The End of Banking

Plus: Ant, Consumer Credit and the Market for Lemons; United Wholesale SPAC; Litigation Finance

Welcome to another issue of Net Interest, my newsletter on financial sector themes. Every Friday I go deep on a topic of interest in the sector and highlight a few other trending themes. If you have any feedback, reply to the email or add to the comments. And if you like what you’re reading, please spread the word. Thanks!

The End of Banking

I started looking at banks 25 years ago. In those days banks were simple organisations. They took in people’s savings as deposits and they lent them back out again as loans. Banks stood in the middle, earning a spread. People referred to it as 3-6-3 banking: borrow at 3%, lend at 6% and be on the golf course by 3pm. 

That’s not to say banks would never blow up. They did, with regularity. I arrived on the scene in time to see wounds healing following the early 1990s recession. One of my first responsibilities was to help bring the Swedish banks back to the market after they had been bailed out by their government following an ill-judged lending boom. Later, I helped bring Crédit Lyonnais back to the market after it was almost bankrupted by dodgy loans to Hollywood studios. Usually bank collapses were triggered by bad lending, they were recapitalised, and they recovered. (One useful rule of thumb was that once recovered, banks would tend to be more robust in the next downturn. UBS suffered more than most in 1998 and was less vulnerable in 2002; JPMorgan suffered more than most in 2002 and was less vulnerable in 2008.)

My nostalgia was triggered this week by the observation that, 25 years on, many bank stock prices are back to where they were when I started.

Take HSBC.

Just before I started working in the City, HSBC had relocated its headquarters from Hong Kong to London. It operated three businesses—its founding business in Hong Kong, established at the end of the nineteenth century to facilitate international trade, a bank it acquired in Buffalo in the US in the late 80’s (Marine Midland) and a bank it had recently acquired in the UK (Midland Bank). Together, these businesses made around $3.1 billion of profit on assets of $315 billion. 

Subsequently, HSBC went on to acquire more banks all over the world. It made acquisitions in Brazil, in Argentina, in Mexico, in France, in Turkey, in Poland; it bought more in the US. It became “the world’s local bank”. Last year it made $6 billion of profit on $2.7 trillion of assets. Strip out some one-offs and underlying earnings can generously be attributed at $11 billion.

In the arc of my career HSBC’s balance sheet has grown by 9x and its earnings have grown by 2-3x. Its shareholders’ capital, by the way, has grown by 11x.

Yet its stock price is flat. What’s going on?

Complexity in Banking

One clue lies in the dusty annual report I gleaned those 1994 numbers from. It’s only 88 pages long. Last year’s annual report, by contrast, was a staggering 334 pages. More disclosure is certainly no bad thing, but the increase in report length reflects something else—an increase in complexity. Gone are the days of 3-6-3 banking; hyper financialisation saw that off. HSBC is an inherently more complex organisation now than it was then. The best illustration of this is in its group structure. In 1994 HSBC listed 22 subsidiaries in its annual report. Today it lists 477. That’s a whopping 22x increase! 

All organisations grow more complex over time. It’s a lot easier to add a new subsidiary or a new product or a new channel to a portfolio than to remove one. And every new subsidiary, new product and new channel adds non-linearly to the number of connections within the organisation. 

It was easy for HSBC to expand into France in 2000. It simply paid more than anyone else for its target, CCF, and completed the deal in a few months. Getting out is not so easy—HSBC has been trying to sell for a year. Reports suggest it’s close, but it looks like it’ll come at a steep cost: HSBC may have to pay €500 million for buyers to take CCF off its hands. 

It’s the same with distribution channels. In this case, expansion was less a strategic choice and more about meeting customer demand. Back in 1994 distribution was done principally through branches, but HSBC was beginning to explore other channels. It states in its annual report:

“Our group made further advances in banking technology. Our electronic banking system, Hexagon, attracted its 10,000th customer, and our international ATM network, GlobalAccess, was linked to that of Wells Fargo Bank in California.”

Today, like all banks, HSBC distributes through multiple channels. But the cost of decommissioning antiquated channels is very high. Commerzbank has put aside €1.6 billion to close a fifth of its branches and Svenska Handelsbanken has put aside SEK1.5 billion to close half. 

The irony is that it was pretty expensive to layer in complexity to begin with. A 25 year view of HSBC shows none of the cost benefits that supposedly come from scale and lots of costs associated with escalating complexity. Over the period, HSBC’s revenues went up 5x but its costs went up 6x. If we graciously strip out some 2019 costs as one-off (although they themselves are a feature of the group’s growing complexity) we’re on par—it cost the bank 60 cents to generate a dollar of revenue in 1994 and it costs the same today.

