Comment/ Banks Have Growth Opportunity in Less 'Vertical' Age
July 1, 1998
American Banker : People often ask me, "Is Microsoft
a threat to the banks?" This is a very surprising
question.
GE Capital has almost $300 billion of financial assets.
GMAC has $12 billion of financial services revenue,
more than Microsoft's total corporate revenue.
Microsoft has no leasing subsidiary, takes no deposits,
makes no loans, and offers not a single financial
product-in an age when everybody has financial
products. Yet Microsoft is viewed as the threat, not GE
Capital or GMAC.
People feel this way for a simple reason: Because of
advances in information technology, the banking
industry is becoming less vertically integrated over time.
During dis-integration, the industry changes. More of
the costs and the work are done by nonbanks, which
tend to be technology or services companies. Job
growth and much of the innovation occur outside the
banks, not within. Bankers see this trend as a threat.
Vertical integration is the degree to which an industry or
company creates all parts of its product. Does an auto
manufacturer make its own steel or does it buy the steel?
Does a computer company make its own chips or buy
them elsewhere?
It also means the degree to which a company distributes
and sells its products itself. Does the automaker sell
directly to the public, or does it license independent
dealers to do the sales and service? Does the corn flakes
company sell directly or depend on supermarkets?
The trend today is away from vertical integration. At
many companies, such as Dell and Nike, most of the
product is bought from other sources. In other words,
these companies coordinate, define, and assemble; they
are not integrated.
Banking is one of the most vertically integrated
industries anywhere, but that too is changing. These
long-term changes, not in any way created by
Microsoft, are what really worry people. Microsoft,
because of its visibility, symbolizes dis-integration. This
trend is advantageous for Microsoft, and for thousands
of other companies too.
The total cost structure of banking consists of interest
expense, loan losses, and noninterest expense, which
the Federal Deposit Insurance Corp. further breaks
down into people, occupancy (and equipment), and
"other." All these expenses except some portions of
"other" occur within the industry, and are therefore
vertically integrated.
Portions of "other"-including expenses such as
outsourcing the data center, buying software
applications, and hiring outside companies to do
marketing-occur outside the industry. Such spending
has grown more than twice as fast as the internal
expenses of the "other" category. It has also more than
doubled as a component of total costs, from 4.9% in
1986 to 10.7% last year, and the figure is likely to be 15%
to 20% a decade from now.
Costs are not the only indicators of vertical integration.
Bank revenue may decline during vertical dis-integration
as customers move revenue to nonbanks. For example,
the credit card merchant acquiring business was once,
circa 1975, predominantly bank work. Revenue was
small, and the process at the point of sale was not
automated. As electronic draft capture penetrated,
volumes and revenue grew dramatically. But much of the
business and the revenue moved to specialty nonbank
merchant acquirers and processors.
This phenomenon has recurred many times. The
volumes of financial transaction processing, financial
customer data, and financial reporting have increased by
factors of several hundred during the past few decades.
Yet the banking industry's noninterest income grew at a
compound annual growth rate of only 10.2% between
1986 and 1997. Though this is faster growth than that of
interest income, which grew at only 3.3%, the nonbank
financial transaction processing companies have grown
at about 25% to 35% over the same period.
Why is banking dis-integrating right now? The reason is
the power of information technology. Vertical
integration lasted as long as it did because
record-keeping and processing were paper-based and
local. Information couldn't move quickly, it was bulky
and awkward to handle, and much of its true meaning
was only in people's heads. Note that these factors
apply to all information- based businesses, not just
banking.
The parts of the industry most likely to dis-integrate
over the next five to 10 years are the delivery channels.
Banks' 70,000 "stores" cost about $50 billion to operate.
All other channels combined (call centers and ATMs)
add $5 billion to $10 billion. Securities firms' branches,
staffed with full-service brokers, are in the same
position. So are 10,000 to 20,000 other financial service
delivery locations owned and operated by thrifts,
finance companies, mortgage companies, and the like.
Why will delivery channels dis-integrate? Not because
some other industry will come in and operate the bricks
and mortar. Bank branches won't mimic independent
insurance agents. But the evolving electronic
information highway distribution system-exemplified by
the Internet-will eventually displace most of the cost of
today's channels, particularly the bricks and mortar. In
its place will come new costs to service the new
channels: the costs of participating in the electronic
highway.
However, banks will not own the electronic highway the
way they do the branches and ATMs. All industries will
participate in the information highway, and none of them
will own it, except for those in the information- highway-
owning business.
This could be very advantageous to banks. Transaction
unit costs will ultimately be much lower on the highway,
and many of those costs will be borne by
others-telecommunications companies, Internet service
providers, software companies, PC companies, and, yes,
Microsoft.
Some bankers believe they won't "control the customer"
anymore. Yet this belief comes with the assumption that
bricks and mortar control customers today. It implies
that customers cannot distinguish between the channel
and the financial service.
This is probably short-sighted. Many other industries
have no trouble selling and servicing through channels
they don't own. Financial services firms already use
indirect channels to raise retirement funds or to sell auto
loans. Customers do have to receive value to be sold,
but they don't necessarily have to be "controlled."
A second concern is that banks won't get the revenue
derived from new financial transaction processing
services on the information highway. For example, the
bill payment and presentment business will probably be
dominated by a few nonbank financial transaction
processors. Of course, these same firms will absorb the
costs as well. Given banks' dismal revenue growth
prospects, why can't banks expand in this direction?
Unfortunately, banks aren't well positioned. A bank, by
definition, takes deposits and makes loans. Precisely
because of dis-integration, this is no longer the same as
doing financial transaction processing. The players in
the new areas will probably be smaller, quicker,
technology- driven companies, befitting our
entrepreneurial culture. Even a big area, like bill
presentment, is small relative to the revenue of big
financial institutions.
What is to be done about dis-integration? The
nonbanks should continue to seek new opportunities in
financial transaction processing that result from the
trend. Generally speaking, our capitalist system is doing
a fine job of motivating firms to develop and exploit new
products and services.
For banks and other financial institutions, three
strategies are possible. The first is the "ostrich"
strategy. Industry dis-integration is a fairly long- term
trend, and plenty of profits are possible today. The
industry is at historic highs for profitability, so simply
ignoring the issue for a while is possible.
The second is the "general contractor" strategy. Instead
of just building most things for themselves, banks could
begin to assemble pieces of products from elsewhere.
This strategy is not restricted to the supply of
technology per se, such as outsourcing or buying
application packages. Other examples include the sale of
"name brand" instead of proprietary mutual funds, sales
of loans, and the growing tendency toward indirect
channels for loan origination.
The third is the "radical departure" strategy. A new cost
structure completely replaces the old one, with no long
transition period. Security First Network Bank is an
example where the traditional retail channel was
eliminated and only the electronic highway used. In this
case, the costs and difficulty of switching enough retail
customers were high. Security First chose to sell the
bank and keep the technology vendor, perhaps
preferring the growth side of the dis-integration
equation. Firms such as Schwab have a lower
entrenched cost base and may be better equipped to
adopt this strategy.
For many banks, a move from "ostrich" to "general
contractor " may be appropriate. Risks can be
controlled; some immediate benefits are possible.
The key change is in attitude. Management needs to
recognize the macroeconomic reasons behind
dis-integration. It is not a question of banks' lack of
vision or the malevolence of selected vendors. In fact,
banks' vision should go into thinking about success in a
less vertically integrated industry. Banking is not so
unique that the experiences of other industries won't be
repeated here. Copyright c 1998 American Banker, Inc. |
