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Are big banks value traps ?


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I had some thoughts on big banks (and small local ones) after selling my WFC position. My near term concern on WFC is NIM compression due to interest rates, but another thought that occurred to me, partly due to trains of thoughts from other boards here and on Twitter is that the big banks may be the department store equivalent of the financial industry.

 

With that, I mean a company that does a bit of everything, but nothing particularly well. This applies to many business lines like mortgages (in about 80% of the cases, one is better off with a good broker), payments (a lot tech companies here start to dis-mediate and Visa/ MC go after b2b payments), wealth management/ Broker (banks offer discounted trades as a bundle, but who cares when trades at a brokerage firm are free), Credit cards  and possible other things.

 

So it seems to me that big banks will be losing market share to innovators and smaller banks may be worse off, since they don’t have IT heft. I am no sure how long takes, but it seems like one can see that over time nimble competitors take more and more share away from what once considered core bank business.

 

I would welcome thoughts here. I have personally decided to ditch my Wells Fargo brokerage and checking accounts (I got a package with 100 free trades annually) that I had since 2006 and use Schwab instead for cash management/checking and brokerage accounts.

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I don't see a natural replacement for them yet, so m not terribly concerned. They'll just roll-up the innovators in the field and then the tech will become commodities over time.

 

Banks are hard to supplant because of the network effects. Where else do millions of borrowers and savers come together for mutual benefit and limited effort?

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Also, who has billions/trillions on hand to lend out to massive companies and massive populations?

 

And, who has the institutional know-how to effectively risk manage that entire operation?

 

The barriers to entry to banking are immense. This is why we haven't seen a new big bank in a looooong time.

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Also, who has billions/trillions on hand to lend out to massive companies and massive populations?

 

And, who has the institutional know-how to effectively risk manage that entire operation?

 

The barriers to entry to banking are immense. This is why we haven't seen a new big bank in a looooong time.

 

I have large positions in banks so I am really arguing with myself here.

 

Who has billions in cash?  Apple, Google, Facebook.  Even without taking in deposits they have huge reserves. 

 

Who has institution mal knowledge?  Not them but they probably know more about us than our banks do.  Maybe they could carve out niches by building internal credit models and expand from there.

 

I think big tech will come for banks but I think it will take time.  You can see it happening with things like Apple pay and maybe libra.  You definitely have to be vigilant with the banks.

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Also, who has billions/trillions on hand to lend out to massive companies and massive populations?

 

And, who has the institutional know-how to effectively risk manage that entire operation?

 

The barriers to entry to banking are immense. This is why we haven't seen a new big bank in a looooong time.

 

I have large positions in banks so I am really arguing with myself here.

 

Who has billions in cash?  Apple, Google, Facebook.  Even without taking in deposits they have huge reserves. 

 

Who has institution mal knowledge?  Not them but they probably know more about us than our banks do.  Maybe they could carve out niches by building internal credit models and expand from there.

 

I think big tech will come for banks but I think it will take time.  You can see it happening with things like Apple pay and maybe libra.  You definitely have to be vigilant with the banks.

 

Great point.

 

And players coming in from the side.  Thinking mostly Square, but if Square can do it, why not Apple.  Or Costco or Amazon.  Not necessarily a threat, maybe a shakeup?  Where players with imagination/innovation/capital/captured clients can do something unexpected.

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Also, who has billions/trillions on hand to lend out to massive companies and massive populations?

 

And, who has the institutional know-how to effectively risk manage that entire operation?

 

The barriers to entry to banking are immense. This is why we haven't seen a new big bank in a looooong time.

 

Competitors will go after the higher ROI business first and then try to make run them better. Think, Credit cards, loan generation, mortgages, payment, wealth management. Lending itself is harder to dis-intermediate, but Even if that were all that is left, banks would be much worse business than they are now. In the longer run, crypto solutions could put a dent into this business too and basically make the banks redundant as loans would go peer to peer. We are a long way off, but this doesn’t mean it won’t happen.

