Are banks to big to change?

Reformists and regulators in the US, in the EU and in other jurisdictions are grappling with the problem of massive banks and how their financial health is tied up with the very vitality of the economy. This happens because as the banks are so large and represent a major indicator of the health of the stock market, and thus the macro-economy, it is possible that one of them went under it would have deleterious effects on the economy at large.

In the US space JP MorganChase, Wells Fargo and Bank of America are all in the top 20 traded stocks by market capitalization, Citibank makes an appearance also in the top traded stocks by volume. If either of one of these 4 banks were to go under, the effect on the stock market and the economy would likely be devastating. This is the classic argument of those that support the ‘too big to fail’ position.

There is another factor at work here, however, these organizations are structural behemoths. Between these 4 organizations, they employee just under 1 million people in North America alone. Between Google, Microsoft and Apple these top tech firms manage only 150,000 employees. In a tough year financially, the big 4 banks struggled with collective profit of $21.4Bn, while the top 3 tech firms reached a whopping $29.3Bn in operating profits.

To put this in perspective employees of the top US banks contributed roughly $22,256 each to the profit of their employers, whereas tech employees amassed an impressive $195,973 each as a contribution to the bottom line. This difference in core profitability comes from relative organizational efficiencies and the ability to generate new revenue streams through innovation.

As banks have grown, they appear to become less efficient at generating returns for shareholders. This is where the issue of proprietary trading comes in. Proprietary trading has been used by banks in recent years to generate arbitrage opportunities for profit taking where shrinking margins no longer allowed the same. However, proprietary trading turned out to be an extremely risky way of earning profits during the financial crisis with bets on CDOs going the wrong way and banks getting hammered as a result...

“Merrill Lynch lost nearly $20 billion… Morgan Stanley had a nearly $4 billion loss in proprietary trading in [Q4] of 2007. Goldman Sachs spent $3 billion to bail out one of its hedge funds… Citi lost big — as much as $15 billion, on the CDOs it decided to hold rather than sell off…”
Stephen Gandel, Is Proprietary Trading Too Wild for Wall Street? Time.com, Feb 5th, 2010

So in an environment where product margins are being squeezed, markets are struggling (further reducing margin on investments) and where prop trading is under the microscope, where are new revenue opportunities to come from?

There are a raft of innovations rapidly occurring the in financial services space at the moment, largely independent of the banks. Smartypig, as one example of a cooperative model with traditional players, has developed a platform that has put a unique web 2.0 approach to deposits. Since launching in April of 2008, Smartypig has already taken deposits of more than $400m and are well on the way to more.

P2P lending, derided by traditional players as risky and unregulated, has started to generate some serious looking results. In May the Lending Club, a P2P collaborative social lending network, passed more than $10million a month in Loan Originations. Zopa, another social lending network based in the UK, is approaching half a million users who are happy to lend and borrow to each other.

In the payments arena, there is a plethora of competitors to the mainstream card issuers Visa and MasterCard. There’s PayPal, who continue to go from strength to strength. There’s Square, founded by Jack Dorsey of Twitter fame. More recently Facebook has entered the P2P payments space too.

The thing is – all of these really interesting innovations in financial services are being driven not by banks, but by start-ups, technology innovators and much more agile organizations. Why aren’t the banks at the forefront of these improvements?

The issue lies in two core hurdles. The first is organizational inertia, the fact that for a very long time banks have focused on an organizational structure that is built around the branch as the core of the customer relationship. Products are manufactured around the branch, and marketing is limited to either branding or campaigns of the month. The most senior bankers in the organization are generally those from the ‘distribution’ side of the business. It all works like a grandfather clock.

The second issue is that banks have a metrics and financial system that is fundamentally flawed. Today bank strategy is reinforced by line item budgets that were built during the branch era, and management teams dominated by bankers with 30 years of traditional banking pedigree heavily invested in their real-estate.

These two hurdles are leaving third-parties to innovate the customer experience, and evidently this is where the intersection of changing consumer behavior and business models is creating real opportunities for improved revenue and profitability.

Banks need to hive off a portion of their best people, along with some new aggressive Y-Gen and digital native thinkers, to start thinking out of the box in an independent, cashed-up tiger team. This can’t be under the traditional organization structure because it will otherwise die a slow and agonizing death. This has to be about incubating very different approaches to an otherwise very traditional business, and it can’t happen within the current structures or environment.

Future EPS depends on it!