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When the Affluent Become the Unbanked

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Concern about those who have been left behind in receiving financial services (“the unbanked” and “the underbanked” ) have been popular topics of conversation amongst bankers and regulators over the past few years.

An important thread of these conversations has been the fact that in many cases, it is the customers who are leaving the traditional financial service providers behind, not the other way around.

I spend most of my time working with the “overbanked”– affluent families who have no shortage of financial services options, and as I have written previously, they too can find a variety of services to borrow, hold, invest and move money without the need for a traditional bank.

Yesterday’s Wall Street Journal reported on an affluent family who has “…no need, desire or want to go to a regular bank,”

Footnote to Financial Crisi: More People Shun the Bank – WSJ.com

 

 

The Convergence of High Tech and High Touch in Wealth Management

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I wrote a piece for the popular fintech blog netbanker yesterday on how high tech and high touch are converging in wealth management, and what I will be watching for in that convergence zone next week at Finovate Fall 2012 in New York.

In the article, I mentioned that most of the notable traction to date has been in the payments space. One might not think that this “dumb pipe” portion of banks’ business models– moving dollars and data from Point A to Point B– would provide such fertile ground for disruptive innovation, but consider the impact and potential of players such as Finovate alums Dwolla and Simple, as well as Square, PayPal, and others.

I also noted in the article that innovative specialty lenders and crowdsourcing platforms are breaching what had long been banks’ deepest moat–  the ability to monetize their balance sheets. Most simply defined, banks’ primary function is to be a financial intermediary. Besides moving money from one place to the other, they hold excess capital when it is not needed for investment, and lend it out when it is; providing liquidity to all sorts of macro and micro markets along the way.

Oligopolists acting like oligopolists

Even though there are over 7,000 banks (plus a similar number of credit unions) in the U.S. alone, the industry has long operated as an oligopoly. For the most part, it continues to act that way despite disruptive threats from all around. After all, their primary product is the ultimate undifferentiated commodity, money. Bank A’s money isn’t better designed, sturdier or more portable than Bank B’s.

Parenthetically, oligopolists acting like oligopolists has a lot to do with the reason most consumers hold banks in just slightly higher esteem than they do the U.S. Congress. Banks integrated vertically and horizontally, they bought weaker competitors, they raised prices, they made up new fees, they cut costs and maximized profits for shareholders with scant regard to other stakeholders, like, you know, their customers.

Predictably, smart players from outside the industry have visions for better ways of doing business.

As frightening as any of these threats should be to any entrenched bankers who are paying attention, the ongoing march of innovation should be scaring them right out of their moire suspenders. Innovators are moving beyond solving the algorithmic problems of the industry and beginning to tackle more dynamic and heuristic areas, such as wealth management.

I continue to reference a recent American Banker article cited a KPMG survey that said 9 out of 10 banks were considering a major overhaul of their strategy, and that 40% said that wealth management was essential to growing revenue in the future.

Wealth management is an attractive business, and if done right, the business can also be a key differentiator, but it requires the ability to develop, manage and leverage intellectual capital beyond the commodity that is the bulk of many banks’ current business models.

Not all will be able to make the leap.

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USB CEO Davis Gives Advice to Bankers

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Over the past two weeks I have been a Faculty Fellow at the Pacific Coast Banking School, the premier graduate school of banking, held at the University of Washington. It is energizing and humbling to be surrounded by so many talented students and faculty members.

At  last night’s keynote address, U.S. Bancorp CEO, President and Chairman Richard Davis gave his advice to the assembled crowd of over 500 banking leaders. Davis is known to like sports analogies as metaphors for leadership and strategic concepts, and he described the industry as being at halftime in a basketball game.

Richard Davis at PCBS

First, he described the industry in basketball terms:

The Rules: Changing

With Dodd Frank still only roughly one third finalized and work still being done to finalize global capital and liquidity standards, the rules are changing even as the game is being played. He urged the crowd to get with the decision makers and advocate for changes that might be needed, but not to complain. Complaining only gives permission to others to complain, and unless and until things change, the rules are the rules, and the team who executes the best under the rules in place will win the game.

The Venue: Poor

Davis likened the economic and regulatory pressures on the industry to playing in a poorly lit arena with a tilted floor, warped floorboards and where the air conditioning doesn’t work. What’s important to realize though, is that the competition is playing under the exact same conditions, and the team that figures out how to adapt their game to the conditions will win.