 

The problem is that banks are stodgy and not tech savvy in general and that will probably be the most important factor going forward, not balance sheet strength or branch networks. JPM probably looks best here, Wells Fargo the worst from then it banks.

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I'm playing devils advocate here but I think you guys underestimate the banking business, particularly in today's world.

 

Calling the banks stodgy or tech-averse is superficial IMHO. Banks are not tech averse, they are incredibly financially disciplined (it's their raison d'etre!). These are not VC shops looking to cash in by inventing the next best tech.

 

Additionally you are ignoring the regulatory component. The FRB will be so far up a new bank's colon that it's too painful to think of. The large banks took 10 years to comply with FRB/OCC matters. And they are still not done.

 

Citi, Wells, JPM all have over 200,000 employees, each. Google and apple have half that. Simply to bring on the kind of manpower needed will be a billion dollar endeavor.

 

It is not just 'lets build some credit models and start slingin' cards". On the models side, these banks have 2, 3, 4 thousand models each. Who is going to build these? Who is going to validate them? How long is that going to take? It is not feasible. And the people building these models - they are not cheap. We billed out at 600, 700 an hour for regulatory models, not even valuation models which are much more important. And then you need a validation group which again, is incredibly not cheap.

 

Then you need to integrate into the markets. On the consumer side, now you need instantaneous scoring services at a massive scale and you need retail partners to integrate it. Retail partners who are already being serviced by these large banks and at a lower cost than you can provide. And these banks and policy teams who know these business better than you (and they) do. This is not just incredibly expensive but a hell of an endeavor to start from scratch. Systems migrations take two years - and that's a migration.

 

On the institutional side, it's even more opaque. First you have no idea what these product which are being traded. Show me anyone at Apple or Google who can explain why Kirk's spread option model is conceptually unsound but under what circumstances it is still acceptable to use. Nobody. Now tell me who is going to figure that out and then design a systems application to price certain products with certain models under specific circumstances. Of course you can use vendors to tap into the market in this way but the regulators will destroy you. And they're expensive as hell and there's a reason all the banks have migrated to in-house solutions. So unless you want to lose money on every trade for 4-5 years until you can build your own system to migrate over from a vendor platform, you're out of luck.

 

This article: https://seekingalpha.com/article/2561895-apple-pay-has-long-term-implications-for-visa-mastercard-and-retail-banks

postulates that Apple is entering the retail payments sphere as a means to enter the financial industry at a whole.

Well look at the payments - has Apple or Stripe built their own systems? No, they are playing on top of the established rails. Maybe this will change but it is difficult to see why. To build out such a system is incredibly expensive and the payoff is very uncertain. Expected ROI today is almost certainly very negative. And V/MC and the banks are expected to sit tight while this happens? I think not. Even if Apple or Google does go down this road they are opening themselves up to so many costs it will be absolutely brutal and the banks will slaughter them on the institutional side.

 

Anyways take it with a grain of salt because predicting the future is a foggy endeavor but if I had to wager I would say the odds are with the status quo.

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I'm playing devils advocate here but I think you guys underestimate the banking business, particularly in today's world.

 

Calling the banks stodgy or tech-averse is superficial IMHO. Banks are not tech averse, they are incredibly financially disciplined (it's their raison d'etre!). These are not VC shops looking to cash in by inventing the next best tech.

 

Additionally you are ignoring the regulatory component. The FRB will be so far up a new bank's colon that it's too painful to think of. The large banks took 10 years to comply with FRB/OCC matters. And they are still not done.

 

Citi, Wells, JPM all have over 200,000 employees, each. Google and apple have half that. Simply to bring on the kind of manpower needed will be a billion dollar endeavor.

