The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Monday, April 18, 2011

Why banks should ape Apple...

Many believe that our banking system is saturated by four ‘oligarchs’. It is true that, by definition, these institutions will find it hard to grow faster than national income, which is destined to sit in the single digits.

Yet latent opportunities lie in wait for both the big banks and would-be competitors. I would contend that securing success in the future will require two, complementary things: a complete redefinition of what ‘retail banking’ means, and an unwavering commitment to innovation. These sound like glib statements. But one thing I have learnt is that change is tough to implement. And the degree of difficulty rises with an institution’s size. So these opportunities will, in all likelihood, remain for the courageous to seize.

A germane but rarely asked question is why haven’t there been any new entrants into Australia’s retail banking space in over a decade? This is, after all, an incredibly valuable market that accounts for over $1 trillion of deposits, and around $250 billion per annum of new home loans. One can add the rapidly growing self-managed super sector to these figures.

The last meaningful debut was ING Direct, which in 1999 successfully stormed the savings and loan markets without the benefit of a branch network. Within a few years, ING Direct had risen from no retail presence at all to having accumulated more than $15 billion in domestic savings, and ranking as the nation’s fifth largest lender ahead of Suncorp, Bank of Queensland, and Bendigo & Adelaide Bank.

ING Direct had one special advantage: an overseas parent that was willing to supply it with funding support to deliver superior interest rates. It is questionable whether this could ever be replicated again in a post-GFC world where banks are being increasingly punished by regulators for their offshore exposures.

The most likely explanation for the dearth of entrants is that it is just bloody hard competing against the four incumbents in the core savings and loan domain. The majors have higher ratings, which means they can raise funding more cheaply. They leverage off powerful economies of scale, which means their unit processing costs are lower. They can generate valuable second-order synergies through selling customers across product classes, which permits lower overall prices (or higher margins). They have enormous, national branch footprints that allow them to avoid the more expensive third-party distribution channels that smaller lenders rely on. And they are, for all intents and purposes, too big to fail, which means creditors are more comfortable extending them money during times of crisis. Witness, for example, the flight of depositors (who are creditors) during the GFC away from smaller banks, such as ING Direct, Suncorp and Bank of Queensland, for fear of their failure.

In the scale enterprise that is banking, big is often better. This is most strikingly borne out by reported return on equity (RoE). Based on APRA figures, the major banks' RoEs have been consistently several hundred basis points higher than their smaller banking peers over the last decade or so.

The market power of the monoliths can also make acting as a cog in their value chain hard yakka. The distribution of financial products is increasingly a commodity game as the majors have consolidated both the funds management and financial advisory sectors. Third party originators, like mortgage brokers, had the economics underpinning their operations slashed by the majors during the GFC as smaller lenders fell by the wayside, and the incumbents sought to funnel customer flows into their cheaper branch networks.

At the same time, regulators have lifted the training and licencing costs associated with selling financial products (and mortgages in particular), while trying to phase out conflicts of interest posed by more attractive commission-based fee structures.

I would nevertheless argue that the business of ‘retail banking’, which has, in many ways, remained remarkably unchanged for decades, needs to be overhauled. More particularly, I think current and future participants would do well to ‘ape Apple’. In short: simplify complexity through convergence and bundling.

To be sure, there have been changes to the sources of funding, and the manner in which products are delivered to customers as a function of, respectively, securitisation, and the new competition this enabled, and the Internet, and the profound efficiencies it unleashed. Yet the underlying service relationship between customers and the people at banks they deal with has not evolved in lock-step.

It is instructive here to reflect on some history. Retail banking in Australia has undergone several distinct phases. Post the Hawke-Keating deregulation wave, the most vivid of these was the emergence of the non-banks--eg, Aussie, RAMS, and Wizard--funded via the securitisation markets. These new businesses in turn facilitated the growth of the non-aligned ‘mortgage broking’ models (eg, Mortgage Choice), which could work on behalf of a multiplicity of product suppliers. Yet the non-banks only ever competed on the ‘asset’ side of a bank’s balance-sheet—they never offered deposits, and never got into financial advice.

This infusion of competition compressed once-fat mortgage margins, and precipitated a laser-like focus on cost cutting. It just so happened that these events occurred at the same time as the Internet--and the new modes of communication it liberated--was starting to proliferate. The response of the banks was to invest enormous amounts in front and back-office technology in an attempt to cost-effectively streamline customer management and product processing. For a time there, physical branches were even slated for the junk yard, although this did not last long.

