Could the financial services industry learn from cereal? - May 30, 2009

Post is currently running a funny television ad for Shredded Wheat that “puts the ‘no’ in ‘innovation'” — mocking competing products touting complex combinations of supplements and miracle food cures in place of nutritious, simple foods made of familiar ingredients we can all pronounce.

Of course, the timing is perfect.  Post knows consumers feel nostalgic for simpler times, when products and companies were trustworthy and offered good value.  Shredded Wheat has offered its same, simple formula — with a name that tells you everything that’s in it! — for over 100 years.

There was a time when financial products were just as trustworthy and easy to understand.  Banks paid interest on deposits, lent money at a higher rate, and kept the difference as their profit.  Bank mortgages were backed by properties in their own markets.  The FDIC insured depositers funds, and monitored bank reserves to guard against insolvencies.  Insurance companies pooled risk under a simple model. And investment banks were a completely separate kind of institution — not really “banks” at all in the mainstream sense, but boutique firms that handled the more delicate needs of private equity transactions and the like.

“Innovating” away from simpler models — the quest for new financial products, and for enormous scale — created many of the problems our financial system faces today.  But, much of what passed for innovation arguably was not innovation in the sense of in the sense of doing things better, faster, more efficiently. 

Many blogs and other publications are questioning the “too big to fail” notion that this quest for scale and growth has created.  The Baseline Scenario, for example, regularly asks if institutions that are “too big to fail” are instead “too big to exist.”  Given that this question implies government curbing of the banking industry might be a good thing, even crucial, it’s naturally drawing fire from bank executives and free market purists alike. I wonder, though, if even that simple question — TBTF=TBTE? — is not quite simple enough. I think a more fundamental question is whether this bigness has the inherent economic benefits we so frequently assume scale can deliver.

Having spent a few years working at a then-huge commercial bank during its peak, steep decline, and ultimate failure, I have always questioned whether size leads to efficiency in the banking industry.  During my time at Bank of New England it acquired dozens of smaller banks, raced to dominate the regional real estate lending market, and became huge.  Yet there never seemed to be any genuine enthusiasm for  greater efficiency in operations.  In fact, there were powerful forces, beyond typical post-merger turf wars,  working against efforts to streamline – some that I think might be intractable. 

For example, some bank managers would argue that the cost of a few extra employees was a worthwhile trade-off if it better protected depositor funds.  It was never attractive to increase operational risks (real or perceived) just to save a little money. You could argue that this attitude is a very appropriate thing — if you consider that the commercial banking business is heavily insured by the government (even pre-bailout) via the FDIC, and, of course, commercial banks play a critical role in their communities.  What’s problematic is that this quasi-utility-like attitude is not consistent with true free market competitive behavior.

Moreover, this virtuous (if potentially misguided) banking norm is facilitated by a more troubling one (at least for customers): the notion that, because of switching costs, it’s easiest to just increase fees to generate more income and cover higher costs.   

The end result — bigger organizations with higher costs, not lower costs, maintaining profitability by relying on price increases and switching costs — is almost the exact opposite of what we consider “innovation,” which usually brings benefits to the market.

I don’t believe that banks will strive for efficiency as they get larger — and, maybe, to an extent, they shouldn’t focus there.  But, to the extent that this reluctance to streamline partly reflects the banks’ understanding that their responsibilities constrain them in ways that don’t apply to other industries, what does that say about their potential to ever achieve scale economies?

In other words, a key assumption of permitting (or even encouraging) financial institutions to become huge, global and diversified is that this promotes efficiency — and that’s what free market purists are reluctant to give up.  If all shareholders knew what bank employees know, though, I wonder if they, too, would prefer to invest in smaller, more nimble banks who can maintain efficiency, better understand and document their own asset bases, and better understand and serve their local customers.  A portfolio of more right-sized banks, each delivering more true innovation and better real revenue/profit growth potential, might deliver more returns to investors — while also putting less stress on the FDIC and the overall financial system.

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