 

It is not just 'lets build some credit models and start slingin' cards". On the models side, these banks have 2, 3, 4 thousand models each. Who is going to build these? Who is going to validate them? How long is that going to take? It is not feasible. And the people building these models - they are not cheap. We billed out at 600, 700 an hour for regulatory models, not even valuation models which are much more important. And then you need a validation group which again, is incredibly not cheap.

 

Then you need to integrate into the markets. On the consumer side, now you need instantaneous scoring services at a massive scale and you need retail partners to integrate it. Retail partners who are already being serviced by these large banks and at a lower cost than you can provide. And these banks and policy teams who know these business better than you (and they) do. This is not just incredibly expensive but a hell of an endeavor to start from scratch. Systems migrations take two years - and that's a migration.

 

On the institutional side, it's even more opaque. First you have no idea what these product which are being traded. Show me anyone at Apple or Google who can explain why Kirk's spread option model is conceptually unsound but under what circumstances it is still acceptable to use. Nobody. Now tell me who is going to figure that out and then design a systems application to price certain products with certain models under specific circumstances. Of course you can use vendors to tap into the market in this way but the regulators will destroy you. And they're expensive as hell and there's a reason all the banks have migrated to in-house solutions. So unless you want to lose money on every trade for 4-5 years until you can build your own system to migrate over from a vendor platform, you're out of luck.

 

This article: https://seekingalpha.com/article/2561895-apple-pay-has-long-term-implications-for-visa-mastercard-and-retail-banks

postulates that Apple is entering the retail payments sphere as a means to enter the financial industry at a whole.

Well look at the payments - has Apple or Stripe built their own systems? No, they are playing on top of the established rails. Maybe this will change but it is difficult to see why. To build out such a system is incredibly expensive and the payoff is very uncertain. Expected ROI today is almost certainly very negative. And V/MC and the banks are expected to sit tight while this happens? I think not. Even if Apple or Google does go down this road they are opening themselves up to so many costs it will be absolutely brutal and the banks will slaughter them on the institutional side.

 

Anyways take it with a grain of salt because predicting the future is a foggy endeavor but if I had to wager I would say the odds are with the status quo.

 

I typically like to bust your balls; so I will. Congrats on your first useful investment related post.

 

On a serious note, you are 1,000% right here.

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It's like Phil Fisher said...invest in what you know. Explains your portfolio of weed stocks and roadside greek diners  ;D

 

Finally .... my kind of portfolio!

 

Couple of add-on's ...

 

Banks aren't going away, it's just the form that is changing. Brick/mortar branches exist because a lot of product requires a physical facility (sales force, ATM cash dispenser, etc,). There is only so much that you can do via the on-line channel; and any material change in your employment mix will typically require some kind of regulatory approval. Try dropping 10,000 bodies at once, and see what happens.

 

An Apple Pay, Google Pay, etc has clear cost/tech payment advantages over any nations banking industry payment rails. But, the reality is that their global competitiveness is meaningless in a environment of separate local regulatory regimes. You may process differently, but it's our sand-box, and our rules.

 

The Apple Pay, Google Pay, etc, bring networking power to the table, and it is clearly advantageous - but it's not enough.

Far better for everyone if Apple Pay, Google Pay, etc were replaced by Central Bank Pay - and payments were made in Central Bank token, automatically exchanging into local currencies whenever there is a cross-border payment. And better still; if all participants had to have a digital wallet at their home Central Bank; and all transactions were using blockchain/smart-contracts on a 'private' central bank network. Ruins your day if you're trying to money-launder.

 

Just like the prostitution, arms-dealing, and drug trades - the product may change, but the industry stays.

 

SD

 

 

 

 

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I don't see a natural replacement for them yet, so m not terribly concerned. They'll just roll-up the innovators in the field and then the tech will become commodities over time.

 

Banks are hard to supplant because of the network effects. Where else do millions of borrowers and savers come together for mutual benefit and limited effort?

 

Network effects + regulatory capture imop.

