Читать книгу Financial Institution Advantage and the Optimization of Information Processing - Keenan Sean C. - Страница 7

Economic literature includes a rich debate on why firms exist as they do – the main question being why firm boundaries are defined in the ways that we observe. Certain types of activities that could remain in-house are routinely outsourced, while many activities with the potential to be outsourced remain internal to the firm. Mergers, acquisitions, and divestitures do exhibit certain patterns with respect to how firms believe their own boundaries ought to be defined, but these patterns are by no means exhaustive nor are their outcomes obviously probative. Some corporate restructurings are metamorphic and highlight the question of what makes a financial institution a financial institution. For example, in 1987 Greyhound Corp., a bus line company since 1929, spun off its bus line operating units so that it could “focus on its core business of financial services.” To even think about which firms should be defined as belonging to the financial services sector we need to have some practical mechanism or criteria for inclusion. Theoretically we could simply enumerate a comprehensive list of financial services and products, and include firms that engage in this set of activities. With a boundary so constructed, we would have an identified set of institutions to analyze. But does that boundary really exist or is it helpful even as an abstraction? Retail sales finance is one of the largest and most obvious types of boundary blurring, often occurring at the direct expense of banks and retail credit suppliers. Captive finance subsidiaries for manufacturing firms are also common and the obvious complementarity between manufacturing goods and financing their sale seems to suggest that the latter function can be effectively internalized. But while the economic incentive to encroach on the boundaries of financial services seems to be predominantly one way – that is, we have not heard of things like mortgage institutions directly engaging in home construction – no hard and fast rule seems to apply.

There are well-known cases of captive finance companies whose financial services activities grew beyond financing the parent's manufactured products – in one case so much so that the entity became a systemically significant financial institution in its own right with only remnant relationships between their financing activities and the financing of the parent's products. Are there economic principles that would allow us to explain why, and the extent to which (for example) auto sales and lease financing are or are not more thoroughly internalized within auto manufacturers? While to economists the answer is surely yes (what area of human endeavor do economists feel cannot be explained by economics?), it seems clear that management teams at financial institutions themselves do not recognize or embrace such principles. For if they believed they understood the principles that define why the financial institution exists, they would surely leverage those same principles to establish firms that function better overall.

Rather than try to tackle this broader problem head on, in this book we simply focus on the kinds of firms that dominate the financial services industry landscape: banks and insurance companies. We leave it to the reader to consider whether or not the observations made also apply to any specific firm or subset of firms with financial sector exposure or activities. A number of factors characterize the financial services industry in a way that might help us better understand why financial institutions exist in the way they do, and how they can improve their economic strength and competitive positions.

Low Barriers to Entry

Over the bulk of the financial industry's long history, practical barriers to entry in banking and insurance were quite high. In the modern era this was primarily due to regulatory and licensing requirements, but also due to consumer preferences for brand stability and stature. Over the past 100 years or so great banking and insurance industry firms were founded on brand strength, and their ability to attract depositors and policy holders was their primary determinant of growth. However, those barriers began to erode during the twentieth century as cultural changes and an increasing dependence on technology changed both the supply and demand sides of financial services markets. Changing regulatory requirements produced periods that alternated between stimulating and dampening bank and insurance company formation as well as merger activity, which is beyond the scope of this book to either document or survey. What is important is that evidence can be presented to support the claim of low barriers to entry.

Interestingly, the aggregate data does not show an upward trend in the number of operating financial institutions. For banks, the total number of operating institutions in the United States hovered around 14,000 for the nearly 20 years between the early 1960s and the early 1980s. Then, after the savings and loan crisis began to unfold, the total number of banks began to drop – a trend that continues to this day, with the number of banks dropping by more than 50 percent from its 1980s total to fewer than 6,000 in 2013 (see Figure 1.1). However, looking only at the total number of institutions does not tell the whole story. In particular, the stability of the total number of institutions during that 20-year period between the 1960s and the 1980s reflected an offset between periods of great consolidation through mergers and acquisitions that reduced the total and periods of rapid entry of new institutions – particularly savings and loans associations, prior to the S&L crisis. Overall, entry into the banking sector has remained brisk and steady, despite the stable, then declining, count totals. Hubert Janicki and Edward Prescott observed that, “Despite the large number of banks that have exited the industry over the last 45 years, there has been a consistent flow of new bank entries,” and calculated the average annual entry rate at about 1.5 percent of operating banks. The authors further observe that, “It is striking that despite the huge number of bank exits starting in the 1980s, entry remained strong throughout the entire period. Interestingly, it is virtually uncorrelated with exit. For example, the correlation between exit and entry for the 1985–2005 period is only –0.07.”4

