Adders or Leeches? (Future Of Investment Banks)

Are bankers valued members of society, or leeches, or leaches? It all depends on the value they add. In economics, rent seekers are those who compete through manipulating the environment rather than adding value. Rent seekers use methods such as encouraging regulation or government protection to extract wealth (rent) without improving productivity. If it sounds like a term of derision, it is, and is frequently associated with other terms such as lobbying, bribing and corruption. Wholesale banking may be at a cross-roads. Down one road lies a free-wheeling, value-adding industry; down the other a shrinking oligopoly of banks share their takings from exploiting customers.

Pressure Cooking

Banking has had its ups and downs over the centuries and society certainly has had good reasons to regulate it to some degree. In an age of cheaper information, where consumers and businesses should be able to make commercial decisions with lighter regulation, counter-intuitively we see more cries for regulation. While consumer banking stagnates, ask a man on the street not a banker, wholesale banking clients are changing, trading volumes are skyrocketing, margins per transaction are tumbling [see Zero Marginal Competitive Cost (ZMCC) box below] and banks are choosing differentiated strategies - Merrill Lynch is dumping its fund business while The Economist wonders whether Goldman Sachs is just one big hedge fund, and a risky one at that.

The rise of new investment houses, particularly hedge funds, is restructuring the industry, and numerous firms are rising to the challenge of serving them, not just as prime brokers but also providing accommodation, support services or staffing – an outsourced service for everything but the investment strategy. New client charging systems, new regulations, new legislation, new technology, financial scandals and reputational risk all put pressure on wholesale banks. For all players, innovation in customer service, products and operations is believed to be essential. For volume players, the strategies are clear – efficiency, service, control. For marginal players with volumes below the efficiency threshold, and for all players unable to generate returns for shareholders, consolidation looms. Unless some banks start to play the regulatory card!

Commodity Plughole

The first thing to expect in an industry under transformation is a radical re-alignment of players. Consider the forces of competition using Professor Shiv Mathur’s work at City University. Shiv maps generic competitive strategies by concentrating on the interface between an organisation’s offerings and its customers. He sets out a diagram with four competitive strategies – commodity, product, service and system. The four types of strategy are dictated by the amount of ‘hard’ merchandise and by the amount of ‘support’ needed. If we look at wholesale banks we can see the four strategies in action: large scale warehouses already sell custody as a commodity and one can expect more, such as ‘commoditised’ prime brokerage services or corporate actions support; elite suppliers try and brand their product so we care about the label; national or local firms provide a hand-holding service to major corporates or wealthy individuals; some of the biggest firms compete in trying to provide a complete global solution.

New offerings start off in the top right box as systems. The first computers, the first automobiles and the first aircraft were all offerings that couldn’t just be bought. They needed people who understood precisely how they had been made; people who could repair them at short notice; people who would work with the new owners on improvements. So too with wholesale banking, but the evolution of choice is part of the evolution of industries. As competition intensifies, standards emerge, mass production becomes the norm, people are clearer about what they want. The flow in this diagram is from top-right in the System box where new complex products emerge to down-left in the Commodity box. How do you know you’re in the Commodity box? I would claim that “you’re selling a commodity when buyers don’t care who you are.” Increased advertising is a strong sign that people are trying to swim against the tide flowing down the commoditisation plughole, by emphasising the choices we face, whether real or illusionary. This may be an indication that even the consumer banking market may, over a generation, see real change.

Wholesale banks are transforming through outsourcing. Everyone screams about outsourcing and off-shoring, shared services, even near-sourcing. We expect outsourcing to continue even more ruthlessly than before as ZMCC bites. As banks outsource, this will reinforce the globalisation of the investment banking industry, forcing banks to care about global access, security and regulation. But banks also in-source, they seek business as outsourcers themselves. In each generation a few banks move aggressively into the commodity box; the last generation saw some move into custody operations. In this generation some could move aggressively into commodity boxes such as prime brokerage, crossing networks/MTFs, independent investment research or algorithmic services.

Mass Customisation

Business people have been talking for a few years about Chris Anderson’s idea of the “long tail” of the statistical distribution of interest. The idea is that the internet allows firms, for example Amazon, to make money by supplying people with a full bookshop of rare, infrequently ordered books. A traditional bookseller would go broke on space cost alone stocking such low frequency items, but an online bookseller can turn lots of smaller pieces of inventory into significant market share. We see a fantastic range of choice (thought why is it that with so much choice, everyone buys The Da Vinci Code?). Can wholesale banks find ways to deploy thousands of micro-products effectively?

Technology is helping other industries to swim against the tide by undermining the efficiency of commoditisation. Industries are successfully moving away from mass-produced commodities and toward personally customised services. Hardware and software companies now allow you to specify a customised computer online and have it delivered in days. Airlines let us do things personally that formerly had to be done through agents. Drug companies hope to be able to move from general prescriptions to highly effective, personalised drug combinations specific to just one person’s DNA.

Wholesale banks are taking customer management increasingly seriously. First, banks recognise that customer profitability can be far more important than customer volume. Second, costs of customer churn can negate efforts to acquire customers. Third, efficient handling of customers requires exquisite and sophisticated information technology. Some banks are trialling advanced techniques such as dynamic anomaly and pattern response in the hope of giving each customer exactly what they want, online, efficiently. In the Far East one finds “Temples of a Thousand Buddha’s”. In their day, one showed devotion by constructing at great effort a thousand identical likenesses at a time when everything was a “one-off”. Perhaps we will renew this concept of worshipping the wonder of mass production when we look back from the near future where all wholesale banking relationships are personalised, specific to each client’s corporate DNA.

Regulatory Rents, Bring Them On!

