The Bankwatch

In a vaguely worded rebuttal Kodak all but confirms they are in sufficient trouble, having not made a profit since 2004, that they are considering bankruptcy as a lever for a strategic shift.

Kodak Hires Lawyers, Weighing Bankruptcy Filing | Dealbook NY Times

Once in a while a technology shift is big enough to require mention.  Amazon Silk fits that category.  I was sitting with some developer folks listening to a conversation about this stuff and relating it to what Amazon has done.  Basically browsers are not very smart and work on architecture that is more than 20 years old.

In simple terms when you click a link today, it sends several requests to the server and receives the responses. If there are 20 pictures on the page, you need 20 requests and responses, plus a few others for handling the general page.

Silk changes all that by handling all the heavy lifting that the browser did on the server side, and only sending the final product to the browser.  Silk is able to do that because of the Amazon cloud otherwise known as Amazon Web Services (AWS), thus reducing the number of requests and responses required.

This is fascinating and changes everything.  Today we assume that speed is driven by higher bandwidth and processor speed. This new approach means that low speed devices such as mobile phones can receive instant rendering of pages/ movies/ pictures.

Relevance to Bankwatch:

Until now cloud computing has meant either server replacement or an alternate storage device (another hard drive).  This new approach views the cloud and the user device as one.  The connection between your CPU and your hard drive is replaced by an internet connection.  This allows forward thinking companies like Amazon to engineer solutions such as Kindle Fire that have unique browsing capabilities which are ultra fast.

The big shift here is the integration of the cloud and the user device in ways that we have not seen before and that provide speed and usability which is un-precedented.

The Groupon situation continues to deteriorate.  As noted earlier, their financial forecasts were full of holes.  Now they are altering their revenue forecast to reflect the earlier fiction of gross income which is now restated to reflect payments to merchants. 

If a groupon costs $10 then $5 +/- is paid to the merchant.  Previously Groupon claimed $10 as revenue.  Their restated S-1 to the SEC reflects real revenue as $5 in this example.

Who knows if they will even make IPO.  There is so much insidiousness about this company.  Their last raise was designed to pay out investors and founders.  Not a good sign.

Panic is setting in as even the safe havens (Gold, oil, US, Japan) all fall simultaneously.  Interesting times.

Global growth fears sink world stocks

A new report from McKinsey paints a bleak picture for banks and supports the notion that banks need to adapt and adapt in a significant way.  Their survival is at stake.  The banking and economic crisis just brought banks deficiencies to the fore.

This extract from the intro page to the McKinsey study (emphasis mine) highlights that shifting consumer practices plays a role in the falling fortunes of banks.  The banks who choose to not redesign themselves will be relegated to utility banking, which looks more and more, certainly in Europe as involving direct government ownership.

The state of global banking—in search of a sustainable model McKinsey

On its face, 2010 was a good year for the industry. Global banking revenues reached a record $3.8 trillion, and after-tax profits jumped from $400 billion in 2009 to $712 billion—above their 2008 level, if not the 2007 peak. But this rosy picture did not necessarily imply a bright future for banks in Europe and the United States: 90 percent of the profit improvement was attributable to a reduction in provisions for loan losses, and most, if not all, of the good news came from emerging markets.

…

As a result, investors have been reassessing the banking industry’s long-term growth prospects and rerating the sector. The major problems include the rising cost of doing business—thanks primarily to new regulation requiring banks to hold more capital and liquidity to ensure that the industry better withstands future shocks—scarcity of capital and liquidity, changing consumer behavior as a growing number of customers move to mobile and online channels, and diverging regional growth paths.

Full report pdf (registration required)

The report obviously covers many economic aspects including higher costs of capital, regulation and sluggish markets in developed countries.  I will highlight some of the comments though on the changing consumer behaviours.

Finally, banks will have to contend with shifts in consumer behavior – none more significant than the rise of the digital consumer, accelerated by the mobile and tablet revolution. We expect branch density to fall, and average branch sizes to shrink.
Banks will have to deliver superior customer experience to a generation that has much greater choice and is likely to be more price-sensitive.