Figure 1.1 Total Commercial Banks in the United States

Source: Federal Reserve Economic Data (FRED); Federal Reserve Bank of St. Louis.

Technical Core Products and Services Offered (Financial Intermediation and Disintermediation and Risk Pooling)

Janicki and Prescott also observe how market share can shift dramatically. They note that of the top ten banks in 1960 (by asset size), only three are still in the top ten.

Part of this is due to M&A (mergers and acquisitions) activity. But part of it reflects the fact that the product and service sets, based on intermediation and disintermediation and risk pooling, are technical in nature, and as trends in the underlying technologies change, firms have a great opportunity to innovate effectively and gain market share, or fail to innovate effectively and lose market share. What Figure 1.1 does show clearly is that while barriers to entry may be low, barriers to exit are even lower. Failure to stay abreast of technological innovations, as well as the adoption of so-called innovations that misrepresent true risk-adjusted returns, has been causing the number of operating banks to shrink by about 280 per year since 1984. Some of the innovations that led to distorted risk assessments include mortgage-backed securities and complex, illiquid types of derivatives (there are others). But while distorted risk assessments have historically been blamed on personal mismanagement and a culture of greed, these explanations offer little in the way of economic underpinnings and cannot explain the disappearance of nearly 8,600 banks over a 30-year period. The main culprit is that decision makers within these firms have been provided with poor information, insufficient information, and, in many cases, misinformation, and the main cause for this is that these firms were manifestly poor at information management and creation. While the S&L crisis triggered the largest number of bank closures, the bursting of the tech and housing bubbles, and the ensuing liquidity crisis of 2008, also forced many institutions to close. And in far more cases, institutions that did not fail saw their profitability greatly reduced by inefficiencies, losses, and fines – most of which could have been avoided with the appropriate amount of investment in system architecture and process redesign. Recent examples of significant regulatory fines related to information processing failures include:

• $25 billion: Wells Fargo, JPMorgan Chase, Citigroup, Bank of America, Ally Financial (2012)

• $13 billion: JPMorgan Chase (2013)

• $9.3 billion: Bank of America, Wells Fargo, JPMorgan Chase, and 10 others (2013)

• $8.5 billion: Bank of America (June 2011)

• $2.6 billion: Credit Suisse (May 2014)

• $1.9 billion: HSBC (2012)

• $1.5 billion: UBS (2012)

Taken together, these historical facts show how even very large financial institutions can suffer or even cease to exist if they fail to embrace technological innovation, or embrace it without a commensurate investment in the information management capability required to effectively evaluate risk. Thus, the stylized facts that should concern current financial institutions are:

• Firms entering the market, particularly those entering with some technological advantage, are a threat.

• Excessive risk taking based on impaired risk assessments (often the result of technological innovation without the supporting information flow) is a threat.

• The likelihood that any firm succumbing to these threats will be expelled from the market is high.

Poor information management itself has causes. In some cases, the underlying causes may have included a regulatory (and rating agency) arbitrage in which financial institutions were incented to do the minimum while benefiting from things like deposit insurance (an explicit stamp of approval from regulatory authorities) and high public ratings from rating agencies, or even the implicit stamp of approval that comes purely from compliance and the absence of regulatory censure. But more importantly and more generally, low industry standards for excellence in information processing have meant the absence of competitive pressures to innovate and excel. This environment, which has persisted for decades, is now coming to an end.