#6 of our top 10 Fintech predictions for 2017 was:
“Analysts covering Banks will start referencing Fintech disruption when referring to a drop in profits at a major bank. Carried over from 2016. I believe Fintech disruption was the root cause of the Wells Fargo scandal, but this was not a generally held opinion.”
This post will look at why a major decline of profitability at big banks is inevitable and will look for signs that this may be imminent. The post will conclude with some investing/trading options based on this analysis.
Why we only look at Wells Fargo and Lloyds Bank
To start tracking measurable impact of Fintech disruption, we look at two big banks that have been rewarded by investors with a premium valuation – Wells Fargo in America and Lloyds Bank in UK. The 10-year chart of these two stocks compared to an ETF of bank stocks shows the scale of the premium valuation.
Investors like both these stocks because:
- They stick to one country that they know very well – America for Wells Fargo and UK for Lloyds Bank.
- They mainly focus on Consumer Banking – avoiding big exposure to Investment Banking.
- They have strong balance sheets.
Sticking with these two banks avoids getting results skewed by:
– fear of another Lehman event (impacting banks with a weak balance sheet)
– Political risk e.g a return to something like Glass Steagall (impacting banks using retail deposits for a big play in investment banking).
It also makes sense because consumer Fintech innovation has been happening for a long time, but is more nascent in Investment Banking. In short, the consumer Fintech tsunami is a lot closer to the shore.
Why loss of profit is inevitable
This is very simple – the cost to process a transaction via mobile phone, or maybe call center for complex issues, vs via a branch. As more transactions go digital and remote, those huge branch networks turn from an asset to a liability. How close we are to that tipping point is the big question, but nobody seriously disputes the inevitability of most consumer banking being branchless in future. If you dispute that, try raising money for a new venture that sells financial services via your own branch network; selling via grocery stores or Post Offices does not count as those channels are also competition to a bank’s retail branch networks.
Cross Selling & KYC
Cross selling has been the mantra of banks with big retail branch networks. They talk of omnichannel – branch staff + ATM + website + mobile + call center – and the Customer Acquisition Cost of cross selling vs acquiring a new customer. This makes a lot of sense because KYC rules mean that acquiring a new customer is very expensive; that will change as KYC artifacts become digital (see this post for details). There is no question that consumers like the convenience of omnichannel; who does not like having options? The question is the profitability of those customers. That is where cross selling comes in.
The problem is that banks find it is harder to cross-sell because their leverage over customers has decreased.
Historically, banks were one-stop shops for most consumer financial needs. If you had a current account, you also probably had a deposit account and a loan account and a credit card. The unbundling of these services makes it easier for consumers and businesses to shop around, and not surprisingly, the best providers aren’t always the banks they have done business with for years. The rebundling by new services that give consumers a holistic view across multiple accounts further commomditizes the bank/consumer relationship.
No, problem – just put more pressure on the sales guys! That is what happened at Wells Fargo.
Good cross selling will never go out of fashion, but banks need products and services that are competitive on price and feature and user experience. That is a lot harder than increasing the targets of the sales people.
Of course, that’s easier said than done, particularly given some of the challenges in recruiting digital talent, but it’s the only real solution.
The good news is that banks that can improve their products and services, and develop innovative new ones, will not only be in a better position to cross-sell to their existing customers, but to use those products and services as a wedge to lure new customers who do business with other banks. The bad news is that other banks a well as Fintech startups will be wooing your customers with the same strategy.
A level playing field is a big problem for banks that grew up with one tilted in their favor.
Why you cannot forecast when a drop in profits at a major bank will be revealed to the public.
The Wells Fargo scandal is a story about digital headwinds meeting a “make target at all costs” culture. In this post we outlined the Creative Destruction 7 Act Play. Two acts are most relevant to Wells Fargo:
Act 3. Denial
The changes are now real and management can see it. But they don’t know how to react, so they reach for high pressure management to make the numbers work. In some cases, management also reach for creative accounting tricks to smooth out earnings and make it look as if nothing has changed.
Many banks have been in this mode about Fintech since its inception after the Global Financial Crisis.
Act 5. Blow up
This is when reality can no longer be glossed over. This is when we see scandals such as Wells Fargo (and the News Corp phone hacking scandal). This can lead to investors taking a cold hard look at the numbers and when the new numbers do finally appear, it can trigger a stock crisis, often with a restatement of earnings and a change of CEO.
At this stage the reality can no longer be denied and we see real crises in big companies. These crises may lead to radical transformation, or they may lead to Chapter 11 restructuring and fire sales. Before that happens we see the kind of behavior we just saw with Wells Fargo.
This is new for banking, which has not had a major headwind like this in hundreds of years. However, bankers can study other markets that have faced digitization headwinds – for example News Media.
The News Corp phone hacking scandal
News media faced digital headwinds a long time before banking did. To put it another way, software feasted on news media before it looked for the next tasty morsel in banking.
The day the News Corp phone hacking scandal hit, I happened to be meeting with an esteemed Wealth Management firm that had put up a list of their highest conviction stocks. Right at the top of the charts was News Corp. Oops. When questioned, they responded:
“Stuff like that happens. It’s impossible to predict that kind of thing where rogue employees run amok”.
The rationale for putting that stock top of the charts based on financial metrics was impeccable. It is also true that the problem that crashed the stock that day was a Black Swan event and they are by definition impossible to predict. The rogues were fired. Story over? No.
Nobody could predict who would go rogue and when and in what form, but it was reasonably predictable that somebody would go rogue fairly soon in some way.
It was an inevitable event, even if it was not an imminent event where you could predict the timing. The reason that the employees went rogue was that their business was slap bang in the path of digital disruption. Valiant efforts by sales people (Wells Fargo) or Journalists (News Corp) cannot save companies from digital disruption. Top management attempts to make that happen usually end in scandal.
Like Climate Change
Causation does not equal correlation, but when you see correlation you can adopt one of two strategies:
- Either: say causation is not yet proven, so do nothing
- Or: say causation is not yet proven, but there is some evidence and investing is all about assessing probability and so some action is needed.
In the case of Climate Change, the investment concerned is property/real estate in low lying coastal areas that is in danger of rising sea levels. The action you take will depend on your situation and assessment of probability, such as:
– buy more flood insurance
– Sell the property
– Short resort business with exposure.
The parallel is apt because the big force of change related to Fintech is the behavioral change of millions of consumers. You can see the individual change (e.g a Millennial who has never used a Bank branch) but tracking the rate of change in large populations is much harder. Nor can you say with certainty what causes the change.
We call this slow, steady & powerful but hard to measure change Fintech Change.
In the case of Fintech Change, the Investing options will also depend on your situation and assessment of probability, such as:
– Reduce exposure to Wells Fargo and Lloyds Bank stock i.e. sell them.
– Short Wells Fargo and Lloyds Bank stock i.e. a more aggressive approach.
– Buy individual Fintech stocks (private or public) such as Lending Club and Square
– Buy a basket of public Fintech stocks.
– Invest in a VC Fund with good expertise in Fintech to capture the early stage action.
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