1) H1: Banking is increasingly becoming more and more sophisticated. This means you can’t expect average people to do every possible job in banks. More and more jobs are going to become sophisticated with time. With this, banks will need more and more high tech IT systems to support the running of business. All this points to only one thing – investment per dollar earned is only going to increase in the future (unless there are significant economies of scale and scope).
2) H2: Credit crisis dealt a big blow to the banking industry. Politicians world over are under severe pressure to not only bring the world economy back on its feet but also ensure such a thing never happens again. This clearly means that we can expect more and more political interference in this industry in the long run (it is obviously happening at the moment).
In a sense, the above two are counter balancing. Point 2 will try to curb innovation to some extent which will slow down the accelerated sophistication which has become second nature in banking industry.
To validate my hypothesis 1, I expected increasing difficulties for smaller banks and decided to check with some hard facts. Here is what I found.
The number of banks in the US which had assets less than $100million, have come down significantly. This is no surprise. With increasing overhead expenditures, the smaller banks don’t have the wherewithal to match the bigger banks in terms of a) money spent on research to launch new and relevant products b) the economies of scale which justify increasing overheads for only the bigger banks c) hiring the right talent for specific roles which can only be justified if such roles generate enough revenue.
Let us look at the picture from another angle. A few months back, Celent published a report titled “It Takes More Than a Village: The Decline of the Community Bank”. It clearly stated that banks with assets under $100 million are bleeding deposits. Here is a quick peek:
Clearly smaller banks no longer have enough deposits! The report notes: “Running a bank requires a certain amount of scale, and that floor is rising due to increasing regulatory requirements, channel support, and product support”.
Now, let us try to link all of this with what happened and is continuing even now with respect to credit crisis. On both sides of the Atlantic we have people shouting “these banks are too big to fail”. A part of the reality is brought out by the figure one above. Number of banks with large assets has actually increased. Naturally, in the process, some banks have become too big to fail.
The tendency towards becoming bigger is not only driven by increasing costs but by a number of different synergies which all ultimately combine to give higher profits. A study done by Federal Reserve Bank of St Louis confirms this. For a selected set of banks, a study on profits shows these results for PAT/ Total Assets:
Clearly, banks having lesser assets struggle to be profitable.
Having established hypothesis 1, let us focus on hypothesis 2. In their quest for increasing profitability, some banks have outgrown themselves and thus have become a source of systemic risk. This thought now is echoing across the world. Political ramifications are obviously going to be far reaching.
When the crisis first broke, UK took the lead in saving banks by nationalizing them. US followed. Now, UK has taken the lead in breaking up these big banks - Royal Bank of Scotland, Lloyds Banking Group and Northern Rock. Whether US follows or not, remains to be seen.
Having established the nexus amongst size, profitability, risk and politics, let us ponder over the resulting impact of the two hypotheses stated in the beginning.
While H1 pushes the banks towards bigger size, H2 seems to be pushing at the moment towards smaller size. Let us hope the necessary equilibrium is found soon enough. The fact that we can’t really have big-sized banks is obvious – the implicit government backing of such organizations (because they are too big to fail), allows these banks to get capital at more favorable terms, which isn’t fair or competitive. Therefore, there is reason to believe that US also will at least try to cut some banks to size. There is a slim chance of a variant of Glass-Steagall Act being passed as well.
Conclusion
For smaller banks to be continually viable, they need to focus on the segments of the financial services industry where they have comparative advantage. These segments involve personalized service and lending based on information not available to other firms in the financial services industry, because they derive the information through their relationships with their customers.
The operational overheads can be handled with some innovative thinking. E.g., sharing ATMs with a bigger banks gives the required reach without actually rolling out themselves. Hiring the right people and making the right IT investments remain the key for such banks. Only if they do all of this can they survive. Of course, with the increasing political support, there could be additional help in the form of supportive legislations. However, it seems likely at the moment that banks having balance sheet of less than 100 million USD will continue to struggle for survival. Banks with the intermediate size will continue to consolidate and will move towards better profitability. Having said that, let us remember that the biggest bank, by assets, Bank of America started as a small bank (Bank of Italy) meant to help Italians settled in California.
As far as the bigger banks are concerned, in some cases the economies of scale are outweighed by the difficulties in controlling risk inside them. There will continue to be pressure on such banks in the future. We can reasonably expect some more banks to sell parts of their business in the foreseeable future. However, the profitability concerns will keep this drive limited. We have already seen a glimpse of this. For instance, if you look at the list of banks getting TARP money, many are not even in trouble. Some have already made ”arranged marriages,” such as PNC which quickly acquired National City Bank with some of the TARP money.
All of the above bodes well for IT industry. The increasing sophistication in the industry only means that need for better and newer systems will remain. Splitting of banks into smaller businesses will bring its own set of IT needs. Finally, the opposing and balancing act of becoming bigger would mean continuing work in terms of integration of systems.
References
1) “The future of Small Banks” by Alton Gilbert, Federal Reserve Bank of St. Louis.
2) http://smallbiztrends.com/2009/02/death-small-community-bank.html.
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