When you think of the banking sector, chances are good companies like the "big four" American banks -- Wells Fargo (NYSE: WFC), Bank of America (NYSE: BAC), Citigroup (NYSE: C), and JP Morgan Chase (NYSE: JPM) immediately spring to mind. They're dominant in the domestic category, with unrivaled scale, reach, and mind share among consumers.
Yet scale isn't always a good thing. And, in fact, I don't think any of the big banks is a good investment right now.
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The key problem
Generally speaking, banks make their money from arbitrage -- that is, pocketing the spread between two different transactions. In fact, there's an accepted metric -- net interest margin, or NIM -- by which banks measure their ability to do just that. This is why deposits (checking, savings, and money market accounts, and certificates of deposit -- or CDs) are so important to banks. In fact, CDs and loans are a classic example: You lend your money to a bank for years in exchange for a paltry interest rate (NerdWallet's "best CDs" rankings don't mention any yielding over 2.65% annually), and the bank takes that money and lends it out at a much higher rate through, say, an auto loan (current average: 4.55%), pocketing the difference. The bank can lend that money out with confidence because it charges consumers gargantuan prepayment penalties if they withdraw early from a CD -- enough in some extreme cases to wipe out all their gains and then some.
Arbitrage is a bank's payment for facilitating transactions and providing liquidity -- people need cars and can't pay cash, so the bank raises money elsewhere to enable that transaction to occur. Think of it like a tollbooth for someone to use the highway. But, unlike with real-world tollbooths, there's competition: Banks spar with each other to offer those loans, accepting marginal reductions in their theoretical loan APRs so they can win the loan when borrowers shop around. Banks also compete on the other side -- on CDs and other deposit options -- because they know deposits are generally the lowest-cost way to raise capital that they can then lend out at a higher rate.
Nothing I've written so far is new. That's how the banking system works. The problem, though, is that the big banks face new competitive threats that are being facilitated by technological disruption -- threats that they can't effectively fight.
Go online, young man
One of the keys to offering the most attractive loan options to win borrower business -- while still maintaining profitability -- is having a lower cost of doing business. Part of that is having a cheaper way of sourcing deposits. And for a long time, plenty of banks likely got away with paying out lower yields on savings accounts than many of their competitors. The advent of the internet has made that a lot more difficult, as sites (including ours!) provide head-to-head comparisons so consumers can make informed decisions based on up-to-date information. Financially savvy people seek out the best rates they can get on both sides of the equation.
Banks can also lower their cost of doing business by running a tighter, leaner ship. The efficiency ratio, which measures the percentage of net income that noninterest expenses (stuff like personnel and building costs) eat up, is a useful metric for understanding whether a bank has a cost advantage. Of course, much depends on how the bank achieves a lower efficiency ratio: If it saves costs by, for example, cutting compliance staff, management will probably one day regret that decision when regulators come knocking.
Cutting costs -- thoughtfully -- is a reasonable way to compete on loan pricing, as long as everyone has all the same classes of costs (compliance staff, loan officers, branches, ATMs, etc.) That's why the advent of online-only banks (companies like BOFI Holding and Ally Financial) presents an enormous threat. They don't have branches, so their real estate and staffing costs are materially lower -- and their efficiency ratios throw this advantage into stark relief:
|Bank||FY 2017 Efficiency Ratio|
|Bank of America||62.7%|
With a (substantial) efficiency ratio advantage, online banks can simply outbid their traditional competitors every time while still maintaining enviable profitability.
Accelerating the process
The big banks have ways to fight back -- but unfortunately, they are self-defeating in the long term. The big banks can reduce their cost base by trying to move a greater share of their transactions online, enabling them to close branches and run a leaner machine, in the hopes of reducing that efficiency ratio to be more competitive. And, lo and behold, that's exactly what they're doing.
That works well in the short term -- and is good for consumers, as better efficiency means better loan rates, which enable us to borrow money for less. The problem, though, is that the big banks are training their customers to go online to do their banking -- which builds the savvy and skills for people to also feel increasingly comfortable shopping around. If you get used to not going into a branch, what is the advantage of staying with Bank of America, say, when the internet tells you that some other bank will give you double the yield on your savings account? (The answer, perhaps, is "better the bank you know than the one you don't" -- but, over the long term, that will shift too.) And it's not like the big banks have created a frictionless experience with all the money they're spending on apps. In fact, only one bigger bank (Capital One -- not one of the big four) scored in the top 10 banking apps in Magnify Money's annual rankings, and it scored...tenth.
Increased internet savviness makes customers more aware of better alternatives out there and lowers switching costs -- so they're more likely to shop around and will have less difficulty doing so. That's a lose-lose for big banks long term, especially given that surveys show customers are generally dissatisfied with their banks (just 23% reported being satisfied with their bank in a recent one) and that trust in banks erodes as they get bigger.
Now, in all fairness, part of the cost advantage internet banks currently enjoy is an issue of size -- the big banks, as systemically important financial institutions (SIFIs), have much higher compliance costs because their collapse would threaten liquidity across the United States. If any individual internet bank ever gets to be of a similar size to, say, a Wells Fargo, then its costs will increase and it will struggle to compete with its smaller brethren.
But the fact that individual internet banks may resist crossing the asset level ($50 billion, perhaps shifting to $250 billion if GOP-proposed tax reforms pass Congress) that will trigger additional compliance costs isn't a positive sign for big banks. It just means that there will probably be more internet banks fighting for a slice of the pie, as those that successfully get near the compliance tiers stall growth to avoid compromising their profitability.
All downhill from here?
To be perfectly clear: I am not implying the big banks are going out of business. I don't think they will. They have huge customer bases, and most Americans are focused on bigger things than whether they can boost the yield on their savings account (or reduce the cost of their loan) by a percentage point.
My issue, though, is that I don't think big banks are in a place to prosper and deliver market-beating returns over the long term. Fact: The big four (Wells, Citi, Bank of America, and JP Morgan) control about 36% of U.S.-based deposits, according to WalletHub. It's hard to imagine them continuing to grow that market share (which has remained essentially flat over the past six years) in the face of growing consumer adoption and acceptance of internet banks, particularly if they can hold on to their substantial cost advantage. Long term, if they lend conservatively and operate prudently, the internet banks seem primed for plenty of prosperity.
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