Establishing the Bank of the Future
The answer is by no means clear. But what is clear is that the world of banking is changing, and changing fast. Many of banking’s core products, such as loans and investments, are becoming commoditised, and offered by non-banks – witness the rise of hedge funds. At the same time, customers, both corporate and consumer, increasingly want a degree of customisation in the products they buy. Retail customers, for example, want the option to prepay a mortgage early, or want their capital protected when making a stock investment. Products are becoming more complex, while at the same time there needs to be a shorter time to market.
Meanwhile, technology is changing the rules of what is required to set up a bank, and how to run traditional banking operations efficiently. The Internet significantly lowers the cost of entry for banks, and makes geographical location less relevant. But it is not just about setting up a web service. The Internet is just part of the power of technology to change the competitive landscape for banks.
If it seems improbable that an organisation could come out of nowhere and in under 20 years overtake the established giants of the banking world, some of which have been around for a century or more, take a look at what has happened in other industries. There is computing, for instance. When IBM launched the PC in the early 1980s, no one predicted that by 2005 IBM would exit the business and the market would be dominated by Dell. No one could have predicted that because at the time Dell as a company did not even exist.
The established players of other industries have also fallen to the challenge of newcomers armed with new ideas, and the wherewithal to back them up. There is Wal-Mart in retailing and Toyota in car making, both of which rewrote the rules for their industries. Banks could learn a lot from these companies, and from industries such as manufacturing. If they do not, they could find their cosy monopolies in financial services coming under serious challenge by those who have learned the lessons.
I believe that the bank of the future will be a super-manufacturer. It will be super-efficient at manufacturing financial products, and managing all the workflow processes associated with them. The bank of the future will offer many more complex products than banks do today, and this will apply particularly to retail customers. The use of derivatives will become ubiquitous because the bank will not only be attempting to meet the demands of customers for customised structured products, but also because the bank will be able to more easily manage the risk of the derivatives. A central risk engine will be a key to success.
This new market for derivatives-based instruments for retail customers is shaping up to be the next battleground for banks. The winners will be those that are the most efficient, not only at inventing the products that will appeal to the market, but also at managing the products through their lifecycles, including all their risks.
Another sign that banking is changing, and that the bank of the future will be operating in a different environment from its predecessors, is the way in which internet banking is now really taking off. A quarter of adults in the US – around 53 million people – now use the web to manage their personal finances. On a typical day, 13 million Americans are banking online. People now expect a technological interface to their bank.
But this growth in the provision of derivatives and internet banking masks the fact that today’s banks are really quite inefficient. You only have to look at the massive growth in hedge funds in the last five years to see that this is so. Hedge funds are simply taking what banks once used to do in-house, and doing it outside quicker and cheaper. They run lean organisations, optimised to what they do. They focus on their core competencies and outsource whatever else they need.
Hedge funds are typically set up by ex-bankers who see the opportunities to make profit from alternative investments once they get out of the inefficient environment of their banks. It is similar to the car making business, when some people realised that they could go outside the main manufacturer and produce door handles and other parts cheaper and better than, say, General Motors or Ford, and then sell them back to these companies.
But if banks are so inefficient, and are having key elements of their business taken away from them, why do they still make money? Today, across the world, banking is still largely a protected industry. Banks operate in markets sheltered by regulators, with access to the payments system. Banks are critical to a country’s economy, and the authorities of most countries will understandably go to great lengths to protect their financial systems. Although this puts banks at an advantage in terms of what they are licensed to do, and the facilities available to them, this privileged position will not protect them forever. Eventually, outside firms will find ways to attack their markets, like hedge funds have done, and unless traditional banks can find ways of becoming more efficient they will gradually lose their market share.
A useful way to think about this whole problem of banks and how they will face the challenges of the future is to consider them as manufacturers – manufacturers of financial products. You just have to view the full lifecycle of a product in a bank from the point of view of a modern production line and it becomes apparent very quickly that there are enormous inefficiencies.