The Fans: Confused

The fans represent the customers, and they are confused because they thought they understood the rules of the game and some of their favorite teams didn’t perform very well. Some are fed up for good reason, but they will support a winner.

The Referees: Aggressive

Davis was clear in explaining that legislators and regulators all over the world are keen to prevent another global finanical meltdown, and thus are right in calling a tight game. It’s exactly what he would do if he were in their shoes, he said. Bankers need to understand this, accept it and step up their play to be successful.

The Owners: Seeking Success

Shareholders want their team to win, that’s why they invested in their franchise. Davis cautioned that the ROEs of the past few years for most banks are not covering their cost of capital, and that is unsustainable. Firms need to focus on growing revenue, lest they become takeover targets.

Halftime

He wrapped up his sports analogy by playing one of my all-time favorite clips, from Hoosiers. The undersized  team from little old Hickory, Indiana steps into Indianapolis’s Hinkle Fieldhouse wide-eyed and intimidated about their impending championship game in such a cavernous venue. Coach Dale (Gene Hackman) hands the boys a tape measure and asks them  to measure the distance from the foul line to the basket and from the basket to the floor. The players become visibly more confident as Coach Dale winds up the tape measure and says “I think you’ll find it’s the exact same measurements as our gym back in Hickory”.

In other words, we are all playing by the same rules on the same court. Don’t over-complicate it. Focus on what you need to do to win the game.

Davis then declared the game as being at halftime, and halftime is great because anything is possible. He urged the bankers to use the halftime break to assess what is working and keep it up, and to make the necessary adjustments, and most importantly to rally the team to a strong finish in the second half.

Not Just Another Lame Sports Analogy

Lest you think this is just another shopworn, hackneyed sports reference from just another executive too stupid or lazy to use his own words to describe what’s happening in his industry, you should realize that U.S. Bancorp is widely considered one of the best managed financial institutions on the planet. Their bond ratings, price to book, ROE, ROA and efficiency ratios are all absolutely at the top of the industry, and Davis has been at the helm since 2006, and has been a key senior leader there since 1993. He has a unique knack for using simple words to convey complex concepts, and the crowd gave him a rousing standing ovation.

Of course, I have my own biases. I worked for the bank for twenty years and saw Davis up close in a wide variety of situations, from one-on-one to very large crowds, from broad strategic issue to very deep operational details. He does it all very well, and he is simply one of the best leaders I have ever seen.

Even if sports analogies are not your thing, and even if you are not a banker, I think the core of the message is universal and enduring: Spend less time complaining about the rules, the refs, the venue, the fans, the owners and the other teams– just focus on what you need to do. And win regardless.

As Jim Rohn said:

“Don’t wish it was easier, wish you were better.”

© JP Nicols – 2012

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Is Bank Merger Mania Imminent?

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The results of the Federal Reserve’s recent Comprehensive Capital Analysis and Review (CCAR) stress tests have increased the long running speculation that another round of rampant bank mergers may by just around the corner. The number of banks in the U.S. is about half of what it was in 1990, and I don’t see anything changing that trend line.

The most recent spate of bank failures peaked in 2010 with 157, and despite all the headlines, this was significantly lower than the prior peak of 281 failures in 1990. But the primary driver of consolidation in the industry over time has actually been mergers, not failures. Merger activity increased every year from 1992 to 1995, peaking at 606 that year. During that run-up, the number of mergers ranged from 3.7% to 6.1% of the total number of banks.

In 2011 there were only 167 mergers, equal to only 2.8% of the total number of banks, so it would appear that there is plenty of room for additional consolidation. Stubbornly difficult rates of unemployment, housing prices and loan demand make it challenging to achieve decent ROE growth, and the stronger banks have significant advantages over the weaker ones.

Worse, all of those banks competing (all too often on price alone) for a larger share of a slow growing market will likely cause further margin erosions. And again, the stronger banks are better positioned to withstand these pressures too.

Serge Millman of Optirate recently noted that banks are battling with 27 competitors in a typical market, and that 66% of all deposits are held by banks competing in regions with 50 or more competitors!

Since 1990 there have been an average 6.5 mergers for every failure, more than triple the 2011 rate of 1.8 to 1, and the peak of the last cycle was a whopping 598 to 1 in 1997.

Throw in the hassle and expenses of complying with the hundreds of new rules coming out of Dodd-Frank (most of which are nowhere near finalized), and it isn’t hard to imagine many bank directors deciding to sell in the not-too-distant future.