While there have been hic-cups along the way, there is no doubt that banking today is a vastly more convenient and efficient exercise than it was two decades ago.

Having said that, the fog induced by the non-bank war and the transformative effects of the Internet blinded most participants to the changing complexion of their customer base. Once upon a time the largely uninformed (and homogenous) masses were contrasted against a sophisticated, high-net-worth, and more demanding minority.

I would argue that a range of forces have permanently changed this game. These include the revolution in intelligence wrought by the Internet, the rise in the female participation rate (and thus two financially-engaged bread winners), higher rates of secondary and tertiary education, the shift towards a service-based economy, and the inexorable ageing of Australia’s population.

In 2011 a bank customer can walk in off the street armed with extensive knowledge about competitor pricing, product options, the pros and cons of different asset-classes and savings alternatives, sensible views on their retirement and tax planning requirements, and independent reviews and analysis of all of the bank's product and service performance. And these customers are only getting more financially literate over time.

The problem is that the banking industry was not designed with the democratisation of information and financially-enlightened 21st Century men-and-women in mind. It was built on the basis of segmented customer clienteles. And so today we are stuck with a disparate hodge-podge of distribution mediums: bank branches that deal with savings and loans; financial advisors that furnish retirement advice; third-party mortgage and insurance brokers; accountants that manage tax returns; private client stockbrokers flogging shares; electronic direct trading platforms, like CommSec; and, to make life a little more confusing, attempts by all these channels to overlap one another.

Yet the informationally-empowered consumer has rendered much of this segmentation obsolete. Customers find the tyranny of choice, and the conflicting services that accompany it, very frustrating. In many ways, financial services are too disaggregated. What Australian households yearn for is a simple aggregation of solutions, much like Apple does so successfully across the once-independent computing, telephony, TV, Internet, music and general media spaces.

I think Australians want the opportunity to tap into a single customer portal that aggregates (and reconciles) all their basic and not-so-basic financial needs. They want what I would call retail ‘convergence’. A place where they can squirrel away regular earnings in safe savings facilities. A place that can look after their home loan. A place that can map out their life-cycle super and retirement needs. A place that can assist with tax and insurance advice. And a place that can offer a menu of higher-risk investment alternatives. It sounds obvious, but this ‘single-source convergence’ doesn’t really exist. Many will claim it does, much like those who populated the Intel-Microsoft complex. But the truth is that the disruptive, Apple-style of retail banking has yet to be built.

One important thing to understand is that convergence necessitates much higher quality, multi-skilled staff. The Apple approach to banking offers one voice—be that via a shop-front, online, or over the phone—supplying, at a basic level, all of the above services. One person helping you clarify your product needs, one person working out your risk profile, one person writing the home loan, one person explaining the savings solutions, and one person rendering basic retirement, tax and insurance advice. Those more exacting (wholesale) consumers can be siphoned off into a higher value-add and more costly private banking realm, or discarded altogether for other, specialist companies to capture.

If future banking is all about convergence, it is also, just like Apple, all about innovation. Unfortunately, innovation got a bad rap during the last crisis. Some regulators have even canvassed thwarting innovation. But it is only innovation that can, in the long-term, improve our living standards. Innovation is the engine responsible for human progress. And, unsurprisingly when you think about it, innovation goes hand-in-hand with failure. In order to improve our way of life, we have to first confront failure. It is by making mistakes, and establishing what does not work, that we eventually learn what does. Ask Steve Jobs whether there is any short-cut to inventing stuff. While luck certainly plays its part, most advances in human knowledge come about through an iterative process of trial and error.

We therefore want an economic system that actively encourages entrepreneurs and innovators to take risks, to try to go where nobody has ventured before, and, for a fortunate minority, to eventually prevail through persistence (reaping commensurate rewards). Think of all the failures that preceded everything that we take for granted in our lives: the medicines, vaccines, cars, telephones, computers, x-rays, aeroplanes, TVs, credit cards, savings products, and so on. Each of these inventions can lay claim to graveyards full of failures.

In summary, there are diminishing returns to efficiency and cost improvements in retail banking. The highest-growth firms of the future will be those that seek to creatively redefine their service models, and engineer valuable new savings and investment experiences for their customers. And here there will be opportunities for new entrants, which don't suffer the baggage of legacy platforms and switching costs. New entrants also probably have the advantage of fresh, unencumbered thinking.