Some of the shifting behaviours:

• the decline of household leverage in many developed markets, and with it, increased savings rates. 

If this shift turns out to be a long-term structural phenomenon, it could have significant implications for the growth of many banking products, including personal loans, mortgages, and credit cards. The banking industry on average will therefore be less profitable.

• the inexorable rise of digital consumers, further accelerated by the mobile and tablet revolution. In US retailing, more than 40% of total sales are either transacted online or influenced by the online channel; “pure online” sales already exceed $170 billion annually. Similar trends are under way in online banking. In pioneering countries such as Finland, the Netherlands, and Norway, as many as 80% of customers
  already use online banking – not just for transactions, but also for account opening. In major markets such as the US, UK, Germany, and Japan, the figure is approaching 50%. Moreover, there is an extremely close correlation between overall internet usage and online banking –  this suggests that as internet
  penetration increases worldwide, customers will migrate out of bank branches and onto electronic channels.

• Overall, we expect branch density to fall, especially in overbranched countries; even more importantly, we expect the average size of branches to decrease as many advice related and post-sales support activities
  migrate to different channels.
• These shifts will also require banks to integrate their channels seamlessly and efficiently. New marketing activity will be necessary – banks on average spend less on marketing than other consumer-facing
  industries. We would expect particularly strong growth in digital marketing. Finally, banks will have to monitor innovations closely, particularly in the mobile arena, to avoid being leapfrogged by other industries. In the US, for example, financial institutions currently own only about 70 of the around 3,000 financial applications running on the iPad, iPhone, and Android devices

McKinsey propose improvements along three vectors … a word pick to highlight that bold changes, not incremental, are required.

• Vector 1 is about improved capital efficiency – a particular priority in Europe. Here, banks would focus on
  making their businesses less capital intensive and moving the risks they can no longer afford elsewhere
• Vector 2 is about completely restructuring their costs. Banks would recover their profitability through
  reinventing their cost base
• Vector 3 is about capturing new revenue opportunities within their existing areas of operations. Banks
  would tap into new pockets of demand and revenue via smarter pricing, customer centricity, and selective new risk taking

Again I will pick one, – vector 2, which is where technology has a large part to play and banks have much room to improve.  In fact in many cases improvement is the wrong word.  It will require being willing to throw out old technology and rebuild, within the context of a probably smaller, leaner and more efficient bank.  McKinsey estimate a 6% annual cost reduction is necessary.  These are staggering changes that cannot be done incrementally.

They pick up on one of my favourites that I covered here recently.

Finally, banks could move non core operations into industry utilities – a particular opportunity in mature markets. Some countries, such as Norway and Iceland, use shared industry utilities extensively, but others very little. Although requiring potentially complex collective action, the opportunity is there to share or outsource a large part of banks’ non core operations like cash and coin handling, payments, and ATM

Relevance to Bankwatch:

In short this is no time for sentiment.  Just because you are a bank does not mean you have to manage cash, or ATM’s for example.

The McKinsey report is only 50 pages and contains detailed statistics on banking markets by country and on banks.

The video in this Finextra piece shares the vision Paypal have for shopping.  The integration of smart phones, product barcodes, store databases, payments and bypassing the cash register line up is fascinating and potentially disruptive for payments.

It is simply delightful to read about the UBS loss today.  If you read this article by Tett at the FT you will be hard placed to understand how Mr Adoboli did anything illegal.

In Europe, for example, so-called “synthetic” ETFs, or packages of derivatives, have become very hot and now account for almost half of all ETFs.

I say delightful, because not only have no lessons been learned since 2008, things have in fact become worse.  The combination of the now “Delta One” derivatives desks, where Mr Adoboli worked at UBS allows derivatives based on ETF’s.  These are 100% synthetic investments that act kind of like indexes to track assets, other indexes or anything the traders decide to concoct.

Tett wrote this piece in May (emphasis mine) highlighting the risks already identified in the rapidly growing ETF market.