Does Your Team Have What It Takes To Thrive In A New Era?

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In January of 2010 John Kim of Heidrick & Struggles wrote in a blog piece What bank leaders do you need post-crisis?:

There may be little agreement about precisely where we stand in terms of economic recovery generally or financial services recovery specifically, but one thing is certain. When the inevitable recovery gets into full swing the financial services firms that already have in place the skills and the teams to take advantage of it will far outdistance their competitors.

Now, more than two years later, the recovery picture is a little more clear, if not exactly in full swing. The rate of bank failures has been dramatically reduced but the long-predicted consolidation wave has so far been more of a gentle tide. As the economic recovery continues at an almost imperceptible pace– particularly jobs and housing prices– financial firms are challenged to find attractive avenues for revenue growth.

New regulations further complicate the picture, on everything from trading to lending to deposits, and there are still literally thousands of new rules to be written over the next few years.

So what kind of leadership do these challenges demand? I think Kim saw that pretty clearly too:

Before the economic meltdown, the top leaders of financial institutions often fell into one of two types. There was the charismatic personality who motivated, inspired or in some cases dictated through force of his own presence. And there was the hands-on, detail-oriented operator who drove performance through results and significant attention to detail.

Today’s leader needs to be a combination of both types. The operational skills and shrewd judgment of the detail-oriented leader will be needed to achieve focus, leverage strengths, work out bad assets, closely manage risk, and interact more closely with regulators and government. The strategic vision and inspirational ability of the charismatic leader will be needed to take the institution from strength to strength and into appropriate new areas, especially when the economy heats up again. 

About a year ago I gave a talk about the state of the banking industry and how its recovery was linked to the overall economic recovery. Someone in the audience asked how, seemingly, only a handful of banks were smart enough to avoid the ills that plagued so many competitors?

I replied that that was not the question, in my mind. The question was, why did so many firms forget thousands of years of history?

The banks who set themselves apart during the crisis stuck with principals tested over millenia. After all, banking is the second oldest profession in the world. You know, quaint notions like verifying borrowers’ recurring cash flow and insisting on a margin of safety on collateral values. These firms understood that lending was, at its core, a risk management activity (see my post on Why Bankers Need to Think Like Private Equity Investors).

So, how is your team prepared for this new era?

Again, from John Kim’s piece:

These teams will need to be able to make the right decisions rapidly…

They will also break complicated issues down to simple components. No matter how complex a market, a strategy, or other issue appears, the leadership team should be able to frame it in terms of banking fundamentals: liquidity, capital, credit risk, operational risk and cost control.

One of their toughest challenges will be to lead culture change. A renewed focus on core competencies and subsequent growth into adjacent areas will require a new culture, especially at institutions that sought to play across many areas.

Is your team prepared for the new era, or are they still fighting the last war?

Why Bankers Need to Think Like Private Fixed Income Investors

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Banks are in the business of taking and managing risks. Get that wrong and you go out of business, and there are many recent examples.

I have sometimes worked with advisors who view loans as just another product to sell. This type of advisor also tends to view anyone in the credit underwriting and approval process as being in the “business prevention department”. In these situations I try to explain how lending literally involves transferring some of the firm’s capital to a client, on which we expect a return of principal and a return on principal over time.

No matter how much profit the client makes as a result of a loan, a lender’s best case is getting a full return of principal, plus the contractual interest, and not a penny more.

$1 million loan x 2.00% spread = $20,000 of pre-tax, pre-provision revenue

The lender’s worst case is a complete loss of principal and expected interest, plus collection and litigation costs.

The firm that charges off that $1 million loan needs $50 million of new loans to get back to even.

And that excludes income taxes, labor or overhead costs needed to originate the loan, any loan loss reserves set aside, the cost of funds raised to lend out or any time-value of that money (i.e., liquidity issuance premium).

With that kind of mismatched upside/downside risk, it is necessary to view lending like the private fixed income investment that it truly is.

How advisors should think like fixed income investors:

  • They must seek an attractive risk-adjusted after-tax return on capital
  • They should expect low loss rates and low volatility of returns
  • They have to achieve these goals through disciplined management of controlled risks
  • Borrowers typically do not have public debt ratings, so individual underwriting must be performed
  • Borrowers typically do not have established market values, so risk-adjusted pricing must developed
  • Bankers must mitigate these risks through disciplined underwriting, appropriate credit structure and active portfolio monitoring and management.

Advisors that balance the needs of their clients with the long-term health of their firm win in the long run.