L10 - Secular Pressure on the Banking Industry

Question 1

What is causing the secular pressure on banking?

Answer 1

Secular trends are not seasonal or cyclical. Instead, they remain consistent over time

The overwhelming pressure will continue to be increased competition. This might emerge from several sources: -

• The existence of similar competing firms in the industry.
• Increasing contestability in the industry.
• Customers turning to alternative providers and traditional providers responding to this challenge.

Question 2

Is it competition that affects the behaviour of incumbent banks?

Answer 2

• The power of competition to constrain the behaviour of incumbent firms in an industry is not so much indicated by the degree of competition prevailing at any point in time (not the number of competitors in the market right now), but the extent to which the market is contestable.

a contestable market is one with firms facing zero entry and exit costs. This means there are no barriers to entry and no barriers to exit, such as sunk costs and contractual agreements.

• Its profits and there is a threat of new entrants entering the market
• This constrains the behaviour of incumbents - can’t just leave and enter at will due to high fixed costs - therefore have to behave as if the market is competitive

Question 3

What part of banking is becoming more contestable?

Answer 3

• The first thing to be aware of is that it is not necessarily the banking industry that is becoming more contestable, but banking markets.
• Banking products and services can now be unbundled and new firms can emerge as competitors in any area traditionally associated with banking without offering the full range of banking activities.

Question 4

What has led to the emergence of contestability in the banking industry?

Answer 4

• The cost of information has fallen. –> and vast quantities are easily accessible
• Regulatory barriers have eased.
• Credit scoring techniques have been devised. –> project much more about customers now
• Deconstruction has now become possible.
• Securitisation, that is, off-balance-sheet activities have emerged —>
• Contract banking has emerged and the implication is that the scale becomes less important.
• New forms of delivering banking services (eg telephonic banking) have emerged and developed rapidly.
  
  • the internet has dramatically cut the cost to near zero - especially search and advertising costs
  • People dont mind using unbundled services
  • no longer limited to domestic providers - Monzo

Question 5

How has the emergence of Globalisation increased competition in the banking industry?

Answer 5

Competition has increasingly become more global in three ways.

• Customers now have global options available to them and these enable customers to arbitrage between domestic, foreign and international banks and capital markets.
• Banks are no longer restricted to business within their own country.
• Regulatory barriers have declined to the point where banks can now locate in foreign countries.

Question 6

How has the decline of entry barriers increased competition in the banking industry?

Answer 6

A major determinant of the intensity of competition in an industry is the strength of entry barriers. The essence of monopoly power is the ability to maintain barriers to entry.

Question 7

Why have entry barriers declined?

Answer 7

• New entrants can gather information about their customers easily
• Scale has become less important and, because of lower fixed costs associated sub-contracting service provision, economies of scale can effectively be bought in from specialist providers.
• Scale economies are therefore in the processes rather than firms.
• Regulation with respect to allowable business has declined. Consumers have become less restrictive in the organisations with whom they are prepared to conduct banking business

Question 8

What has happened to exit barriers?

Answer 8

While entry barriers have declined, so too have exit barriers. This has been facilitated by the development of new delivery mechanisms and the consequent reduction in the need to have an established branch network.

Question 9

How has deconstruction effected the banking industry?

Answer 9

The deconstruction of products lowers entry barriers into some banking markets. A simple mortgage, for example, has three components:-

• Origination;
• Management;
• Asset holding

Traditionally the role of offering a single mortgage was offered by one firm - a bank - which gave them a comparative advantage as they dealt with the whole process

Question 10

How is competition in banking asymmetric?

Answer 10

Competition in the finance industry works asymmetrically. Developments in technology and the erosion of barriers to entry mean it is easier for non-bank financial intermediaries and nonfinancial institutions to diversify into banking than the reverse.

• as they have high incumbent costs, no longer have the comparative advantage they used to - nor the flexibility or specialisation of some new entrants

Question 11

How has regulation affected banks?

Answer 11

• Historically, regulation has prevented banks from diversifying out of finance. However, regulation has also limited balance sheet growth and the allowable range of business that banks can undertake
• limited price competition allowing banks to reap supernormal profit from high rates - regulation made banking immune from cost pressures
• In line with policy generally, the approach to regulation is deregulation and freeing financial markets up to the competition to promote efficiency
  
  • This has also occurred because of globalisation

Question 12

What is the importance of technology in the banking industry?

Answer 12

Technology is transforming the fundamental economics of financial services, just as it is with just about every other industry. However, perhaps uniquely, technology is changing the production AND the distribution economics simultaneously

The power of technology has been and will be, decisive in its effects. Technological change:

• Enables new services to be offered.
• Enables existing services to be provided more efficiently.
• Increases economies of scale in bank processing.
• Enhances management’s access to information.
• Lowers entry barriers in some areas of banking.
• Changes the cost of information.

Question 13

How can the internet challenge the banking industry?

Answer 13

• The internet has the potential to challenge two aspects of the basic economics of banking: Information and delivery.
• By its very nature, it increases consumers’ access to a wide range of information and adds a further dimension to the delivery of financial products
• The impact of the internet spans many dimensions and is ongoing. The specific impact on banking has many dimensions:
  
  • The marginal cost of transactions is virtually zero.
  • Distance between consumer and supplier becomes meaningless and has increased cross-border competition.
  • Usually, consumers pay the access costs. –> banks have passed this onto consumer

As financial institutions have developed their own home pages, the cost of information to the consumer, along with search costs for rival services and products have fallen considerably and this has had the effect of increasing competition in the market for providers

• The transactions costs of switching between providers have fallen and have seriously impacted on consumer loyalty which has largely been eroded. –> no longer difficult to swap banks anymore

Question 14

What pressure has the asymmetric decline of entry and exit has on the banking industry?