And even if investors are wise enough to understand the risks of individual ETFs, the bigger structural impact is not well understood. The FSB, for example, fears that liquidity mismatches and poor collateral practices could create unpleasant markets jolts in a crisis. It also notes there are potential conflicts of interest because of “the dual role of some banks as ETF provider and derivative counterparty.” And there is another, more basic concern: precisely because the market has exploded with such stunning speed, it may be changing flows in unpredictable ways.

So here we have a 4 year employee able to trade these products and while we do not know all the facts, there are rumours that it involved Swiss francs and judging by his Sept 6th Facebook comment requiring a ‘miracle’ it could have involved the Swiss Central banks support for the franc catching him out.  The loss he incurred equates to 4% of UBS capital.

There is a fine line between activities of the employee and those of the organisation that permits such activities.  Many folks online are already speculating that he is a fall guy for poor risk monitoring practices at UBS.  This is not the first time for them.  They had terrible losses on CDO’s in 2007.

The argument for ring fencing just got stronger.  This won’t be the last such loss whether attributed to an employee or not.

The most controversial aspect of the Independent Commission on Banking is the ringfence.  Now we have a definition in the final report:

The Commission’s view, in sum, is that domestic retail banking services should be inside the
ring-fence, global wholesale/investment banking should be outside, and the provision of
straightforward banking services to large domestic non-financial companies can be in or out.
The aggregate balance sheet of UK banks is currently over £6 trillion – more than four times
annual GDP. On the criteria above, between one sixth and one third of this would be within
the retail ring-fence.

The novel approach they have come up with is to provide flexibility on certain commercial banking components to be in or out and this to be made clear to customers.

Scope of ring-fence

Which activities should be required to be within the retail ring-fence? The aim of isolating
banking services whose continuous provision is imperative and for which customers have no
ready alternative implies that the taking of deposits from, and provision of overdrafts to,
ordinary individuals and small and medium-sized enterprises (SMEs) should be required to be
within the ring-fence.

The aims of insulating UK retail banking from external shocks and of diminishing problems
(including for resolvability) of financial interconnectedness imply that a wide range of
services should not be permitted in the ring-fence. Services should not be provided from
within the ring-fence if they are not integral to the provision of payments services to
customers in the European Economic Area1 (EEA) or to intermediation between savers and
borrowers within the EEA non-financial sector, or if they directly increase the exposure of the
ring-fenced bank to global financial markets, or if they would significantly complicate its
resolution or otherwise threaten its objective. So the following activities should not be carried
on inside the ring-fence: services to non-EEA customers, services (other than payments
services) resulting in exposure to financial customers, ‘trading book’ activities, services
relating to secondary markets activity (including the purchases of loans or securities), and
derivatives trading (except as necessary for the retail bank prudently to manage its own risk).
Subject to limits on wholesale funding of retail operations, other banking services – including
taking deposits from customers other than individuals and SMEs and lending to large
companies outside the financial sector – should be permitted (but not required) within the
ring-fence.

The margin of flexibility in relation to large corporate banking is desirable. Rigidity would
increase the costs of transition from banks’ existing business models to the future regime.
And it would risk an asset/liability mismatch problem if, for example, retail deposits were
prevented from backing lending to large companies. Mismatch could give rise to economic
distortion and even to de-stabilising asset price bubbles.

The Independent Commission on Banking released its Final Report on 12 September 2011. It is available here (ICB site pdf).

Some early indications tonight about the implications of the Vickers report tomorrow.  Ring fencing is in, but with the qualification that banks can pick what is in or out, and customers can pick too.

It will be interesting to watch the unintended consequences of the higher funding charges and how banks will allocate.

UK banks eye £6bn cost of reforms

As foreshadowed, the central recommendation of the Independent Commission on Banking, chaired by Sir John Vickers, will be that banks’ core operations – including consumer deposits and small business lending – must be ringfenced from the rest of their businesses.

The cost impact of the changes will mainly be the result of higher funding charges for the banks’ operations that are left outside the more highly capitalised ringfenced entity. In the eyes of investors, operations outside the ringfence will lose the benefit both of a government guarantee and of a broad bank’s current diversification.