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... There is only so much that you can do via the on-line chanel; and any material change in your employment mix wii typically require some kind of regulatory approval. Try dropping 10,000 bodies at once, and see what happens. ...

 

Just like the prostitution, arms-dealing, and drug trades - the product may change, but the industry stays.

 

SD

 

SharperDingaan,

 

SAN [relatively] did exactly that in May this year.

 

In Europe there's no way around this ... - only the way through it - by doing it - because of relatively more intense pressure on European earnings margins compared to in the US.

 

Head count reductions goes hand in hand with digitalization.

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When ATM's had large growth in the 90's - some thought that the ATM was the "future bank" and would be a big disruptor, instead it lowered costs and made retail banking more operationally efficient. The banks forecast this same cost savings with digital technology. 

 

As mentioned here, the banking business is complex and protected by a moat of regulation when it comes to actual lending and deposits. The regulation + large amount of capital required to actually compete with the banks is enormous. Mobile/online banking is still largely a transactional medium (mobile remote deposit/e-transfers/bill payment etc vs. savings/ direct deposits/mtgs/helocs etc)

 

To protect their moat in the brokerage business - Jamie Dimon preemptively took away brokerage fees earlier this year and Schwab/AMTD did the same this past week. This ultimately makes ROI on this business a lot lower but at the same time protects cash deposits in the brokerage accounts (obviously declining NIMs don't help here either).

 

The payments business for the banks vs tech will be an interesting space. I see this playing out similar to ATMs.  Ie. Cardtronics/Diebold will partner w/ big banks via their large distribution network and reach rather than having their own payment businesses - which is a win/win for both.

 

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... There is only so much that you can do via the on-line chanel; and any material change in your employment mix wii typically require some kind of regulatory approval. Try dropping 10,000 bodies at once, and see what happens. ...

 

Just like the prostitution, arms-dealing, and drug trades - the product may change, but the industry stays.

 

SD

 

SharperDingaan,

 

SAN [relatively] did exactly that in May this year.

 

In Europe there's no way around this ... - only the way through it - by doing it - because of relatively more intense pressure on European earnings margins compared to in the US.

 

Head count reductions goes hand in hand with digitalization.

 

Fully agree.

But I would also add that in most cases - the employee mix should be no more than 40/60 permanent versus contract staff (measured on total cost, not head-count). To compete effectively, a bank has to be able to rapidly adapt cost structures to meet current (& projected) conditions.

 

The reality however is that the banking sector has material Corporate Social Responsibility (CSR) restraints, and national regulators/unions enforce them; any individual banker who doesn't 'get' this - is just quietly replaced. Banks are allowed to drop large numbers of permanent staff, but they have to pay severances well above the going rate, and wherever practical - execute the redundancy over an extended period vs all at once. There is more flexibility with contractors, subject to bleeding them off (not renewing contracts) at a reasonable rate.

 

And then there are the 'trading banks'.

If you think your trading job is at risk, the bank takes on your 'agency' risk. But if entire risk 'divisions' are on-the-bubble - isn't the 'collectively' smart thing to do, to just bet the bank?, then keep the positions from blowing up until after bonuses and severances have been paid? Following which you would just short the bank as soon as you're on the street - in anticipation of a blow-up, and a second pay-day ;)

 

Understand the cycle, and you can position yourself accordingly. 

 

SD

 

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Didn't ask me, but depending on your definition of "big banks" (I think of this being JPM, BAC, C and WFC) the names that come to mind are Capital One, American Express and Discover Financial.

 

Credit cards

 

You said "credit cards" twice now. Please tell what non-big-bank CCs have any penetration. That Goldman Sachs Apple card does not count really.  8)

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Didn't ask me, but depending on your definition of "big banks" (I think of this being JPM, BAC, C and WFC) the names that come to mind are Capital One, American Express and Discover Financial.