Answer 14

• Since exit barriers are declining faster than entry barriers, the inevitable result is the emergence of excess capacity.
• However, the existence of excess capacity does not imply that new firms will not enter the market.
• That will happen so long as new entrants perceive they have a competitive advantage over incumbents.
• This, in turn, creates pressure for incumbents to adjust.

It difficult to actually determine if their is excess capacity, as it is hard to classify the output of a bank in the first place

• The likelihood is that there is an excess volume of capital in the global banking industry. - banks had to recapitalise and have a large capital base to protect against another financial crash
• To the extent that this is true, the implication is that the required rate of return cannot be earned in the long run.

Question 15

How has excess capital affected banks?

Answer 15

• Excess capital, that is, capital in excess of what is needed to support the current or expected level of assets raises the required rate of return on assets in order to service the capital base.
• However, the same competitive conditions that have caused banks to lose some lending business also make it difficult to increase the rate of return on assets.

Question 16

How can banks combat the problems of excess capital?

Answer 16

• Expand the balance sheet (increase the business they get involved in) perhaps by taking on more risky loans. So long as banks do not levy the appropriate risk premium, this will have the effect of eroding lending margins and the destruction of capital - (may solve the problem of excess capacity, but still not making the required rate of return on capital so this problem still persists)
• Make acquisitions such as purchasing and insurance company which, historically have been purchased at a premium which subsequently makes it difficult to obtain a risk-adjusted rate of return.
• Repay capital to shareholders. This might be the best option if regulation limits the extent to which bank capital can be deployed in new business areas. Several banks have already done this and others seem certain to follow.

Question 17

How is the number of banks affecting economies of scale?

Answer 17

Globally there are simply too many banks to enable the full exploitation of economies of scale. Whilst there is ambiguity about the economies of scale available to bank firms, there is no doubting the availability of economies of scale in banking processes. –> although we don’t know what is type is available to banks as we cannot define their capacity

• This could mean that we will see a consolidation of banks, a reduction in number through M&A

Question 18

How is excessive infrastructure affecting the banking industry?

Answer 18

• The third concept of excess capacity relates to the basic infrastructure and branch network rather than the number of banks per se.
• To the extent that are too many banks in relation to the optimum number, there is necessarily duplication of banking infrastructure which implies relatively high fixed costs.
• Banks are closing down branches and merger to reduce costs.

Question 19

How has technology capacity influenced the banking industry?

Answer 19

In many areas of financial processing, the impact of new technology is twofold: It creates more substantial economies of scale (technology puts on a lower LRAC curve) and it increases the volume at which the optimum scale is reached.

• Increases the capacity of banking services (keeps with the trend of fewer but bigger banks)

This has had an influence of employees:

• As capital and technology progresses, people are replaced and excess capacity emerges. In the last few decades the number of people employed in banking globally has fallen substantially and continues to fall.

Question 20

How has cross-subsidisation been sustained in banking?

Answer 20

Cross subsidisation is common in multi-product firms and is a way of spreading fixed costs. Banking is no exception and different products such as loans to different types of customers subsidise one another so that prices do no accurately reflect costs and risks.

Cross subsidies have been sustained in banking for several reasons:

• Relatively high entry barriers
• Customer loyalty
• Banks didn’t distinguish between customers in terms of risk etc

The implicit argument here is that the market can be segmented into subsidising and subsidies products –> as entry barriers fall, new entrants come in and go into these areas, this is going to force change in the pricing behaviour of banks - no longer going to earn the rates it did

Question 21

What are consumer trends in banking currently?

Answer 21

Consumer expectations and demands are also changing. The likely trends are:

• Consumers will become increasingly aware of greater competitive pressures and they will seek to exploit any advantages offered.
• Demand for higher standards and greater reliability will increase.
• It seems certain that consumers will come to demand more convenience and speedier access to financial services and products.
• It seems likely that consumers will demand more choice
• . It seems likely that a wider range of delivery mechanisms will be demanded.

With access to more and cheaper information, consumers will become more sophisticated in their demands for information and clarity about what is being offered by financial providers

Alongside these changes, banking products are being unbundled due to financial innovation, deregulation and growing competition –> consumers are not demanding and competing for these

Question 22

Where has the pressure to cut costs come from in banking?

Answer 22

Across the board, the financial institution is under pressure to cut costs. Pressure for this has come from three sources:

• The emergence of increased competition.
• The erosion of entry barriers.
• The specific effect of technology

Question 23

How is the capital and short-term money market effecting banks?

Answer 23

• Banks face competition from the capital market and the short term money market. The rapid growth of commercial paper markets in so many countries demonstrates the power of markets to displace banks.
• Similarly, both depositors and borrowers now have a wide range of capital market instruments and companies now turn to the capital market for funding that would normally have been provided by banks. Securitisation has been at the forefront of this process of change.
• Growing competition from the capital market is imposing more discipline on bank management which has been forced to shift its attention away from balance sheet activities to the rate of return on capital.