Cost cutting, playing catch up and layoffs, all the hallmark signs that you are in a slow growth or dying company. I am not there yet but the signs are worrying. Is banking in general headed this way?
Banks definitely do not find themselves in a high growth area at the moment, rather they are starting to find their place in a new ecosystem. China seems to be at the forefront of the “online financial store” concept. 70% of all the payments that Citibank processes in China are through AliPay, the payments business of Alibaba. The bank is also connected to social media platforms like WeChat and LINE. These tech companies have essentially cut out the banks from the client facing part of the business and relegate them to utilities that handle back end customer accounts which hold deposits, ensure compliance and process transfers.
Banks in places like the US maintain expensive infrastructure: physical branches, in house custom built technologies, not to mention owning and renting commercial real estate in some of the most expensive markets. Tech firms can now reach customers bypassing these expensive legacy systems through smartphones and the internet. They have created new and innovative ways to both snatch transactions away and consolidate business from, the big banks.
Take foreign exchange for example. The old way was for banks to build up large reserves in various currencies or to aggregate retail needs and purchase foreign currency wholesale from large dealers. Companies like Transferwise however, take a different approach, it matches for example an American traveling to France who needs Euros to a European traveling to the US who needs dollars. It acts as a middle man for dual demand and makes what can be thought of as a finders fee. This cuts out 2 spreads that the bank may charge but the end customer never sees: the mark up it charges to the customer and the markup the bank pays to the currency wholesaler (or cost to maintain foreign currency liquidity reserves on its balance sheet).
Lopsided Growth
However the growth has been lopsided. Tech companies are good at a number of things. Many of those things tend to deal with the masses: analyzing, predicting and classifying data on large numbers of people being able to spot large scale trends as well as drill down to demographics for their advertising clients.
This naturally bleeds into the part of banking that has to do with the masses: retail banking and payments. Even wealth management can benefit from automating standard advice and cutting out the human element. This may explain why some of the fastest growing parts of the fintech world, the parts growing faster than banks in general is concerned primarily with payments and linking payments across platforms and products.
Source: The Economist
The evolution in market cap in the financials space has come almost exclusively from the payments business. Interesting enough, most of this has shown up initially with traditional payments processors like Visa and MasterCard, the latter of which used to be owned by a consortium of banks. Payments it seems are leasing the way in the erosion of the banks markets.
Payments Apocalypse
Every year I attend a banking event which will go unnamed, that is unique in the industry in that it includes both senior people in the areas of payments as well as other parts of banking and younger less experienced bankers. By chance I caught myself at a table at one of the receptions with all fellow millennials and Gen-Z workers. As the more senior bankers presented and patted themselves on the back for another successful year fending off the threat of the fintechs, I could see the collective eyes roll at my table. When I discussed this with them afterwards, almost everyone was in agreement: banks were moving too slow and were too conservative, they felt they were eventually going to be swallowed up in a tech wave.
As bank employees, they all had bank accounts but as younger folks they also used all the latest apps to their advantage: Transferwise internationally, Venmo, PayPal, GooglePay, ApplePay, Splitwise When going out with friends and even Revolut for multi country banking. When apps like these dominate the client facing experience, they can direct the client where they want them to. Be doing payments with other services like wealth management or insurance, potentially from other companies. On the back end these companies wanting to offer the products end up becoming the clients of the tech companies because tech becomes the gateway to the end consumer, simule to what we are seeing in retail and advertising. The only area where banking can fend off tech is in the deposit holding space, where they can manage the idle cash of consumers and a ton of regulation and government monitoring keeps the tech companies at bay.
In addition to losing out on the client experience, the low interest rate rate environment has sapped the profitability of banks even further. Net interest income or NII which is the difference between the rate banks lend at and the cost of their funding, is seeing further squeezes with the fall in rates. Add to that rising loan losses with the fallout to business from the Covid inflicted recession and you have all the hallmarks of a struggling industry that is ripe for even further consolidation. It’s no wonder that we have seen even more large mergers recently such as with Truist Bank and Morgan Stanley’s purchases.
What Does This Mean for You?
So what do all of these developments mean for investors? It means that financials, and banks in particular seem like the classic value trap: facing significant competition headwinds with a lackluster outlook for industry growth, albeit with seemingly attractive valuations. The Fed has announced that rates will remain at zero until at least 2023, bond yields are at all time lows and even the return to capital is being restricted by the Fed through bans on buybacks and dividend increases.
Valuations remain the lowest across the US market with a forward P/E around 16 and a B/V around 1.1x. The dividend yield for the sector of 2.6% is greater than that of the market as a whole which is around 1.5%.
ETF’s like the Financial Sector SPDR Fund (XLF) have been been second to last in terms of performance this year, only better than energy. The year to date return for the sector is -16% while energy has dipped almost -47%. Tech on the other hand, is up over 36% year to date. It’s clear where investors see the momentum. In terms of overall performance even utilities have beat financials over the past 1, 5 and 10 year periods, all with a higher dividend yield most of the time.
The one bright spot may be those companies that look like good targets for acquisition or fill particular niches. Slow growth means consolidation in just about any industry and small regional banks will struggle to match the IT investments of behemoths like Citi and Bank of America. Banks that lack a footprint in particular regions like the south may look to snatch up a name ingrained within the area. Think Regions Bank or Fifth Third.
Additionally, although the field is getting crowded, those banks specializing in the ultra high net worth wealth management customer segment tend to have unique specializations and sticky customers. If you are worth $200k it may be easy to drop one wealth app for another. If you have $10 million or $20 million and manage an estate for your entire family, it may be much more cumbersome to move to a new wealth manager that is intimately familiar with your situation.
Not Over
Banks will still have a place in the plumbing of the financial industry, even with significant disruption. Their expertise in terms of regulation and balance sheet management as well as credit risk will be difficult for tech to match. One of the last barriers to more and faster consolidation we may see in the coming years however is the cultural difference in the workforce from tech. Tech’s throw it against the wall and see what sticks, freewheeling innovation deviates strongly from the ultra observar is banking culture. I would say that even here, US firms are ahead of the game. Many banks in Europe and Asia have pushed employees back into traditional offices while US firms seem to be embracing work from home for most, even if reluctantly.
This was evident in a survey done by consultant PWC in 2016 that looked at the main challenges tech firms and banks faces in their collaboration.
Source: PWC
For the tech companies, differences in management and culture topped the list of challenges. Based on recent comments from Wells Fargo CEO Charlie Scharf, they still have a long way to go in terms of their thinking.
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