Why Google, Apple and FB don't want to be banks...

Recent research has shown that banks spend more on IT than any other industry sector (See Deutsche Bank Research - IT in banks: What does it cost?). In fact, on average banks expend 7.3% of their budgets on technology, where other industries average half of that at 3.7%.

Bankers would defend these costs because of high compliance and regulatory costs, as well as legacy system support, security and fraud measures along with mission critical performance requirements.

"The reasons for a higher use of IT in the banking industry are manifold," writes Mai. "Financial service firms have to fulfil exacting regulatory requirements which translate into IT costs that do not contribute to the firms’ earnings. Furthermore, banks rely heavily on IT in their back offices as well as their distribution channels"
Heike Mai - Deutsche Bank.
Source: Business Insider - Banks Spend Way More On Info Tech Than Any Other Business 

While that may be a reason for such high spend, in this day and age of transformation and innovation, it's hardly an excuse.

Banking has long been considered one of the more profitable segments of the market, and big banks (these days called the TBTF crowd) have often been amongst the best or safest blue chip performers on the stock market. Since 2009 and the great recession, we've had to rethink that. Although many bank stocks have recovered quite well this year, of the 4 dominant banks in the US (BofA, JP Morgan Chase, Wells Fargo and Citi) their average Beta β is 1.935 making them extremely volatile historically. Comparatively the 4 dominant tech brands (Google, Apple, Microsoft, Oracle) have an average of just 0.983 - meaning they are as half as volatile as bank stocks. Amazon shares this characteristic with an Beta of 0.8. Admittedly Facebook doesn't have enough operating history to provide a meaningful Beta right now, but it would probably be pretty volatile as well.

Can banks be as efficient as tech companies?

The key problem, however, is really productivity. Banks, while generally being quite profitable businesses at the top end of the market, are increasingly becoming less efficient at delivering revenue. This is undoubtedly due to increased regulation, tons of outdated and legacy process and distribution bias, and historical organization structure.

Let me illustrate.

If we use the same group of companies above to compare relative performance, the tech industry has been performing very well from a profitability perspective these last few years. Apple alone generated close to $41.7Bn in profit last year, which is essentially the same as BofA, Wells and Chase combined with $43.6Bn. The 4 top banks generated $51Bn in profit for 2012, whereas the big 4 tech giants generated $85.2Bn in profits for the same period. While that looks on the face of it like a decent performance by the banks coming off a tough few years, the reality is that the effort it actually took to deliver that revenue is comparatively poor.

Despite a bigger IT spend than any other industry sector, the revenue or profits generated per employee are telling.

Bank of America, JP Morgan Chase, Wells Fargo and Citi between them employee 1.051 Million people to deliver that $51Bn in profitability, or roughly $48,517 per employee.

Google, Apple Computer, Microsoft and Oracle have between them 341,777 employees that delivered $85.2Bn in profitability in 2012, or roughly $249,285 per employee. More than five times the margin than their FI equivalents.

It's problematic that growth has slowed for the big banks too.

This all begs the question as to the long-term viability of the current model.

Would Google, Facebook or Apple be better at banking?

While many have pondered the question as to whether FB, GOOG or AAPL might make better banks, I think the question is more likely how is this disparity going to evidence itself in future business models.

Right now we see a plethora of start-ups in the payments space, and we see the likes of Moven, Simple, GoBank, and Bluebird taking on the question of alternative distribution. The prepaid cards industry in the US has been growing at a CAGR of 16% according to Visa's research, which compared with the decline in checking accounts in the US at -2 to 4% CAGR over the last few years, is instructive in this regard as well.

The fact is that the fastest growing deposit product in the US has been prepaid debit cards, and this have been delivered with a much lower distribution cost (although cost of acquisition remains high). The potential for disruptive distribution plays is certainly evident.

However, Google, Facebook and Apple are unlikely to want to be banks with the sort of capital, compliance and regulatory overhead associated with the banking business. Having said that, Apple should probably get it's own bank license in the Caymans just to hold their huge wad of cash reserves right now. I'm sure that would somehow make sense. The more likely outcome is actually that Google, Facebook and Apple are part of the solution for lowering distribution costs for banks, and they'll likely be able to charge a premium for that access in the future. Especially as banks realize that customers aren't opening new accounts in-branch and they start scrambling for new ways to acquire.

What can banks learn?

The key message is clear. The legacy transactional banking and distribution infrastructure, supported by outdated metrics, budgeting, processes and organization charts has over time, built up into an unsustainable operating model. While regulatory imperative has significantly increased operational costs, we've ended up simply adding complexity and inefficiency on top of the old system, rather than rebuilding the underlying bank and its processes.

It's really, really tough to replicate the compliance and transactional processing capability of a bank today. That's why the cost is prohibitive. It's also why Google, Facebook and Apple don't want to get into the business of banking. However, they're going to increasingly be in the business of selling banking products, apps and services to consumers (in an effort to maintain acquisition traction), and they're going to be looking at owning more and more of the payment instance (before, during and after a transaction) because of the opportunity for high-frequency, low-margin revenue and advertising.

Banks are going to have to take a hard look at friction in the front-end, because that is where the inefficiencies of the model will result in loss of share of wallet, the end of the concept of the primary financial institution (replaced by the primary financial application), and other such tectonic shifts. As a bank it's not about spending more money on IT, or becoming an IT company - it's about lowering core operating costs through consolidation of legacy platforms, lowering distribution costs and seeking revenue through new channels. But mostly it is about getting rid of the friction at the front-end.