Friday, January 21, 2011

Banking is Changing: Look Out for the Opportunities

Banking is changing. I have argued this case for a long time. The number of banks in the banking industry is declining. A year ago or so we had over 8,000 commercial banks in the banking industry and several thousand organizations called thrift institutions. Now, we have less than 7,800 in the banking system and the thrift industry is legacy. My guess is that over the next five years, the number of commercial banks will drop below 4,000. This, of course, does not consider the credit unions and the increasing role they play in financial services.

The largest 25 commercial banks in the banking system hold about two-thirds of the assets of domestically chartered banks in the banking system. These banks hold over 57% of all the banking assets in the United States. Foreign-related financial institutions hold almost 13% of all banking assets in the United States. Thus, the biggest 25 domestically chartered banks in the United States banking system plus foreign-related financial institutions in the United States hold 70% of all banking assets.

This means that the average size of commercial banks not included in the largest 25 banks is a little more than $450 million. This means that there are a lot of very, very small banks “out there.”

What if the 25 largest banks in the United States plus foreign-related financial institutions move up to 80% of the total banking assets in the United States which I believe will happen? If the banking system drops to below 4,000 banks and, just to build an estimate, the asset size of the banking system doesn’t grow, then the smaller banks in the banking system will average right around $600 million.

The only conclusion that one can draw from the assumptions I am working with is that the big banks are going to get bigger, foreign banks are going to play a larger role in the United States banking industry (See “Japan’ No. 1 Bank on Prowl,”, and the smaller banks are going to get bigger.
Given this scenario the question becomes “How are commercial banks going to change?”

I would like to call your attention to a book I reviewed back in August by Leo Tilman, “Financial Darwinism,” ( The book is subtitled “Create Value or Self-Destruct in a World of Risk.”

One distinction Tilman makes in his book is between the “static” model of financial management and the “dynamic” model that incorporates a totally different risk-management perspective.

The general “mode of operation” of institutions existing within a “static” framework is akin to the “carry trade.” Simply, the “carry trade” can be defined living off the differential returns between assets and liabilities. Because of the “local monopolies” that commercial banks historically operated in that were controlled and regulated by the banking authorities, commercial banks could engage in “balance sheet arbitrage” and earn a very good living. (Lend at 6%, borrow at 2%, and be on the golf course by 4:00.)

As the local monopolies broke up in the 1970s and 1980s and the Net Interest Margins of banks began to decline, commercial banks started concentrating on fee income to keep returns up. But, this only worked for so long. As a consequence, Tilman argues, financial institutions, particularly the larger ones, began moving into “Principal Investments” and “Systematic Risks.”

Principal Investments (primarily “alpha” type of investments) include private equity funds and venture capital investments, proprietary trading, hedge fund activity and other forms of investment in financial instruments, products, and tools. Decisions were generally made at executive levels, but were decentralized with risk only being considered within a specific silo.

Examples of Systematic Risks (“Beta” type of investments) include operating in markets where the organization were exposed to interest rate risk, credit risk, mortgage prepayment risk, commodity risk, currency risk and so forth. Again, these efforts tended to be compartmentalized.

Even for the bigger institutions these latter movements were not aggregated and integrated: risk management in these financial institutions remained “static” even though the world became “dynamic.”

For the smaller commercial banks that moved in this latter direction, they tended not to know what they were doing. In doing bank turnarounds, it always amazed me the number of managements that felt they could deal with the most sophisticated financial instruments available, yet couldn’t manage their own “balance sheet arbitrage.” Moving into areas that were not based on “traditional” banking models only exposed these smaller banks to disaster as markets collapsed and they descended into insolvency.

The bigger banks have learned a very costly lesson relative to risk management. This is what Tilman’s book is all about. Within the dynamic world of modern finance, commercial banks are not going to be able to live off of “balance sheet arbitrage” alone. More and more these bigger banks are going to build portfolios of “Principal Investments” and investments with “Systematic Risks.” But, they are going to integrate and manage their risks differently. And, the management of these risks are going to be world-wide as the United States banks take on more of a global presence and as foreign-related financial institutions become more prominent in the United States. (

One major differentiator of performance in large banks is going to be tied to the ability of top management to manage the risk of their multi-structured institutions. This is one of the reasons why Jamie Dimon and JPMorgan, Chase & Company supposedly got through the recent financial collapse as well as they did. (

Smaller banks, however, are not going to be able to operate in these areas requiring a sophisticated understanding of how these risks are managed but also require a very sophistication management team to manage them. The smaller banks are going to have to find out how they can become better at “balance sheet arbitrage” and build up an expertise in these areas so as to “out-execute” rivals. This will be their way to “raise the bar.”

The other major differentiator will be the control of expenses: this will have to do with the structure of the branching system and number of bank personnel. It is embarrassing to walk into sizeable bank branches these days and see five employees of the bank and maybe two or three customers. I don’t remember walking into a bank recently where this was not the case.
Furthermore, commercial banks are way over-staffed in their back offices. Managements have not really dealt with this issue in recent years because they have either been “dancing to the music” or had major solvency proglems to deal with. But, now attention is starting to be paid to the excessively high expense ratios that exist within banking. (

One way the banks are going to change in this area is in their use of information technology. ( I plan to spend more time on this in the future and will also be spending more time discussing banks that are changing.

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