Jim and Dallas chat about the ramifications of being a complacent commercial bank. You'll learn why you shouldn't keep kicking the tires on digital transformation, what it means to be a passive bank, and where pricing fits in with all of this.
Jim Young: Hi, and welcome to The Purposeful Banker, the podcast brought to you by Precision Lender, where we discuss the big topics on the minds of today's best bankers. I'm your host, Jim Young, director of communications at Precision Lender. And I'm joined again today by Dallas Wells, our EVP for international operations. We're gonna talk today about an article that was written in Forbes in early February by Alan McIntyre. He's the head of global banking practice at Accenture, and obviously someone who spent a lot of time thinking, talking, and writing about the future direction of banks. The article that McIntyre wrote is called No Time for Complacency for US Banks, Aggressive Technology Use Can Create Real Shareholder Value.
So, Dallas, let's start first with that title. Do you think that, even with all the attention paid to digital transformation and FinTech disruption, that some banks could actually still be guilty of complacency?
Dallas Wells: Yeah, I think that's definitely true. And I think that there are fewer banks who are just outright ignoring digital transformation, but there are still quite a few that we run into that are, they're kicking the tires. They're thinking about it. They're talking about it, but they aren't actually doing a whole lot yet. So, it's not true complacency. It's on their mind, but it hasn't turned into action yet. I think the why, there's lots of reasons why, but I think it really comes down to, in their mind, if it ain't broke, don't fix it. So, this is one of those things where you have this quarter's number to hit. You have this year's earnings and this year's budget to deal with, and a lot of the digital transformation you won't see the return on that investment, certainly not this quarter. Maybe not this year for a lot of those projects. And so, if there's no acute pain, if we're not feeling near term disastrous effects, why go through the pain, why spend the money for something that we won't see until some point in the future?
I think we are just in the early days of starting to see the negative consequences of complacency. We're just starting to see some of those banks that were early adopters bring stuff to market and to start to distance themselves with it. So, it's coming where boards start asking questions of why aren't we doing that same thing, and how come we are being left behind. That's when some of the thoughts need to turn, will have to turn to action. But in the meantime, there's still lots of people waiting. They're more talk, more thought, but still not as much action as there should be, which I think is what McIntyre's talking about here.
Jim Young: Yeah. To go back to our old friend from the book Earn It, the Eisenhower decision makers. I guess a lot of those banks are in the important but not urgent category.
Dallas Wells: Exactly, yep.
Jim Young: And Alan is sort of making an argument for moving it over to the urgent quadrant. And part of that, he makes that argument by is going through this passive bank scenario that was run by some Stanford and Harvard professors. Can you take us through what that scenario is, and from my vantage point, it seemed like a pretty big indictment on banks. Correct me if I'm looking into that too much.
Dallas Wells: Yeah. The scenario is that basically the way banks make money, the way the business foundationally works is that banks take money from investors, in their case depositors, so low cost deposits in this case, and they pair it with longer term assets. They take short liabilities, longer term assets, and they earn the spread in between. That spread in between is made up of really three pieces. There's the slope of the yield curve. So, there's the interest rate risk that you take between short and long. There's the credit risk that you take in there, so being able to properly evaluate that. You get paid for taking that risk. And then the third piece is being able to source those things, so having the local market knowledge and relationships to be able to actually get that business onto your balance sheet, as opposed to someone else's.
So, the passive bank scenario looks at, rather than using those relationships, and even evaluating the credit risk, just saying, how much of bank returns comes from that duration mismatch. So, short liabilities, long assets. So, they take short term liabilities and they just invest them in longer term treasury securities, so they remove the interest rate risk. It's an obligation of the US government. So, closest to a risk-free asset we have. And they just move out on the yield curve. What that study said is that that passive bank of just taking short, investing long, actually out performs the banking industry as a whole, over quite a long timeframe, through several different market scenarios. So, through several cycles essentially. It's better returns on a risk-adjusted basis. It is also less volatile returns.
Part two of your question, which I think is the harder part, is that is as big of an indictment of the industry as it seems like. The industry as a whole, probably so. Where you can say, "Look all of that effort, all that work that you all are going through, doesn't really generate any additional return." And McIntyre actually talks about there's some interesting societal good that comes out of that. But is that really what shareholders are after? Are they investing in a bank to do good for the community, instead of generating actual shareholder returns? On average, yeah the industry has a lot of work to do.