 

Credit cards

 

You said "credit cards" twice now. Please tell what non-big-bank CCs have any penetration. That Goldman Sachs Apple card does not count really.  8)

 

These all are "big banks" for me.

 

Edit: but you are right, this thread is not very well defined. Spek starts with talking about both big banks and small banks. He also talks about brokers taking bank business, but some of the banks own brokers and some of the brokers are banks more or less. So it's not clear if the claims are that just big banks will lose market X (mortgages, CCs, whatever) or whether both big and small banks will lose it, or whether "lose it" is overall applicable if business goes from a bank to a bank-like company like Cap One or AmEx or DFS or Schwab or E-Trade or ???. Is it about "classic" banks losing to really-not-bank-fintech companies?

Or Spek's "mortgage broker" example - that example is mostly broken, since "mortgage broker" mostly sells the mortgages to big - or not so big - banks. My mortgages were sold to Chase, BAC, Webster, but also the "not-very-bank-but-also-not-new-fintech" companies like Nationstar.

 

So overall, I think claims in the thread are pretty washed out and not consistent. 8)

 

If the thread is just about the SuperBig (JPM, BAC, C and WFC) losing to any-other-companies (smaller banks, broker-banks, non-banks, techs, etc), then I don't see that either. I can argue that SuperBig won't grow very fast, but that's kinda tautology because they are so big and their growth is mostly limited by size and regulations. I don't think they are melting ice cubes though. So unlikely to be value traps based on that. Unless you'd call anything that returns a single digit return a value trap.  8)

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I think the banking sector isn't going anywhere and will consolidate more and more towards the bigger banks.  All depository institutions are agents of the Federal Reserve.  That is why their deposits (up to a certain amount) are guaranteed by the Fed (and US Treasury).  You have to think of the banking sector as a vital connector of the US Treasury/Federal Reserve on one side and the private sector on the other.  There are two things that create deposits in the banking sector.  The first is lending - a new loan creates a new deposit (reserves aren't as necessary anymore).  The second factor that creates deposits in the banking sector is net deficit spending by the US Treasury.  When the US Treasury spends, it credits an account at a bank via the Federal Reserve.  These two factors create an ever growing deposit base in the US banking sector.

 

These are irreversible trends IMO (my data goes back til 2003).

 

1) Deposits in the US banking sector continue to grow year-after-year.  By my calculations, deposits have grown +5.6% per year since 2003 to today.  Total US banking deposits were $5.7 T USD in 2003, they are over $14.0 T USD today.

 

2) The market share of the biggest banks in terms of share of total US banking sector deposits continues to grow year-in-year out at the expense of small banks.  The Big 3 deposit banks (JPM, WFC, BAC) had 14% share of total deposits in 2003, they are at over 32% in 2019.  Over and above the normal growth of deposits in the US banking sector, deposit growth at the big 3 has been +9.1% per year since 2003.  The big 3 have grown deposits by 4.25X in 16+ years.

 

In addition, one of the keys is that the big banks are central to the payments system through which the economy operates.  This payments system is in turn tied to the US Federal Reserve.  Banks clear payments with each other every day in the tens of trillions of dollars.  They often need overdrafts with the Fed while they wait for clearing.  I've seen stats that show that reserves at the Fed swell intra-day by a factor of 10-15x until they are netted and cleared at the end of each 24 hour period.  We're talking $10T per day or more.  This is not going to get replaced by Apple or Bitcoin, IMHO. 

 

I don't think banks are going anywhere nor does the central bank want to eliminate them.  I also think that the big banks will get bigger over time despite the charm of the local community bank. 

 

wabuffo

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You have to think of the banking sector as a vital connector of the US Treasury/Federal Reserve on one side and the private sector on the other. 

Bingo. In terms of the Charlie Munger generalized mental models - this is one of the top models you should have in your mind when thinking of the banks. They do "the dirty work" of the central bank.