Some of this is due to the burden of regulation which has increased over time. Banks and regulators have played a game of tit-for-tat for years. Banks play fast and loose here, regulators tighten up guidelines; they play fast and loose there, regulators tighten up guidelines. The result is a fat rulebook. The Bank of England’s PRA Rulebook runs at over 638,000 words; that’s longer than the Old Testament. The Bank itself acknowledges that regulatory complexity has only increased since the financial crisis.  

This is evident in a look back at HSBC. In 1994 I was able to calculate its regulatory capital requirement on a few rows of an Excel 4.0 spreadsheet. That was when regulatory capital was based on Basel I rules. We’re now on Basel III and it takes more than a degree in mathematics to do the math. Just as well HSBC employs teams of people to conduct the exercise; other UK banks like Metro Bank and Coventry Building Society got their calculations completely wrong. 

So far, we have a picture of a system growing more complex with age, compounded by regulatory intervention. It’s a picture that is evident in other old sectors (HSBC is, after all, 155 years old). What makes banks slightly different is that they use complexity strategically to drive profits. 

A good example of this is in retail structured products. The FT published a decent overview of this market last week. French banks are at the forefront, packaging options and other equity derivatives into structured products sold to retail investors in Europe and Asia. In its simplest form a structured product may consist of a zero coupon bond and a call option. If the market goes down, the bond pays out so you get your money back; if it goes up you get the upside from the option. So capital is protected but there’s scope for upside if the market rises.

Over the years structured products have been a source of healthy profit for the banks. However, research a few years ago documented a trend of increasing financial complexity in these products with more bells and whistles being added over time. It’s an interesting development because the financial crisis reined in complexity across many other product areas, but that didn’t happen here. Why not? The research finds that the more complex a product is, the more profitable it becomes. Away from the spotlight faced by products more closely associated with the financial crisis, retail structured products tended towards greater complexity. 

Across other categories the trend is evident in the sheer number of products available. In mortgage, for example, the average number of products offered by the top 20 UK banks grew from 10 in 1993 to 61 in 2013. 

The problem banks face is that whatever value that can be derived from complexity has diminished. No one wants it any more. Customers now have the tools to identify it and to circumvent it. In fact, it’s those tools that are creating the most value. Adyen is one of the best performing financial services stocks in Europe this year. It has doubled in the time that HSBC has halved. What does Adyen do? “We use a single platform to solve complexity [in payments].” Across multiple categories, technology is being deployed to root out complexity.

And Other Issues

HSBC is on the wrong side of complexity. But if that’s not enough, it and banks like it have other issues to contend with.

First, they no longer steer their own capital allocation strategy. Capital allocation is a key source of corporate value creation and its execution falls to senior management. If senior management is responsible for anything, it’s capital allocation.

Yet at banks, managers do not have access to the full range of investment opportunities that their peers in other sectors have. Since March this year, European banks have been banned from paying out dividends or undertaking share buybacks. In the US, onerous restrictions were put in place.

In both cases the regulatory intervention was temporary, although restrictions were this week extended in the US through to the end of the year. However, such a regulatory response has never been deployed before and raises the question of when it may be used again. An ongoing Net Interest theme has been the metamorphosis of private sector banks into policy banks across the world. In China this comes through explicitly, with banks being told they have to sacrifice $210 billion in profits to prop up their economy. In the West it comes through policymakers’ influence over capital allocation; in the process private shareholders are subordinated. 

The second issue is the low level of interest rates. If banks hadn’t already abandoned 3-6-3 banking, low rates would have forced them to by now (granted, the causation may work the other way round). In other industries – like oil – the cure for low input prices is low input prices, and vice versa. That doesn’t apply to interest rates, which are held low by a player of considerable influence, so they stay low regardless of the position of other players.  

Finally, banks now have to compete with all the government debt that is being issued. Lending growth may be curtailed as private sector savings get crowded out by higher government borrowing.

Clearly the market gets all this, which is why HSBC is back to trading at the same level it was 25 years ago. At least it’s still in the index. Other banks like BBVA, SocGen and Santander have been deleted from European stock indices altogether. The rump that’s left now makes up just 5% of the market index, down from 20% before the financial crisis and 12% at the beginning of 2018. Any underperformance banks suffered during the Global Financial Crisis has been left in the dust compared to the underperformance they are suffering now (frustratingly for them, because this time it’s not their fault).

