Can you build a tier-1 bank from scratch?
Is it possible to build a tier-1 bank from scratch to compete with the biggest high street players and would anyone even want to?
If anyone knows about the failings of big banks, it’s George Magnus, who was one of the few economists to predict the financial crisis of 2007-8.
A key lesson from that debacle is that bigger is usually not better when it comes to banks, says the former senior economic adviser to UBS. “I’m not sure you can or should want to build a new tier-1 bank today to compete with say Goldman Sachs, J.P. Morgan or HSBC,” says Magnus. “These are the models we should be trying to move away from.”
Critics feel big banks have done too little to change their ways since the crisis, offer poor customer service and have failed to serve marginalised people shut out of the system. Some have also seen their profits languish in the last decade due to tougher regulation and intense competition.
Still, it is not hard to imagine that a newer, tech-based challenger could one day reach the tier-1 scale and, if they do, customers and investors alike will ask the same thing: can they avoid the mistakes of the past?
Magnus, who worked at UBS from 1995 to 2012, says the banking world is safer than in 2008, but not safe enough. Lawmakers missed an opportunity after the crisis to draw “thicker lines” between low-risk retail banking and higher-risk investment banking, and so many lenders continue to engage in both activities.
“Too big to fail is still a problem if there’s a systemic crisis,” he says, suggesting taxpayers might still be on the hook in the event of another meltdown.
“I could see creditors and shareholders having to carry the cross for a single bank that got into trouble, but if we were hit by a crisis that undermined the financial system as a whole and deposits were to flee, I suspect the ‘hit’ would be too big and sudden to allow.”
The pros and cons of being a small bank
This won’t cheer a small lender dreaming of entering the big league, particularly given the other financial hurdles they are likely to face.
Banking markets such as the UK’s are saturated and interest rates are at record lows, says Thorsten Beck, Professor of banking and finance at Cass Business School in London. That has left margins stretched and profits under pressure, something reflected in the large numbers of job cuts being made by the likes of HSBC and Deutsche Bank.
Smaller players must also overcome regulations that require them to hold a higher ratio of capital in reserve, along with trust issues due to their less well-known brands.
In such a tough set of circumstances, Beck says it would be tempting to try and expand quickly by buying up “bad legacy banks”, but he suggests organic growth, while much slower, is preferable.
“They should also look for niches where they can get a higher return using technology [to cut costs]. So do less small and medium-sized enterprise lending, which is high cost as you need to deeply assess the risk, and focus more on mortgage lending where you can automate the risk assessment process,” he says.
Big banks have a patchy reputation when it comes to customer service and innovation, unlike their more nimble fintech rivals that are gaining market share. So any new tier-1 bank would have to have innovation and good user experience at its core, particularly as tech giants like Apple and Facebook make further inroads into the sector.
“These Big Tech firms have the advantages of big data; they know so much more about us than any bank does and can offer much more tailored products,” says Beck.
Tech gives banks an undeniable edge
Tech-based providers have also started to tap into a market traditionally overlooked by the biggest banks: people shut out of the system who cannot open a bank account. When Facebook last year unveiled Libra, its blockchain-based payment system, it said one of its most important markets would be the billions unable to access traditional banking services in the developing world.
Charity Turn2Us notes that around 1.3 million people don’t have bank accounts in the UK. “This is highly problematic for so many reasons; it makes claiming benefits much harder, it reduces options for getting decent deals with phone contracts, utility providers and broadband companies, and it makes getting any sort of credit incredibly difficult,” a spokesman says.
He adds the flexible measures put in place by banks during the pandemic could also provide ideas for other products. “Mortgage holidays, payment freezes and interest-freeze overdrafts should be available to anyone experiencing a life-changing event. Life events often cause financial hardship,” Turn2Us points out.
Should banking be getting smaller, not bigger?
Beck doubts big banks will rush to change as there simply is not enough profit in serving the unbanked. It would take a change in regulations to enable lenders to open accounts with less than the usual amount of paperwork, at which point a viable market could emerge.
By contrast, he thinks the biggest banks will always take risks deemed unethical because it’s so lucrative. “There will always be ways for bankers to get around certain rules on speculative activities because that is where the money is. Any new bank would get involved too, otherwise you would leave money on the table,” he says.
For this reason Beck agrees with Magnus that “biggest is best” is not the right mantra. “I actually think the banking system needs to shrink. If there were fewer players, they would find it easier to make better returns and that would be better for both customer service and investors,” says Beck.
Magnus thinks the only way we’ll avoid a rerun of 2007-8 is to bring in two distinct models for tier-1 banks. On the one hand, there would be low-risk retail banks subject to looser oversight; on the other, higher-risk investment banks facing tougher rules.
“I can see newer banks can present models in which costs, profitability and funding risks are better addressed, but I don’t see any new banking models that pass the ‘would they be OK in a systemic crisis?’ test. For that, I think we’d still need to break them up and redefine their functions and risk profiles,” Magnus concludes.