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Credit cards

 

You said "credit cards" twice now. Please tell what non-big-bank CCs have any penetration. That Goldman Sachs Apple card does not count really.  8)

 

Discover, Amex are non- bank offerings. To be fair, this one went more towards the banks, because CC vendors benefit from cheap and stable funding. Whether this remains this way, is another question.

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Credit cards

 

You said "credit cards" twice now. Please tell what non-big-bank CCs have any penetration. That Goldman Sachs Apple card does not count really.  8)

 

Discover, Amex are non- bank offerings. To be fair, this one went more towards the banks, because CC vendors benefit from cheap and stable funding. Whether this remains this way, is another question.

 

Actually, they are both bank offerings ( https://en.wikipedia.org/wiki/Discover_Financial https://en.wikipedia.org/wiki/American_Express#Individual_banking ). But I've answered similar comment above.

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Also, who has billions/trillions on hand to lend out to massive companies and massive populations?

 

And, who has the institutional know-how to effectively risk manage that entire operation?

 

The barriers to entry to banking are immense. This is why we haven't seen a new big bank in a looooong time.

 

Competitors will go after the higher ROI business first and then try to make run them better. Think, Credit cards, loan generation, mortgages, payment, wealth management. Lending itself is harder to dis-intermediate, but Even if that were all that is left, banks would be much worse business than they are now. In the longer run, crypto solutions could put a dent into this business too and basically make the banks redundant as loans would go peer to peer. We are a long way off, but this doesn’t mean it won’t happen.

 

The problem is that banks are stodgy and not tech savvy in general and that will probably be the most important factor going forward, not balance sheet strength or branch networks. JPM probably looks best here, Wells Fargo the worst from then it banks.

 

Crypto markets don't make credit analysis unnecessary. They'll make the banks record keeping cheaper via block chain technology, but won't make individuals any more savvy or willing to do credit analysis for such a small pay-back.

 

I, personally, have no desire to do credit research on an individual to loan them money for 30 years to finance their mortgage so I can make 3.75%.

 

I'd much rather sit on my ass and earn 2.25% for doing nothing, and have access to the money any time I need, and let the bank collect the spread from my deposits vs their loans and deal with the liquidity management.

 

Crypto currency isn't going to change this dynamic one iota IMO.

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Also, who has billions/trillions on hand to lend out to massive companies and massive populations?

 

And, who has the institutional know-how to effectively risk manage that entire operation?

 

The barriers to entry to banking are immense. This is why we haven't seen a new big bank in a looooong time.

 

Competitors will go after the higher ROI business first and then try to make run them better. Think, Credit cards, loan generation, mortgages, payment, wealth management. Lending itself is harder to dis-intermediate, but Even if that were all that is left, banks would be much worse business than they are now. In the longer run, crypto solutions could put a dent into this business too and basically make the banks redundant as loans would go peer to peer. We are a long way off, but this doesn’t mean it won’t happen.

 

The problem is that banks are stodgy and not tech savvy in general and that will probably be the most important factor going forward, not balance sheet strength or branch networks. JPM probably looks best here, Wells Fargo the worst from then it banks.

 

Crypto markets don't make credit analysis unnecessary. They'll make the banks record keeping cheaper via block chain technology, but won't make individuals any more savvy or willing to do credit analysis for such a small pay-back.

 

I, personally, have no desire to do credit research on an individual to loan them money for 30 years to finance their mortgage so I can make 3.75%.

 

I'd much rather sit on my ass and earn 2.25% for doing nothing, and have access to the money any time I need, and let the bank collect the spread from my deposits vs their loans and deal with the liquidity management.

 

Crypto currency isn't going to change this dynamic one iota IMO.

 

Yep & yep.

 

Crypto will be useful for frictionless internal transaction, though.

 

https://www.forbes.com/sites/korihale/2019/09/25/wells-fargo-co-signs-cryptocurrencies-with-new-digital-cash-product/#1ea26319363f

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