When size becomes a problem
The last 20 years have seen in the global banking system a strong process of mergers & acquisitions creating a number of big banks around the world. The mantra that has been driving this process is that economies of scale make the banks more efficient.
The evidence that we are facing today points to a different direction and the only reason many big banks are not failing is that they are “too big to fail” and are finding the protection of Governments.
The question is, how far gigantism in banks is part of the problem and can actually be identified as one of the sources of the current credit crisis?
Banks are a different business
No matter how technology re-shapes the businesses, the banking business of borrowing money from savers and lending to companies and individuals is different from any other business.
The traditional banking companies are intrinsically leveraged businesses that borrow and lend for a multiplier of their capital. Even the wealthiest, best managed bank in the world can default at any time if all of its depositors ask their deposits back simultaneously. This is not the case for other businesses.
Banks are different. They have an intrinsic weakness, no matter how big, well (or badly) managed and powerful they are.
The Mistake of Gigantism
We believe that the search for size has been a dramatic mistake that has made them not-controllable and has not delivered the efficiency that was promised. We illustrate below a number of reasons that support the case.
Systemic Risk. Given the intrinsic weakness of banks, it is in the interest of the communities (no matter if States or Continents or the entire World) to limit the size of a single bank. When one bank becomes too big, the embedded weakness of being a bank translates to the full economy and becomes a problem of the community, as we discovered during the crisis. Profits are private, BIG losses become public.
Economies of Scale. Economic history counts many cycles of mergers and de-mergers in the banking sector. The main reason being that banking is based on relationships: the human component is important and limits the economies of scale that can be reached with size. Mergers have been followed by de-mergers because the diseconomies of scale that came with size had not been overcome by the economies of scale. This happens because the revenue side of the P&L sheet remains strongly linked to the human workforce of the bank and precisely to its size and its skills.
We had been told that this time it was different. The important IT investments and the technological innovation of these years had created a fundamental new area of economies of scale for the banking business. While this is undoubtedly true there are a number of flaws in this thinking:
- in deciding for mergers banks have looked only at the economies of scale in the cost side of the P&L sheet and have not focused at all in the diseconomies of scale in costs and revenues. Size comes at a cost and increases in size make only sense if the economies of scale are higher than the diseconomies of scale.
- One of the reasons IT costs are so high at banks is that banks are not necessarily good in doing businesses different from banking. If we have economies of scale in the IT divisions, then let’s spin off the IT divisions, specialize them as service providers, let them compete to become more efficient and let them serve different banks. In other words, business process outsourcing could make for all the economies of scale that banks were looking for in the merger-mania. Let me make an example based on my personal experience. I have seen in banks Market Risk departments of 100 people with highly inefficient cost/benefit ratio. Speaking to the Head of the Desk he/she was telling you how proud they were to have such a big team. I was instead thinking that you could reduce the team by 70% and get much better results with outsourcing that activity to companies that are specialized into that segment, profiting from the important economies of scales in the data management and IT side. The Risk Manager was thinking in terms of power, I was thinking in terms of efficiency.
Business of Relationships. If you agree with me that banking is a business based on humans where human relationships and the human factor is central, then gigantism has failed on 3 respects:
- humans are not scalable, if for increasing revenues you need a proportional increase of headcount you have a business that is intrinsically not scalable;
- size comes with several diseconomies of scale, among which a complication of communications and inter-company relationships: this makes tougher to direct a bigger organization rather than a smaller one. Diseconomies of scale associated with size have not been taken into appropriate account and not measured consistently while deciding for mergers.
- The increase of size has come together with a very centralized business model. The availability of technology has created the false belief that it is more efficient to centralize all decisions on lending, standardizing the lending process via technology and models, trying to cancel or minimize the human component. If banking is based on relations this was a mistake and the centralization process has created a bigger and bigger gap between the bank and its clients, fundamentally destroying the relationship of trust. My opinion is that we have gone too far and have used technology in the wrong way, with the false illusion that it was efficient to remove the power of local relationship managers: these managers know clients, they know their story, they know the entrepreneurs, their reputation. The importance of these elements has been undermined by the combination of increased size and increased centralization.
The Proposed Way Forward
I think that smaller banks will consistently reduce systemic risk and become even more efficient, with further benefits to the Community.
The concept of “small” should be applied where the systemic risk operates. Today, this systemic risk operates at Country, Nation level. Single Nations are rescuing banks; they pay the price of gigantism.
This implies that we can and probably must have Global banks, but that we need to create disincentives to size at Nation’s level, not at global level. Global banks should have local entities, subject to local capital requirements.
My proposal is to increase capital requirements – at Nation’s level - as size increases above a certain threshold. Such a mechanism would leave banks totally free to grow: if they are able to be efficient and use size to find the economies of scale that can pay for the higher capital requirements, then we should let them grow, but let them be better capitalized than smaller banks.
On the other side, the important IT economies of scale created during the merging-mania can be easily maintained by spinning off the IT divisions of these banks. These companies could be further merged to maximize the economies of scale and should compete with each other, in a search for improved efficiency.
Outsourcing is growing because it is efficient and makes a lot of sense. In the 70s you had mega IT desks of banks trying to build their own computer processors. Then Intel and the others came, making it clear how silly it was for a bank to invest massive sums of money in the highly-scalable business of producing computer processors.
Similarly, you have a plethora of areas where outsourcing and IT centralization among banks would dramatically increase efficiency.
A future of smaller banks with bigger business process outsourcers (BPOs) would deliver to the banks all the economies of scale they were researching in a merger, without penalizing them with the diseconomies of scale linked to banking size. Banking would definitely become a much better and efficient sector.