When someone orders a computer from Dell they will more than likely have reviewed the options on the internet and decided on their own customised configuration for a machine. They are able to place their order online, and this kicks off the production process. First step is to order the components. Although Dell produces millions of computers, it does not hold huge inventories of components in stock – it only orders them as and when it needs them. This is called just-in-time manufacturing. In car manufacturing, the concept is applied both to externally created parts, and to those built within the factory – a part is only made when those further down the production line indicate they are ready for it.
A bank’s manufacturing process, on the other hand, works like this. First, you have the origination of a product, either internally or externally. Let us take the example where a group within the bank creates a product – say, a mortgage. Financial engineers design the mortgage, model the risk and return, and come up with a viable product.
Then there is a production process. This includes things like pricing, and credit checking, and getting other information from a number of different places. At the moment, none of this information is centralised in banks, so gathering it is convoluted and time consuming. It is certainly not available just-in-time. It is as if workers on a car production line had to go off and find each part somewhere different in the factory as they are assembling a car, instead of having them all to hand as the chassis comes down the line. Production in a bank also involves establishing how to store the mortgage, and setting up the back office functions to support it, for example collecting payments and managing accounts.
Then there is distribution – the mortgage has to be sold to the end-user. Meanwhile, all aspects have to be wrapped in risk management – market risk, credit risk, prepayment risk, operational risk. And then the bank has to be able to repeat the whole process for the next product.
The front offices of many top banks are good at their part of the manufacturing process – the origination, and some of the early parts of the production process, such as pricing and risk measurement. But then they have to get credit approval, and this is where the process often runs into the sand.
Take another example. A corporate client calls a bank and says it wants a lookback option with certain special features. This is a bit like someone calling Dell and saying they want a computer with two CD-ROM and two DVD drives instead of the usual one of each. This is no problem for Dell. It takes a basic computer – it is not starting from scratch: it has a basic configuration for the kind of computer the customer wants – and simply adds the extra drives. The computer goes into the production process, and then out the door to the customer.
The bank tries to do something similar. Financial engineers build a model for the instrument the client wants, deriving their model from existing models so building on what is already there, and they then add the new features. In a couple of hours they have modelled the instrument, and they integrate the model into their risk system. They figure out all the information they need to price the instrument, and all the factors they need to monitor in order to manage its risk. It is all very efficient, re-using components where possible, and employing sophisticated technology. The instrument has been priced, and integrated into the risk system. But when they try to get it out the door to the customer they run into trouble because it has to go through the credit approval process. That is when the bank goes into a time warp, falling back into practices of yesteryear when life was slower and banks had a monopoly on financial products. It is as if Dell has to suddenly go back to using a quill and parchment to complete the final part of its order for the customer.
Credit departments tend to be traditionally run, low tech, and with little incentive to increase efficiency. At least there was not much incentive until Basel II, the new capital adequacy regulations – due to come into force in 2007 – came along. This is going to force banks to update their credit risk management. Meanwhile, the frustration at the delays in the production process, especially around credit approval, is one reason why many talented and innovative bankers leave to set up their own hedge funds, where they know they can get new products out more quickly – and with lower overheads – so they make more return on capital.
The Basel II regulations are clearly telling banks that they need to become better manufacturers. The regulations say that if banks want to achieve the capital relief that Basel II offers, then they need to bring their processes up-to-date, especially in the areas of credit and operational risk. They need to make use of technology, not only to collect data for regulatory reports, but also to address the underlying issues that are the source of risk.
The new accord puts risk at the centre of business operations, and will make banks demonstrate that they are using their risk systems to do their business. Today, banks do their business and then compute their risks at an enterprise level. The bank of the future will compute its risk before doing any business. Banks need to take a lesson from the Dells and the Toyotas of this world. They must rethink their business model and, above all, become efficient manufacturers and distributors of financial products. This will entail a complete re-engineering of their manufacturing process. They will need to compute their risk beforedoing business, and not the other way round. And they will need to build their business around technology. Those that do this best will be the winners in 2020.