The Dilemma Faced By The Smaller Banks: Financial Technology

by: John M. Mason
Summary

Analysts and journalists are still focusing primarily on what products and services are offered by commercial banks, especially, in this technology age, on the smaller banks.

This focus misses the point as the essence of information technology is that it primarily deals with "intellectual property" and "intellectual property" can be scaled almost without limit.

The largest commercial banks, like JPMorgan Chase, are now following the "new" Modern Corporations and are focusing on scale, something that will sweep away the current banking system.

These changes taking place in the banking sector should be taken seriously by investors because they will impact the whole structure of the industry, and, consequently, winners and losers.

A new article by Telis Demos and Rachel Louise Ensign in the Wall Street Journal captures the dilemma of smaller banks in the United States, by what it doesn’t say.

This follows up on an earlier article in March examining the role technology is now playing in the survival of the smaller banks in the country.

Demos and Ensign spend their entire article discussing the products and services offered by smaller banks and the need these banks have to bring their offerings closer to the “cutting edge” by working with firms in the technology industry.

The largest three “core providers” in this space are Fiserv Inc. (FISV), Fidelity National Information Services Inc. (FIS), and Jack Henry & Associates Inc. (JKHY). These companies “provide the technology behind everything from keeping track of customer deposits to powering mobile apps.”

“As the number of community banks has shrunk, the three companies have grown, partly through acquisition of other tech providers, in both revenue and profit.”

The WSJ article dwells on the frustration being experienced by the smaller banks in terms of products and services and their accessibility, the contracts that are being written, and the sometimes “mediocre digital offerings.”

Demos and Ensign write:

“Executives at some small banks say they feel like they are becoming franchises of the core providers because they are so reliant on their technology.”

The authors add:

“The three biggest core providers today do business with 90 percent of U. S. banks with less than $1.0 billion in assets….”

But, the future of the banking industry does not lie in the ability of banks to just provide products and services connected with the latest technology.

The future of the banking industry was central to the recent BB&T (NYSE:BBT)/SunTrust (NYSE:STI) merger where the executives claimed “Technology was the main impetus for the deal...”

And, in terms of the “new” Modern Corporation, the crucial element of the technology advance is the impact it is having on the scale of businesses. This is exactly what the executives of the BB&T/SunTrust merger were talking about.

This development should be of major interest to shareholders and potential investors. It changes what will create value in the banking industry. It will change who survives, something that investors should be very interested in.

The future of BB&T and SunTrust is different now because its leaders realized that they could not really play with the top tier unless the combined institutions were able to scale in a way that kept them in the ballgame.

Some banks may be able to maintain a relatively small niche in the industry just focusing on products and services, but they will be constrained because they will have to remain within their niche.

I have expanded on this in other recent articles like “The Growing Size of American Banks” and “Bring on the Larger Banks.”

The major issue here is that the “new” Modern Corporation does not dwell on products and services, the main concern of the Demos and Ensign article.

The major issue is one of intellectual property, the substance that the “new” Modern Corporation is built around.

The crucial element in the use of intellectual property is the ability of users to create platforms and networks that tie businesses and customers together in interacting and interfacing webs.

The legacy organization that focuses just on products and services is referred to as a “linear” model where a customer buys something from a supplier. It is linear because this is the only relationship.

Platforms and networks can flow any which way and one fundamental outcome of this interaction is scale, a scale that can be achieved at zero marginal cost or close to zero marginal cost.

This is what the BB&T/SunTrust merger is all about.

The combined companies will create the sixth largest bank in the United States. However, the merger of BB&T and SunTrust will create a bank with less than 25% of the assets of the largest U.S. bank.

Scale is important in banking and will become even more so as we move forward in this technological age.

The supporters of community banks and/or Main Street banks have very good intentions in attempting to keep this part of the banking system competitive and alive.

I was born in the state of Missouri and my grandfather was the proverbial “Missouri banker.” To him, the banking structure should be a “unit” banking system. That is, a bank should only have one office. This viewpoint was held as strongly as anyone ever held religious beliefs.

There was a time and a place for “unit” banking, but now is not the time. The technology will not allow it.

And, if the United States wants to have a banking system with 4,500 commercial banks, give or take a few, the American banking system will cease to be competitive within the world banking structure. I believe I made this very clear in one of my posts, mentioned above.

The attrition now taking place in the US banking system confirms this movement. Demos and Ensign write:

“Midsize and local banks hold 13 percent of primary banking relationships but capture only 7 percent of the customers who switch banks….”

That is a pretty substantial attrition.

However, that is the state of the world today.

Non-bank organizations are going through the same process, it is just that the commercial banking industry is substantially behind other major sectors of the economy as the information age changes just about everything.

But, the big banks are moving, too. JPMorgan Chase (JPM), for example, has shifted into a higher gear in terms of incorporating much more cutting-edge information technology into its operations.

The dilemma of the smaller banks?

Their existence. Investors take note because they must look at individual banks differently now. There will be just a few options.

Can a bank absorb and work with the evolving technology becoming one of the "new" Modern Corporations? Can a bank combine with another... or others... like BB&T and SunTrust have... and build sufficient scale? Can a bank become a part of another organization that is at the leading edge of the changing technology? What if a bank cannot change, cannot provide access to needed markets, and cannot scale, does it have much value?

Within the environment I am describing, the commercial banking industry is going to decline substantially from its current number of about 4,600 banks. Investors looking over a seven- to ten-year time horizon are going to have to pick the potential winners and the looming losers, not in terms of providing good products and services.

Just review the data I cited above about how midsize and local banks only keep 7 percent of customers that switch banks.

Investors need to examine how this attrition is impacting the banks they are interested in investing in. To me, it tells the story of who will create sustainable competitive advantages in the future. This is what they should be interested in investing in.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.