The coming revolution in banking

Retail Banking is broken

Why and what can we do?

This graphic (HT Harold Jarche) tells us most of what we need to know to answer these questions. In the last 100 years we have lived through 2 paradigms for how society and an economy works. We are living in the transition to the third paradigm right now. Understanding these transitions will enable us to navigate to the next paradigm.

Each paradigm has unspoken but real rules. This post will expose the rules.

A new context

Transactional retail banking is very new. It is rooted in the regulatory changes of the 1980’s, the apogee of the industrial  way of life. A time when most people had a pay cheque and a job.  A time when investment banking and retail have been combined into a business based on the balance sheet.

But now fewer and fewer of us have a pay cheque or a job. A banking system based on simple job based algorithms will not work in a free agent society. (More on why here) Retail banking, as a vast vertically integrated, machine process and balance sheet based organization will be less and less able to serve the needs of the economy that is emerging.

The new economy will be made up of many ultra small businesses organized in powerful networks.  ( See this link for more on this point) The “banks” that will thrive in this new context will mirror their customer base. They will operate using the classic rules of eternal banking but with a twist.

They will have to learn how to apply these rules in the new network context. (See more on this idea – here)This will enable them to keep their costs low, their ROI high and will enable them to align to those they serve.

So let’s now look at the old eternal rules for banking and sense how the old may apply to the new. Then we will close by adding the full network context. We will see why Credit Unions have such an advantage.

Deja Vu all Over Again

1.0 – It’s Personal – Banking always used to be personal. The character of the customer was the determining factor. The real question was “Will he pay us back” more than “Can he pay us back”.

For it is the total sum of a person that governs his credit not an algorithm based on a detached and contextless view of transactions.  It is his character and all of his behaviour and all his circumstances that affect his credit.

To “Know your client” is more than getting him to fill out a questionnaire.

2.0 – Relationships Trump Transactions  –  A Banker often had a lifetime personal relationship with his (Then always a man but of course not now) clients. His relationship was much broader than banking alone.  Jarvis Lorry of Tellson’s Bank (based on the real bank Child and Co) is the ideal.

The good banker always worked with his clients to make them more successful. He worked with them also to help them out of trouble.  He had a real relationship based on mutual self-interest.

We can still see remnants of this traditional banking in private banking.  Child and Co still exists today. It is part of the Royal Bank of Scotland Group. Hoare’s Bank  is the last completely truly Private Bank left. It is owned by the 11th generation of the family. They have clients today that have banked with Hoares for many generations. Hoares know their clients in a way that is rare today. 

3.0 – Alignment – To have a legitimate relationship means that the two parties have to have an alignment of interests. This means that there cannot be too great a power imbalance. This means that both the bank and the customer win.

Sound banking was aligned to its customers by scale and by model. There was a match on all fields. This alignment is a key element as we look into the future.

Most of our customers are small and personal.

About three quarters of all U.S. business firms have no payroll. Most are self-employed persons operating unincorporated businesses, and may or may not be the owner’s principal source of income.

Their banker has to be aligned to this reality.

A person can only have a relationship with another person. What people need is not services and products but care and attention. They need a person who serves their interests and so serves hers.

A major part of the new customer’s interest is the health of their network. This was true in the past but not true for most banks now.

This is a critical part of the real new economy. We know how to so this. Just as we used to know how to serve our clients personally.

4.0 – The community is also a focus of the banker’s attention – The smart banker not only knew his clients well but he also worked to make his entire community better. The healthier the community, the better all its members will do. The result was of course a larger and a healthier book of business for the banker. Alignment again.

In this context, he worked holistically to improve the social and business environment for his customers. Let’s see an example of how this was done in the recent past.

The Royal Bank had only 2 managers in a 30 year period at their main branch at 2 Cockspur St in London.   Both were called Mr Murray. No relation. With such long postings, the manager could develop the local expertise to offer a whole new level of service. With such long postings, the manager could establish and maintain authentic and deep relationships. All of the Royal’s UK business was centred on one person. That’s leverage!

The Branch was the hub of the Canadian community. Expatriate Canadians arrived in London knowing no one and nothing. The Murrays were your passport. They connected you to the Canadian community. Like Jarvis Lorry, no act was too small. Your passport is out of date and you travel tonight? No problem! They got the High Commission to issue a new one that day.

They connected you to the British establishment and acted a cultural interpreters. The Murrays were the real Canadian Ambassadors in London.

What this meant for the Royal Bank was that their book of business as a portfolio was being constantly improved in both scale and quality. It also meant that the Royal had immense power in the the UK.  The Royal was a player and made things happen.

