The world of banking is changing

Interview with Marcus Agius, Chairman of PA Consulting Group and former Chairman of Barclays, the British Bankers Association and Deputy Chairman of Lazard Ltd.

The world of banking is changing. It is impacted by economic conditions in countries and regions, by technological trends, new competition and changing preferences and behaviour of their customers, among other factors.

PA: What is your view of the situation in the banking industry around the world today? Is it different from five years ago? Ten years ago?

Marcus: The global financial crisis started in 2007, ten years ago. Banking has gone through more change in these ten years than it has in any equivalent period in the past. Regulation has played an important role in that change, and it is likely to continue to do so. Going forward, we will see regulation and technology combine in new ways. We can split the global banking scene into four groups of countries:

First, we have the developed and technologically advanced countries. The banks in these countries are building significant technological advantage, exploiting Fintech through dynamic customer involvement. The Scandinavian countries are among these.

The second group consists of developed countries where banks are technologically lagging. It is most intriguing that we find the United States in this category. Although the US is the home of world-leading technology, its banks are rather antiquated, and well behind the curve in technological advances.

The third group contains developing countries where banking is technologically advanced. An example here is Kenya. Without going through traditional intermediate steps, they have leap frogged into an impressive banking setup based on mobile phones.

Finally, there are the developing countries where technology is lagging. We find both India and China here, with banking systems still evolving.

PA: Many have claimed that we are entering a new era: The old banks are becoming dinosaurs, unable to keep up with the changes, innovation and the evolution of Fintech. New players in the industry and from other industries will take over. On the other hand, many observe that current challengers have grown slower than expected, and the “dinosaurs” seem to innovate. What is your view? Will the industry change dramatically, and if it does, will it be driven by current major players or by the challengers or new entrants?

Marcus: I think there will be different answers to that question in different countries. Many find it surprising that the new challengers have not yet been more successful and that the classic stickiness of existing customers has prevailed. This is principally because banking is all about money and there is nothing more important to an individual than their personal wealth. People may comfortably use a new online holiday booking system, and buy a washing machine or other products online. But trusting their bank account to someone new is a much bigger step.

Having said that, there will be further change. Regulators are pushing for it and PSD2 may accelerate these changes significantly. There is a strong desire in parts of government to see change and increased competition in banking, and to see the challengers strengthening.

PA: Some say that it might not be just the challengers who will benefit from PSD2 and open banking. It may increase competition among the big banks, who will change and develop and compete effectively for each other’s customers?

Marcus: This is a very valid view. Large banks are not about to cave in to new entrants but they will need to consider whether the smart thing to do is to be a pioneer or whether it is better to wait and see which technologies may succeed before they act. There is no doubt that the pace of change is so great, that failure for some banks and some new technologies will occur. A bank or an existing company could easily spend a lot of money trying to push a new device or a new technique, only to find out that they have been left behind by someone with a newer or a better idea. The second point is that many banks are big, rich and powerful organizations. They take this threat very seriously. I don’t know of any banks who are complacent. They are spending a lot of money on their own research, and they have access to a wide range of solutions. I think it is difficult to call right now, how this is going to play out.

PA: For many years now, business and trade have become more and more global. Banks have followed this trend, and many previously more local banks have become more centralised, and more international or global in their scope of business. Do you regard banking today as a global, continental, national or regional business?

Marcus: Without trying to be cute, I think the answer is all of the above. I believe the relationship between a bank and its customers is a very personal thing and it has to reflect local traditions, local habits, local spending patterns and all the rest of it. Having said that, globalization is not going to go away, despite some cries for protectionism right now. In trade terms, the world is getting smaller and smaller. For trade to continue there will be a need for global banks which operate across country borders and across currencies.

PA: So you don’t believe we will see a phase of protectionism that will slow this down?

Marcus: I don’t think that protectionism is going to stop globalization, but it may affect the pace of change. It has become part of our everyday life. We go to Marks and Spencer now to buy a rose, but the rose is not grown in Kent but in Kenya. This is what globalization is about. For your smartphone, the supply chain is really very complex and reaches right around the globe. This is not going to stop. Globalization will continue and bankers will need to be active in every stage of the process.

PA: Getting back to my first question, you said that the answer to that was all of the above. Banks are global, they are regional, they are national, and they are local. But if you think about the competitive scene going forward, do you think there is some part that may need to become more internationalized and some parts that may need to remain local?

Marcus: I suspect we will see a further consolidation right at the very top. But there will continue to be a handful of very large global banks, who have the scale, the asset base and the skills to operate that way. But I don’t see any reason why, at a more local level, you can’t have challenger banks or existing smaller banks operating perfectly well.

PA: In past financial crises, we have seen that those banks who are very strong in their local knowledge have had smaller losses than those who have become very integrated, very centralized and very international. Do you think that is something of the past, or could you see the same in the future?

Marcus: Your question touches on one of the key elements of banking, which is bankers, and the need to have people who know that banking is all about risk. Every time a loan is made, the banker doesn’t know whether the loan is going to be repaid. He has to make an assessment, based on the customer, their credit history, the asset cover etc., and that requires judgement skills. I will give you a precise example: When the financial crisis hit the UK, it wasn’t just caused by problems with exotic financial instruments or sub-prime mortgages. Some of the banks that were worst hit, were hit because of an overextension of poor credit and poor lending to the real estate industry. Property was overvalued, leverage was too high, and when the market crashed, it crashed. There were one or two banks who had been caught out in a similar way in similar cycles in the past. They weren’t so exposed, and so did relatively well. The situation was analogous in other geographies where banks came out relatively well. Canada is a good example, Scandinavia another. And the reason for that wasn’t that they were immune to these risks. It was just that there had been crises in those countries in the past, and they had learned their lessons. When the overheating took place they saw it for what it was whereas others didn’t.