Sadly, from the consumer side, irrationally excessive compliance may be rational. Echoing Caplan’s argument about irrationality in economic choices - compliance is a good to be consumed like any other. The less it costs a person, the more of it they buy. As the costs to any individual of excessive regulation are virtually non-existent, the private cost of excessive regulation is zero. Thus it is not surprising that excessive regulation thrives where it is spread over huge numbers of people, though these people may regret excessive regulation when they get stuck in the bureaucratic hell of working through it. However, the costs can be crippling to small firms.

While the burden of regulation and compliance is increasingly rapidly, how are wholesale banks responding? An old Chinese proverb applies – “what you cannot avoid, welcome”. Managing regulation and compliance is becoming a core business skill for many. But, “what should our response to regulation be?” is not just a compliance question, it is a strategic one. Whatever the response, the answer is not outright rejection. Even for those who may hanker after wild, unregulated markets, there may be a particularly good reason for welcoming a small set of externally verifiable standards. Standards markets, e.g. such as ISO9000 or ISO22222, using commercial assessors is potentially a sensible market response to regulation - a ‘third way’ between complete anarchy and intrusive regulation.

Some wholesale banks (dare I say this?) seek regulation as a means of exclusion, of extracting surplus rents. Encouraging regulators to set excessive capital requirements, adding complexity to obtaining banking licences, lobbying for overly-burdensome data protection, working with governments to favour national champions or becoming too cosy with unions – these are all ways to muffle competition. This is the dark side of regulation, leading to bribery, corruption and social despair.

Wholesale banks I know are not evil. But an ability to handle regulation better than others should rationally drive shrewd banks to seek regulation. It is amusing to hear banks criticise their clients for lack of foresight, but then observe how most banks fail to foresee the next set of regulations. The scale of Basel I and anti-money-laundering were a surprise, now it’s Basel II and MiFID, and will be numerous things already in the pipeline. While most banks implement a new system for each new set of regulations, or muddle through with patches so ill-thought-through they can’t validate compliance, a few shrewd banks have realised that their core systems skill is their ability to deploy new intelligence and compliance processes rapidly. If they do this better than others, it is rational to seek increased regulation as a means of disadvantaging their competitors. Their ability to handle regulation better than others stems from novel information systems architectures that permit them to add new anomaly detection and tracking at will while their competitors lag behind. This also makes them more robust.

The Robust Risk-Seeker

Much print has been spread about the importance of risk and risk management, but perhaps the term we should be considering is “robust”. If the wholesale bank of the future is to resemble today’s, then it must be a more robust bank. If the wholesale bank can turn compliance from a burden to a streamlined way of staying on top of the business, it will be a better bank. Further, this gives benefit to having multiple business lines. Combined with an ability to deploy risk capital differently in changing circumstances, banks are less exposed to the charge that they are conglomerates. The efficient use of risk capital and the skills needed for efficiency in compliance would justify a consolidated wholesale bank, rather than one to be broken up for its parts. Risk capital allocation and compliance efficiency are key metrics for fitness – a robust bank is well-capitalised and on top of things. We’re back to the dawn of banking.

The big strategic question facing the wholesale banking industry is how it wishes to compete – as a value extractor or a value adder? Expect to see quite a few brawls as different institutions make different decisions in different countries. A constipated group of social gougers hiding behind national regulatory walls would be local dystopia. Global utopia is a group of vibrant, value-adding institutions competing in open markets.

Wholesale Zero Marginal Competitive Cost (ZMCC) – Pressure for Volume, Pressure on Clients – and no Sloppy Clients!

Trading volumes are increasing rapidly while margins per transaction are falling. The link between commission and cost has broken down as large buy-side clients break their business into smaller orders. Regulatory changes, new legislation, new technology, financial scandals and reputational risk all add to the pressure. Welcome to the stressful world of second tier wholesale banks.

Because every trade incurs clearing & settlement fees, exchange costs, or CLS charges, wholesale banks’ marginal costs will always be non-zero. But some of the larger wholesale banks may be getting to volumes where they approach Zero Marginal Competitive Cost (ZMCC); no one else can process at a lower cost. Some are out to seek all business they can get.

Intense cost pressure may be a positive sign, a sign of an industry moving to the next level of maturity. Looking just at European cash equities, we can see per-trade cost reduction over the past five years due to increased volumes being handled at decreasing cost, largely through automation. The largest equity traders handled around 10M trades per annum in 2000, now nearer 40M. The cost per trade even for the largest players was still above $2 in 2000, now it’s more like $0.25. With “per-trade” as the denominator, volume matters in getting cost/trade down. The pressure increases for those unable to get to efficient levels of capacity or unable to scale the costs of processes in line with demand. However, larger volumes, poorly-processed, increase costs.

Competing on ZMCC, wholesale banks are moving from craftwork to functioning more like power plants or sausage machines. However, the pressure doesn’t stop. Things are getting faster. The evolutionary progress from today’s raw idea to tomorrow’s boring, high-volume commodity product line has sped up. Products move from exotic to vanilla in a few years, not a decade. This puts more pressure on the client-facing side to provide innovative highly structured products in advance of the wave of commoditisation. It also puts pressure on operations & IT for bottom-up innovation that increases efficiency, service and control.

Finally, some banks are ruthlessly analysing their customers. A vanilla trade can be executed for pennies, but only if the customers are equally quality-focused and cost-conscious. The minute there is a problem and a trade steps out of straight-through-processing (STP), people have to fix the problem. And people cost, sending the cost-per-non-STP-trade up to hundreds of dollars. The very savviest banks are, albeit gently, dumping customers who ruin their STP in order to increase profitability, sometimes markedly. Others are trying to fix the supply chain by working with customers. Others are hunting for better quality customers using market intelligence. In time, sloppy customers may find themselves unable to find a prime broker.