This is not networking at the Chamber of Commerce. This is “Community Facilitation”. It is “Group Forming”. It is based on peers working with each other in a safe place created by the “Host”. The Royal in London was the hub in which most of the Canadians worked with each other. The Royal worked to improve each member and all members opportunity and so helped itself.

In the future, Banks will have to pay particular attention to the health of the communities that they serve as well. This is where the new network context will be found.

So what went wrong?

Why did this approach die? It died because of the adoption of the Ford Model in retail banking in the 1980’s. Where transactions supplanted relationships. Where the interests of banking at first diverged and then moved into conflict with its customers.

Retail banking is really a simple business. It is close to a utility. Conventionally it is hard to sustain a return of much over 6-8%. If you expect a return higher than that, your risk profile grows at an exponential rate for point of return.

So when banks just did banking and were separated from investment banks who in turn had to use their own partner capital, the market did not expect imprudent rates of return. Banks were allowed by the market to be conservative.

The break came in the 1980’s when banks were deregulated. With investment banking added to the mix, the investment banks used the bank’s capital and base to drive a race for the highest returns. If a bank was conservative the management would now be punished by the market.

The structural outcome that we have seen as a consequence of this change is a divergence in alignment with the real needs of their customers.

Banking had been a business that amplified the value of its customers. Now it became a business that extracted value from its customers.

Scaling – Part of the Paradigm

This problem of alignment cannot be fixed by using the Ford rules. It’s all about scaling.(More detail about scaling here)

In the Artisan/Independent model you could not scale more than what the person could do. This was fitting when all was local.

The triumph of the Ford Model was that it enabled vast scaling. But this model, being linear has a limit. Solved by mergers. And now at that limit as well.

Here is the limiting feature. In the Ford Model, the structural expenses grow in lockstep with assets. All resources have to be purchased. So when earnings get squeezed, management have to take on more risk to keep up the ROI. By taking on riskier assets, they lower the threshold for default and so increase the future risk of pressure on earnings and capital.

It’s a vicious circle. For a while, this can be offset by scale. Hence more mergers. But in the end, there is no where to offset the risk and all the costs are locked in. Today all the big banks own too big a chunk of the risk. This is where we are in Europe. There is no where to run anymore. (More on this process here)

It can only be fixed by taking the universal rules of banking applying them to the new real economy that is based on the Network. An economy that needs far less capital than the Ford model. An economy that scales in a sustainable way. An economy that is based on more than money as a measure of wealth.

In a real network, most of the resources are attracted in for free. This may sound bizarre. But in fact you know a lot already of how to do this. You just have not applied these principles to your own operations yet.

Look at Visa or Interac. If we use a real network, we can find ways of scaling that breaks this connection between structural costs and assets. In a real network, the resources and revenues scale exponentially while direct costs scale at a modest linear rate. Nearly all the value in a network is not on any members balance sheet. As the total network value scales, so each member gets more value.

We can see this in staffing. Back in 1995 Visa had 3,000 employees and B of A had a 100,000. Visa did a vast multiple of transactions to B of A. B of A now has 300,000 employees and is laying off 30,000 in a vain attempt to get its costs in line with its revenues.

The Twists – Alignment and Ownership – The natural model for banking is one that is aligned with its customers. Customers will be many tiny nodes aggregated into networks.  This is the new market.

So if the real new economy is based on this – then so must banking be the same.

It must itself be a fractal mirror of this. It too must be made up of small local nodes that are similar in scale to the nodes of the networks where the power lies in the future.

It has to have officers who can have legitimate personal and holistic relationships with those that they serve. It has to be also part of networks that give it scale and power.

It’s work will be to amplify the health of its artisanal customers and the networks that they depend on to have their best potential realized.

They will be Group Facilitators. Where it is possible to have exponential returns. Where we find a new way of creating high returns but also keep improving the quality of the portfolio.(More on Group Forming here)

So how would all of this apply to Credit Unions today?

The good news for Credit Unions is that their ownership is aligned with their customers already. This is a barrier to the future that the traditional banks canot cross. It is a barrier that will hurt them deeply in the future as the new model becomes more the norm.

The challenge for Credit Unions is that their operational culture and their model for scale is embedded in the Ford Industrial Model as it is with the Banks.

So learning how to be the kind of bankers that fit the new world will be much harder than simply an intellectual exercise. Knowing the new rules will not be enough. We have to see a model and we have to set up a series of experiences that will take us step by step to that model.

In the next post we will explore the model. And in the final post we will examine a case study of how a leader in this change made the shift in its practices and organization. For there is nothing more difficult to do than to change you operating culture. And that is what is required.