Dario Cintioli is Head of Risk at StatPro
The evidence that we are facing today points to a different direction and the only reason many big banks are not failing is that they are “too big to fail” and are finding the protection of Governments.
The question is, how far gigantism in banks is part of the problem and can actually be identified as one of the sources of the current credit crisis?
Banks are a different business
No matter how technology re-shapes the businesses, the banking business of borrowing money from savers and lending to companies and individuals is different from any other business.
The traditional banking companies are intrinsically leveraged businesses that borrow and lend for a multiplier of their capital. Even the wealthiest, best managed bank in the world can default at any time if all of its depositors ask their deposits back simultaneously. This is not the case for other businesses.
Banks are different. They have an intrinsic weakness, no matter how big, well (or badly) managed and powerful they are.
The Mistake of Gigantism
We believe that the search for size has been a dramatic mistake that has made them not-controllable and has not delivered the efficiency that was promised. We illustrate below a number of reasons that support the case.
Systemic Risk. Given the intrinsic weakness of banks, it is in the interest of the communities (no matter if States or Continents or the entire World) to limit the size of a single bank. When one bank becomes too big, the embedded weakness of being a bank translates to the full economy and becomes a problem of the community, as we discovered during the crisis. Profits are private, BIG losses become public.
Economies of Scale. Economic history counts many cycles of mergers and de-mergers in the banking sector. The main reason being that banking is based on relationships: the human component is important and limits the economies of scale that can be reached with size. Mergers have been followed by de-mergers because the diseconomies of scale that came with size had not been overcome by the economies of scale. This happens because the revenue side of the P&L sheet remains strongly linked to the human workforce of the bank and precisely to its size and its skills.
We had been told that this time it was different. The important IT investments and the technological innovation of these years had created a fundamental new area of economies of scale for the banking business. While this is undoubtedly true there are a number of flaws in this thinking:
- in deciding for mergers banks have looked only at the economies of scale in the cost side of the P&L sheet and have not focused at all in the diseconomies of scale in costs and revenues. Size comes at a cost and increases in size make only sense if the economies of scale are higher than the diseconomies of scale.
- One of the reasons IT costs are so high at banks is that banks are not necessarily good in doing businesses different from banking. If we have economies of scale in the IT divisions, then let’s spin off the IT divisions, specialize them as service providers, let them compete to become more efficient and let them serve different banks. In other words, business process outsourcing could make for all the economies of scale that banks were looking for in the merger-mania. Let me make an example based on my personal experience. I have seen in banks Market Risk departments of 100 people with highly inefficient cost/benefit ratio. Speaking to the Head of the Desk he/she was telling you how proud they were to have such a big team. I was instead thinking that you could reduce the team by 70% and get much better results with outsourcing that activity to companies that are specialized into that segment, profiting from the important economies of scales in the data management and IT side. The Risk Manager was thinking in terms of power, I was thinking in terms of efficiency.
Business of Relationships. If you agree with me that banking is a business based on humans where human relationships and the human factor is central, then gigantism has failed on 3 respects:
- humans are not scalable, if for increasing revenues you need a proportional increase of headcount you have a business that is intrinsically not scalable;
- size comes with several diseconomies of scale, among which a complication of communications and inter-company relationships: this makes tougher to direct a bigger organization rather than a smaller one. Diseconomies of scale associated with size have not been taken into appropriate account and not measured consistently while deciding for mergers.
- The increase of size has come together with a very centralized business model. The availability of technology has created the false belief that it is more efficient to centralize all decisions on lending, standardizing the lending process via technology and models, trying to cancel or minimize the human component. If banking is based on relations this was a mistake and the centralization process has created a bigger and bigger gap between the bank and its clients, fundamentally destroying the relationship of trust. My opinion is that we have gone too far and have used technology in the wrong way, with the false illusion that it was efficient to remove the power of local relationship managers: these managers know clients, they know their story, they know the entrepreneurs, their reputation. The importance of these elements has been undermined by the combination of increased size and increased centralization.
The Proposed Way Forward
I think that smaller banks will consistently reduce systemic risk and become even more efficient, with further benefits to the Community.
The concept of “small” should be applied where the systemic risk operates. Today, this systemic risk operates at Country, Nation level. Single Nations are rescuing banks; they pay the price of gigantism.
This implies that we can and probably must have Global banks, but that we need to create disincentives to size at Nation’s level, not at global level. Global banks should have local entities, subject to local capital requirements.
My proposal is to increase capital requirements – at Nation’s level - as size increases above a certain threshold. Such a mechanism would leave banks totally free to grow: if they are able to be efficient and use size to find the economies of scale that can pay for the higher capital requirements, then we should let them grow, but let them be better capitalized than smaller banks.
On the other side, the important IT economies of scale created during the merging-mania can be easily maintained by spinning off the IT divisions of these banks. These companies could be further merged to maximize the economies of scale and should compete with each other, in a search for improved efficiency.
Outsourcing is growing because it is efficient and makes a lot of sense. In the 70s you had mega IT desks of banks trying to build their own computer processors. Then Intel and the others came, making it clear how silly it was for a bank to invest massive sums of money in the highly-scalable business of producing computer processors.
Similarly, you have a plethora of areas where outsourcing and IT centralization among banks would dramatically increase efficiency.
A future of smaller banks with bigger business process outsourcers (BPOs) would deliver to the banks all the economies of scale they were researching in a merger, without penalizing them with the diseconomies of scale linked to banking size. Banking would definitely become a much better and efficient sector.
Dario Cintioli is Head of Risk at StatPro
Labels: Credit Crisis, outsourcing, systemic risk
0 Comments:
Post a Comment
<< Home