book cover stumbling giants

Stumbling Giants: Transforming Canada’s Banks for the Information Age

Patricia Meredith, James L. Darroch. | University of Toronto Press, 2017.

 

“We need banking, but we don’t need banks anymore”, Bill Gates (1994)”

Twenty three years after Bill Gates made his prophecy we still have banks and they are making record profits, an estimated $42 billion in fiscal 2017. This is double the profits Canadian banks made as recently as 2010. $14.3 billion has been set aside by the banks to pay their staff bonuses1. No surprise then that Canada has 80 per cent more bankers per capita than the average OECD country and these bankers earn almost double on average what workers outside the financial sector earn, according to the authors of this book.

Stumbling Giants or Usain Bolts?

Coinciding with record profits, the take-down of Canadian banks by Patricia Meredith (Fellow at the Rotman School of Management, University of Toronto) and James Darroch (Associate Professor at the Schulich School of Business, York University) might seem as mistimed as Bill Gates’ prophecy. Yet it is doubtful anyone reading this book will be confident that the best days for Canada’s banks lies in the future, rather than the past. The central theme of Stumbling Giants is that the same elements that have allowed the banks to prosper will also contribute, if not to their downfall, then to a long trudge to irrelevance. The assault on Canadian banks’ competitiveness rests on two pillars:

  • The reliance on branches as a distribution channel for credit cards, mortgages, loans and investments is fast turning from an asset into a liability. As the author’s note, bank customers have persistently given banks net promoter scores of around 202 because forcing customers into a bank branch to open an account or start a mortgage is a hassle and “direct banks, those without a physical presence and with very little human intervention, can provide these services, and more, at much lower cost”. In 2015, 30 per cent of new account applications were opened on-line in the United States, compared with almost none in Canada.
  • The true value of banks resides in the information they have about their customers – if they are forced to share this with information giants such as Apple & Google then the banks will be stripped of their future value. The banks may have thought they were in a marathon but it may turn out to be a relay race and the information baton will be given up to nimbler players in mobile payments, on-line services and low cost wealth managers3. Apple, for example, brought the banks to heel in 2016 when they agreed to Apple’s demand for a 0.15 per cent commission on each transaction on their mobile payments platform, Apple Pay, and in return the banks and Apple share the customer’s transaction data.
  • Stumbling Giants examines the Canadian banks attempts to cling to their traditional ways of doing business across payments, mortgages and business lending. A good example is cheque processing. While Canadian banks work on allowing customers to submit photos of cheques for processing most northern European countries have eliminated cheques and moved to electronic invoicing and payments. Canada is only surpassed by Thailand in the use of cheques for business payments.

Your reviewer’s primary interest is investment management and the authors dedicate a chapter to the banks’ dominant role as the custodian of Canadian’s savings.

Where are the Customers’ Yachts?4

The chapter on the banks’ wealth management business can only be read with a sense of awe and wonder if you are a bank shareholder, and outrage if you are everyone else.

Twenty years ago independent firms dominated the mutual fund and asset-managed businesses. Now, combined with some large insurance companies, the banks hold more than 60 per cent of the mutual fund assets held by Canadians and they have made the most of their dominant market position. Drawing on government data, the authors suggest that for Canadians require an annual return of 3.5 per cent, after fees and inflation, to achieve a comfortable retirement. This makes the generous assumption that Canadian’s make maximum use of their RRSP contribution room: the reality is that half of Canada’s tax filers have neither a company pension nor an RRSP and there is an estimated $500 billion of unused RRSP contribution room5.

Based on a study by one of the authors (Meredith) while working for Deloitte’s, an accounting and management consultancy, the real returns to Canadian mutual fund investors has been negligible over the past fifteen years. In the decade to 2012, fund managers, through high fees, kept 88 per cent of market returns, leaving just 12 per cent to the investors, who assume all the risk. Not surprisingly, the annual return to investors, after fees and inflation, averaged only 1 per cent, far short of the 3.5 per cent required.

In the face of such meager returns the authors conclude, “more than six out of ten Canadians do not have a workplace pension, and most of them lack the savings needed to support their lifestyles in retirement”. Compounding their retirement woes, Canadian have acquired a preference for avoiding risk (understandably, given the paltry returns from their mutual funds investments) and have heavily skewed their savings to bank deposits that earn a return close to zero. This is a windfall for the banks who have enjoyed access to capital at rock bottom rates with $1.2 trillion (2014) sitting in deposit accounts.

The other route Canadian have pursued to earn an investment return is to leverage their own capital by taking out mortgages and buying property. By now the reader sees a pattern emerging… guess who controls over 70 per cent of mortgage lending in Canada?

Stein’s Law6 states that “things that can’t go one forever, don’t”. There is a strong case for arguing that Canadians are tapped out7. Even without competition from new products and technology, the current cycle of skimming mutual fund investors, sourcing short term deposits for free and lending long term for mortgages and home equity loans is coming to an end. The banks drive to diversify abroad recognises this, although the authors note that the return on equity for banks’ domestic retail operations is in the range 30-51 per cent(!), yet the banks’ overall return on equity ranges from “only” 12-20 per cent. The inescapable conclusion is that domestic operations are subsidizing loss making international operations. As the authors note, this might make some sense if Canadian banks offered a competitive advantage compared to foreign incumbents but often they are competing as laggards.

In wealth management, as in other bank operations, new products and technology are making an impact, but there is a way to go. Low cost exchange traded funds (ETFs) and index funds make up 30 per cent of all retail investments in the United States, whereas they represent only 8 per cent of investment holdings in Canada. More generally, Canada lags the global average for fintech (the umbrella term for financial technology innovation) with an adoption rate of 18 per cent compared to a global average of 33 per cent and “developing countries” such as India (52 per cent) and China (69 per cent).8

The authors conclude by sketching out three options for the banks. At the extremes: do nothing, or open up to competition akin to the City of London’s “Big Bang” in the 1980s which opened UK banking to foreign competition. The middle option requires the banks to work with regulators to engage in a reinvention of the banking landscape to offer Canadians a better deal, and less importantly, a competitive future for Canadian banks.

 

1 https://www.bloomberg.com/news/articles/2017-12-05/bonus-pools-at-canadian-banks-surge-26-to-record-12-9-billion

2 Meaning only 20 per cent of the bank’s customers would recommend them to others. The most admired US bank in 2015 had a net promoter score of 83.

3 Disclosure: The author of this review worked for a Canadian bank brokerage prior to starting PWL’s office in Waterloo, Ontario.

4 The chapter on wealth management reprises the story of an out of towner being shown the bankers’ and brokers’ yachts close to the New York financial district and asks “Yes, but where are the customers’ yachts?”  From the book of the same title by Fred Schwed, Jr (1940).

5 Globe & Mail, March 2017

6 Herbert Stein, https://en.wikipedia.org/wiki/Herbert_Stein

7 http://business.financialpost.com/news/economy/canadas-household-debt-is-now-bigger-than-its-gdp-for-the-first-time

8 http://www.ey.com/Publication/vwLUAssets/ey-fintech-adoption-index-2017/$FILE/ey-fintech-adoption-index-2017.pdf