse to retain branches.

2010 will be the year when we see branches being actively reduced amongst the large banks. What will be interesting is to see to what extent they follow BofA’s lead and ensure the services can be offerred online. In that vein, who will be first to go for cash replacement with electronic purse/ smart card type offers?

Bank of America to Eliminate Wire Transfers from Branches, Moving Volume to Online Banking | netbanker

Beginning this summer, wire transfers will no longer be available in your local banking center…
What it means: When the nation’s largest online bank starts talking about reducing branches and takes steps to eliminate a traditional (and labor-intensive) branch-based service, you have good evidence that branch banking is on the wane.

Thoughts welcome!

FT reports on a new Bain report concerning RoE at Banks, and the unliklihood that Banks’ can regain previous RoE levels.

This fits with the theme here of no more business as usual, post crisis. The spreads in this low interest enviroment are simply not high enough to accomodate spreads like we saw over the late 90′s and early 2000′s. Furthermore and separate from the spread issue, the growth in credit will not be there either because consumers are unwinding unwieldly debt levels that are now disproportionate to asset levels.

The course banks must follow is rejuvenated product suites, and of course reduction of cost base, which is why Bain leapt right to branches.

Banks’ may need to close a third of branches’ | FT

Business consultancy group Bain concludes that UK retail banks face a tough future in which their return on equity (RoE) could be 50 per cent lower than pre-recession peaks.

Bain said that over the past two decades, leading UK retail banks have posted RoE – profit divided by equity – averaging 24 per cent and are unlikely to see those levels again.