Friday, October 22, 2010

Is there really a bank overcapacity, and have we reached the tipping point of bank privatization

It has been repeatedly said that there is a big overcapacity in the US financial industry. But is there really an overcapacity? So how come we see instances of this, of banks using robosigners to mindlessly sign foreclosure papers, and not employing adequate staff to check for proper documentation?

This overcapacity depends, to a significant degree, on what part of the bank you are looking at. Look at the trading and securitization side, and yes, there would seem to be a major overcapacity. Look however at the traditional banking operation side, and well, everywhere you look you’re bound to you see the work of an army being done by a platoon, on some cases, by a squad, and even, more frequently than is supposed to, by a lone person.

So why do we see this dichotomy? At a time when banks are supposed to be the biggest profitmakers in the economy, a time when it seems that they can extract a spread out of every deal, fart, or twitch a market makes, why do we see staffing in crucial and oftentimes franchise-breaking operations severely constrained?

Blame it on the same cost-cutting mentality found on every other industry. Operations is a cost center, not a profit center. In any business, the profit centers are where the deals get done, where the sales are made, and where the trades are decided. Never mind that any of these activities cannot be done without adequate operational backup. If you are not in a client-facing role, you may as well not exist. If you do not bring any transactions, you are eating off the pie of the hardworking rainmakers.

Let’s pause a minute to consider the economics of banking. Being intermediaries, they act essentially as middlemen. The more a particular banking service becomes crowded, the less profitable that service becomes. Any form of banking service is non-patentable. Hence, any and all new innovation is easily copied and competed away by its peers. The less profit, the greater the need to cut costs.

A banking service niche can easily be stolen by a competitor, by poaching key salesmen, technical staff, or traders. After the competition has bid away these key people, what you have left are the support people. Without the volume generated by, or any key people to support, these operations become too unwieldy and costly to maintain. After all, it is mainly the fees, trading gains, and commissions that subsidize them.

So what does a typical bank CEO do? Driven by the profit motive, and egged on by insistent board of directors, and shifty shareholders, he will focus his efforts on keeping the rainmakers, and on curtailing the operations side. The focus then becomes doing as many deals as possible, and taking on as many risky trading bets as can be found. This is what affords the heightened costs of keeping the rainmakers as well as maintaining the operations side.

So we see the proliferation of endless origination, packaging, and selling off of deals, even after the market for viable clients has long been saturated. For as long as the bank’s value at risk seems maintained at a reasonable level, and in a market where every asset is pushed up to ever-higher levels it will be, the success of previous deals and bets sets off a continuous pipeline of further deals and bets.

In the first stage, the bank’s goal is to achieve economies of scale, for this is what justifies having the infrastructure that executing these deals and bets successfully needs. In the second stage, the bank’s goal is now to achieve growth for growth’s sake, profit for profit’s sake. If you do not take that last piece of the market, you competitor will, and before you know it, it’s also taking away the piece you already have. If you do not take that last piece of profit, you competitor will, and before you know it, that profit is enabling him to under-price you, and is now taking away the piece you already have.

So what do we have here? A bank which engages in a lot of utility banking, the kind that you and I use in our everyday needs (checking, credit cards, wiring and payment remittances, etc) also engaging in a lot of risky and directional bets (casino banking) to compensate itself for the “God’s work” that it does for society.

In this current American foreclosure crisis, we’ve seen that banks, in their race to the bottom to cut costs, have found themselves inadequately staffed to undertake a process whose proper execution is to their own interest. How much less do you think are they adequately staffed to undertake a task whose proper execution is to the client’s (you and I’s) interest?

I ’m taking this up because what becomes industry standard in the US becomes industry standard elsewhere in the world. If the onset of globalization had not suddenly and violently been shaken by the crisis, how much more of crucial operations ( crucial to yours and mine, the general public) would have been subject to the axe and chainsaw? How long before this unsustainable standard is the standard in your local bank?

Banks do a lot of utility banking, the kind that are so crucial, that the government needs to step in at times to maintain them in functioning order at all times. But they also do a lot of casino banking, both to maintain the utility side, as well as to satisfy their leaders’ and their shareholders’ need for more wealth. And more often than not, the government has had to step in to save the bank from its casino deals than to ensure the continuation of utility banking.

How much easier it would be if we were to find a way to completely separate the utility and the casino sides of banking, and to extend the government blanket on just the utility side of banking. And perhaps, freed from the (seemingly) excruciating burden of having to maintain an adequate operations side for utility banking, the private investors and shareholders of pure casino banking would be satisfied with much lower profit expectations. The knowledge that the government umbrella has been divorced from their casino activities should further dampen their need for greater risk and yield.

But we do not live in an ideal world, nor has anyone found the ideal way of separation. We live in a world where the government needs to constantly monitor banks, and regulate them like a hawk. It needs to constantly see whether bank competition is getting out of hand, because the banks’ goal is now to achieve growth for growth’s sake, profit for profit’s sake.

In this way, it ensures both that the traditional utility banking that you and I have come to depends on keeps running, as well as ensures that the need for further government bailouts of casino bets gone made and bad are avoided. Perhaps the ideal is for the biggest utility banks to be state-owned banks.

Have we finally reached the tipping point of the move for bank privatization?

3 comments:

The Money Paradise said...

This is habit of human being to blame someone else for their misdeeds. And now the organizations are learning this. The talk of over capacity is just rubbish. if there is over capacity then how they are failing in verify the documents of their beloved clients for said relationship based approach. They are just trying to some else by saying something else and may be targeting something else. You know dear over the time these organizations have become more diplomatic than servicing the customers.

Min said...

"But is there really an overcapacity? So how come we see instances of this, of banks using robosigners to mindlessly sign foreclosure papers, and not employing adequate staff to check for proper documentation?"

Sorry to be cynical, but maybe sloppy paperwork is what the banks want, considering the previous sloppiness or even fraud.

"How much easier it would be if we were to find a way to completely separate the utility and the casino sides of banking, and to extend the government blanket on just the utility side of banking."

Gee, didn't we have that, once upon a time? I wonder what happened. Hmmm.

Rogue Economist said...

Min, plausible points, on pt. 1, but being understaffed and sloppy is not a very effective way to commit fraud. You get caught.

Pt. 2, Yes, the US had done that once upon a time, but undid it. Time for a reconsider.