Now, underneath that average of course, there are those who lag way behind, and there are those out-performers. So, there are plenty of individual banks who out-do that passive bank. And I think that's really what everybody in the industry is after, superior risk adjusted returns. The reality is, just like everyone thinks their kid is above average, everybody thinks the bank they work for is above average, too, and it's just not. That's really getting to the core of what McIntyre's talking about here is what's the difference, and how are some of those able to out-distance that passive bank, and others are not.
Jim Young: Yeah. I sort of analogize it to almost index funds versus-
Dallas Wells: Exactly.
Jim Young: Having someone invest. Yeah. So yeah, McIntyre starts getting into that. Okay, well how do you get beyond a passive bank and become valuable to your shareholders there? And he goes into some of the tried and true cost cutting tactics that banks can follow, particularly reducing compliance spending, but then, and look, we don't just pick these articles out of thin air. We find ones like this one, where he turns to a topic that's near and dear to our hearts, pricing. Can you sum up his argument here?
Dallas Wells: Yeah. The first part is the one that everybody first jumps to, which is well maybe technology can help us get more efficient. Part of the reason that that passive bank out-performs is that banks do have a lower cost of funds, just in terms of interest expense that they pay for those short liabilities, but when you add in the cost that they actually incur to get those, so personnel, branch, compliance, those costs actually make it more expensive for their short term funding than if they were just to go out and borrow the money in the capital markets. So, the classic argument of, well let's find a way to do that more efficiently. Can we make a digital bank that reduces some of that branch and personnel burden to gather those?
So, his argument though is that while we can do that, and there are some pennies to be picked up there, the real value is actually on the other side of those assets that the banks feel like where they're actually generating that return, that additional spread. So, properly taking risk and having those relationships where they can source that business. That's the part that they've, as an industry, been really bad at. And his argument is, is that that's where the investment can actually make a difference. That's where you can essentially get smarter about the assets that you're taking. So, better quantify the risk, better source those deals, and make the whole process smoother so that you evaluate the risk that you're taking, you get properly compensated for them, and you do that in a repeatable fashion. And the number he throws out is you can see a lift of 10 to 20 basis points just by paying more attention, doing it in a smarter way. I think our numbers reflect that same kind of lift.
We see real banks doing that same thing. So, by all means, get more efficient on the liability side, but you really are talking about picking up pennies and scraping basis points there. The real value, how you actually vault above that passive bank, is on the asset side. And that's where you can truly out-perform the banks around you.
Jim Young: He makes this argument for why banks shouldn't be complacent, and goes through, arriving at pricing as one of the big ways for ... Basically going into the thing of getting the technology to allow you to price better and investing in that. But he doesn't really go so far as to predict what happens if you don't snap out of this. What's your view then of what the future looks like for the banks that say, "You know what, we're still doing fine"?
Dallas Wells: I think you see a bigger and bigger gap between those banks that do pay attention to this and do get the performance lift from it and those that don't. And so historically, the difference in banks, at least over a long enough timeframe, it's generally been about risk management. As long as you don't blow yourself up, you should be able to do okay. This is one of those turning points though, where that is not the case. There are banks who are making better use of this data. This data is a new asset for the industry, and there are those that are making good use of it to make smarter, more informed pricing decisions in a more efficient way, and there are those that are not.
So, what happens is those banks get left behind. And shareholders are only patient with that stuff for so long. You know, when there are better opportunities out there. So, share price languishes and the bank gets purchased or becomes essentially forgotten. But that's part of why you see so much consolidation in the industry, is the winners stick around and they pick off the losers, and those that have not done this, we've seen that. That's a big picture trend that's been going on for 20 plus years now, and that momentum, if you look at percentage of the industry that's turning over, that number continues to click up. And so, fewer banks and it's the winners that are sticking around, and this is how they're actually doing that.
Jim Young: All right. Well, that'll do it for this week's show. If you want to listen to more podcasts or check out more of our content, you can visit our resource page at PrecisionLender.com, or you can just head over to our homepage to learn more about the company behind this content. Finally, if you like what you've been hearing, make sure to subscribe to the feed in iTunes, Sound Cloud, Google Play, or Stitcher. We love to get ratings and feedback on any of those platforms. Until next time, this has been Jim Young for Dallas Wells. You've been listening to the Purposeful Banker.