PA: You have previously stated that “Just because the City is strong at the moment doesn’t mean that it has a perpetual right to remain so.” How do you think Brexit may impact the banking industry?

Marcus: Brexit is work in progress and I can’t sit here and say that I know exactly what is going to happen. What is clear, is that the banking industry will be affected. According to the Prime Minister’s speech, we are going to leave the single market and therefore, the access which UK based banks have had into the rest of the EU will change. How that is going to be done remains to be seen.

The tension relates to what comes out of the negotiations. From a British point of view, the importance of the City and the contribution it makes to the employment and to tax revenue is unquestioned. It is a vital industry and it must be protected as well as possible. By the same token, the City of London doesn’t just operate as the capital market for Great Britain, it operates as a capital market for continental Europe.

It is THE prime capital market in the time zone, and provides capital for all European countries. Access to that is going to continue to be an absolute requirement for people who operate outside the UK, but within EU. So there is a common desire to see the City of London continue to prosper. Inevitably, there will be some impact, and jobs will go, because they will need to accommodate changes, but the central question is whether this is going to lead to a collapse of the City of London. I doubt that, if only because the installed base, the ecosphere which is the City of London, is so complex and so well established that it is too difficult to reproduce. It is a little bit like trying to cut down the rainforest and recreate it somewhere else. Theoretically, it is possible but it is actually very, very difficult to do.

But I don’t think there should ever be grounds for complacency and I say that because I have seen a couple of regulatory revolutions in my time. While they are quite different from each other and quite different from Brexit, it is interesting to study their impact. One would of course be the Big Bang in the City of London in 1987, where there was deregulation and increased competition. In the early stages the City of London was like a battlefield, with banks who failed to adapt and could not compete suffering mightily. Ultimately, the City prospered, but the short term cost was enormous.

The second example I have in mind is the aftermath of the Enron scandal. The US authorities introduced the Sarbanes-Oxley Act to prevent further abuses by making sure that regulation was far more rigorous and far reaching. This impacted, but didn’t destroy Wall Street, but it did lead to a dramatic and, never since reversed, change in the relative size of the City of London and Wall Street. Business moved to London, which wouldn’t have moved if it hadn’t been for the regulation. So these big changes are seldom terminal but they are relatively impactful.

PA: So it is not unlikely that we could see regulation or laws being passed that will influence the balance between London as the financial centre of Europe and maybe Frankfurt or some other place.

Marcus: A lot of the regions will want to try encourage such a shift and try to make it attractive whether through personal tax or low property costs or whatever. I think that the reason why a marketplace exists is because this is a place where people know that they find other people with the ability to do whatever trade it is that they want. And for that you have to have a certain critical mass. And the threshold of critical mass is huge. The City of London has it and other centres don’t. It is a huge barrier to cross over.

PA: Banking is a highly regulated industry, and major regulatory initiatives impact the industry all the time. What do you think may be the key regulatory areas over the next years, what’s likely to come?

Marcus: I think a lot depends on what Mr. Trump does. He is making noises about relative deregulation of the financial services sector in America. I don’t know whether that’s going to be the case. But if he does, then I think it is likely that other financial centres will follow suit. The regulation which has followed on from the last financial crisis has been massive - for perfectly understandable reasons because the financial crisis was so huge and the damage it did was so great. But there is no question that its impact has been an enormous increase in the cost of running banking operations in terms of compliance, and a huge number of heads are involved in that. Coupled with the increased capital requirements, it means that it is actually very difficult for banks to make a sensible return on their shareholders equity. While shareholders may tolerate that for a short time, eventually they won’t, and something has to give. Maybe we will end up with fewer banks charging higher fees or maybe we will end up with different ways of handling regulation, which will require less. I don’t know, but my sense is that the pendulum will probably swing a little bit back from where it has got to.

PA: Regulators often state that their objective is to increase competition in the Financial Services Industry, as you said when we talked about PSD2. But often, people feel that regulation has the opposite effect. New regulation complicates compliance, and require resources and, it requires an organisation of some size to comply, and it makes life more difficult for the challengers. Therefore it reduces competition rather than the other way around. What is your view?

Marcus: I think the point you make is an excellent one, and it is part of the reason why the challenger banks haven’t made more progress than they have so far. It is an extraordinarily complex business to run a bank, a bank of any size. I agree that regulation tends to act as a brake on the pace of change.

PA: Taking it all into consideration, do you believe that the major banks of the world, such as City, Deutsche Bank, HSBC, Santander and others will be the major forces in the industry ten years from now?

Marcus: I think it is hard to imagine otherwise. The only thing that could possible change this would be if someone such as Google, Facebook or whoever, decided to really go for it. That’s about the only thing I can think of which would be able to challenge banks on the scale that they exist at the moment. Maybe they will. If you think about it, part of the success of banking is knowing your customer and no one knows their customers better than these huge social media corporations.

PA: And if you guess, will the big current banks become stronger? Or will there be a Google or an Amazon or an Apple, or whatever, who will carve out a strong position in the financial services industry?

Marcus: I couldn’t say. But since the companies we think about can go into driverless cars, they could certainly go into banking. It is perfectly possible, and it is really a question of how the people who run these companies see their opportunities as they exist. They are not short of opportunities. The banking industry is huge but maybe they will decide that the return isn’t going to be attractive enough.