One investor willing to swim against the tide is Chinese insurer Ping An. Already HSBC’s largest shareholder, they picked up some more this week, taking their stake to 8%. They think the capital allocation issue is only temporary, according to their spokesman. They didn’t address the issue of complexity but an FT opinion later in the week did. One solution is to wind HSBC not 25 years back but 30 years back, to its roots in Hong Kong. It’s where most of the money is made, and it would make HSBC a far simpler entity.

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More Net Interest

Ant, Consumer Credit and the Market for Lemons

There’s an informational asymmetry at the heart of consumer credit: customers who want credit the most tend to be less creditworthy than those who want it the least.

Finance companies do their best to accommodate this. At the subprime end, Wonga famously introduced a ‘slider’ on its home page which customers could drag to determine how much they wanted to borrow. Customers who unwaveringly dragged the slider to the max wanted credit a little too much and were turned down. For most customers, the asymmetry is resolved in price. The average APR on a US credit card currently is around 16%. That’s not much lower than the average APR offered to someone with distinctly bad credit, which is 24%, because again, simply exhibiting demand provides a sufficient base rate of information.

Ant Group offers a novel solution to reconciling the problem. According to the FT, “some users complain Chinese group is pushing them to take out credit they do not want.”

The article goes on:

“It induces you to use Huabei [one of Ant’s consumer credit products] all the time,” said 38-year-old Vincent Cheng. “As soon as your default payment method is not Huabei, the app will continually push discounts and promotions at checkout to get you to pay with Huabei.”

“Once you’ve accidentally paid with Huabei, it becomes set as the default,” said Mr Cheng.

Janine Wong said she so frequently ended up paying with Huabei that she set a Rmb500 credit limit to minimise using it by mistake. But it did not solve the problem.

“They would temporarily raise my credit limit automatically, so sometimes even if my credit balance was not supposed to be enough to pay for something, it still got paid with Huabei if I didn’t pay attention,” she said.

Ant’s credit business is the group’s key earnings driver. It contributed 39% to revenues in the first half of 2020 and 52% of net income according to new disclosures in a revised prospectus. A new 15.4% regulatory rate cap introduced in August limits the cushion Ant has in lending to people who really want credit. So instead, it’s lending to people who really don’t want it.

United Wholesale SPAC

The biggest SPAC deal yet has happened, and it’s happened in financial services. Following the IPO of Rocket Mortgage, the number one mortgage originator in the US back in August, the number two mortgage originator is now coming to the market via a SPAC merger. The SPAC in question is Gores Holdings IV, raised by Alec Gores in January. It is merging with United Wholesale. 

The listing of both mortgage companies via different means provides us with an interesting comparison of the mechanics. Rocket exhibited only an average sized pop, despite sexing itself up as a tech company. It came at $18 a share, below its initial range, and now trades at $22. 

One of the concerns was sustainability of its earnings, with the company coming to the market at a time both of peak pricing and peak volumes in its category. Two months on, those concerns are still valid so the SPAC structure allows United Wholesale to come to the market quickly, before the environment turns.

That’s not something they expect to impact them, however. The other benefit of the SPAC structure for investors is that companies are required to lay out their earnings assumptions. United Wholesale acknowledges that industry volumes may decline from $3 trillion in 2020 to $2.6 trillion in 2021, but forecasts that its volumes will nevertheless grow from $200 billion to $210 billion. It may win market share from Rocket and from banks if the broker channel which it dominates gathers steam. But the outlook is as much a face-off of listing mechanisms as it is of mortgage origination channels.

Litigation Finance

New asset classes are a fascinating area to explore. Michael Mauboussin recounts the story of Jim Rutt, former CEO of Network Solutions which was sold in March 2000 right at the peak of the NASDAQ: 

When he was young, he played a lot of poker. Now this was before the recent poker craze, so it was much less mainstream. Jim honed his skills by day, learning the probabilities for various hands and studying common poker tells. Then he found games at night. He said he became pretty good and started playing with better competition. He won some and lost some, but on balance he made money.

At that point, an uncle pulled him aside and offered some advice: “Jim, I wouldn’t spend my time getting better; I’d spend my time finding weaker games.” In other words, instead of finding players who are as skilled as you are, you want to find players who are not as good as you are and who are rich. That way, you have a better chance of walking out of the room each night with cash stuffed in your pockets.

New asset classes tend not to have as many skilled players trafficking in them. One such asset class in litigation finance. This week Burford, the largest player in the market, reported results for the first half of the year. Its return on invested capital was 97% and its long-term IRR is around 32%. The company has been mired in allegations around governance and accounting since last summer but if its numbers are right, it’s clear it has found a weaker game.