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Prepare to break out your smallest violins, but the arrival of Spring brings the return of the reoccurring pain in the ears that befalls those of us in finance – conference season.
For those of you who are lucky enough not to be part of the big finance industry, instead of listening out for the first cuckoo or maybe planning a backyard hot dog cookout, Spring signifies the time our email inboxes get carpet bombed with invitations to shindigs, forums and events laid on by the usual suspects – consultancy firms and industry bigshots. Or, at least, would-be industry bigshots and their paid PR boosters.
Mainstream media outlets and various other hangers on hoping to get some crumbs from the lavish buffet that is the financial services industry provide uncritical coverage aiming to then have the ear of big finance’s so-called leaders, such as managers at the Too Big To Fail (TBTF) banks. Even politicians and academics get in on the act. Perhaps wanting to get out the blocks early, here we have Yahoo Finance, for example, wasting pixels on its listicle “10 Disruptive Forces In Payments For 2018”
Despite – or maybe it is because of – the industry not really changing the basics of what it does in nearly 40 years, the top management of the TBTF banks along with industry-watchers then goes through the usual motions of latching on to the latest shiny thing which is being dangled in front of it. Eventually, the idea filters down the organisation to some humdrum apparatchik (such as your humble writer) who has to explain why it is a load of half-baked nonsense.
Ever the optimist, this post is written in the hope that the current flag waving for this year’s contender for the Disruptor Most Likely to Succeed award Alibaba – which featured as #1 in Yahoo Finance’s list — can be debunked early on in the season thus preventing it gaining any further momentum.
I do have some sympathy for what Yahoo Finance is trying to do, because the big banks a) exploit their influence to distort the market for banking services, b) have to – always – have implicit (and, in times of a crisis, explicit) government backstopping and finally c) are generally offering poor and expensive services to their users. So everyone piles in offering what seems like sensible alternative solutions in the form of “disruptive” new entrants or financial services technology (FinTech). And the management of the TBTFs know how atrocious they are, so are ever-vigilant and readily lap up articles like Yahoo Finance’s, just in case the latest disruptive player does, in a stunning reversal of the usual form, turn out to actually be disruptive.
The problems arise as a result of critics and industry-watchers coming up with magic fixes and never thinking about – because they don’t really understand — two essential elements of what a bank needs to first do in order to offer the facilities it provides. These are, namely, product design and operations for servicing.
Taking each in turn, what exactly is a bank account and the payment system which links them? The bank account is a product. It therefore has to be designed. Someone needs to think about what features it has (or doesn’t have). Some are obvious — all bank accounts must keep a tally of the current balance on the account. And they must all have an identifiable account owner or owners. But then it becomes much hazier. Can you have a line of credit on the account? Do you offer checking? ABA routing permissions? Access to a counter service for paying in cash? Card Payments?
Now, when asked, customers would probably reply “yes please” to all the above, plus throwing in other niceties like telephone and online servicing, an iOS or Android app, maybe ForEx (if only for vacation spending, but not ordinarily resident customers might need this for remittances back “home”). And more besides. But each of these comes with costs attached. How does the account provider decide what to offer, how much to charge and who pays?
And there most definitely is a cost associated with these product features. This is because each requires the second element which is completely overlooked by people outside the industry — the operational activity to provide the various services an account requires for its features to function. Honestly, I sometimes wonder if those commentating from outside the industry think that everything that happens in a bank is done by an unseen army of mysterious workers – like the Oompa Loompas in Charlie and the Chocolate Factory. If only.
Right from the start, you need operations — checking identity for Know Your Customer requirements is demanded before you even offer an account to a prospective customer. Then there’s inevitable processing for things like changes of address, marriages and divorces. Even the simplest of account product designs needs to be able to handle situations where the account has to change its details. Deaths are another big admin area – national and local laws are very specific about how money is handled in an estate where there is a will to be executed and it is even more complex if you die intestate; it’s not an option for the account provider to simply say “oh, we never thought of that, we don’t know how to handle that sort of situation”. Changes of address must also be actioned and, again, you need to validate the details the customer is providing.
There’s more. The moment you move away from a strictly cash-only product design, you must support money transmission (payment systems). These not only bring the operational demands like clearing checks and ABA routed payments but they also present credit risk for the payee and the sender of the payment. Even online real-time payments can have transactions interrupted and cannot guarantee to roll back infallibly. The second that happens, one party is exposed to non payment.
It is even more complex than just the parties involved in the payment itself — the institutions providing the bank account to the parties has to assume the credit risk because one party to a payment system transaction might end up owing money which it doesn’t have. Turning momentarily back to a cash-only account, even with such a constraint you then get a huge overhead for cash management and cash handling.
And there’s still more… bank accounts don’t exist in a vacuum. They store individuals’ assets. So law enforcement needs to have the ability to monitor and seize funds where there are questions about their sources. Accounts might need to be blocked (think Trump’s missive on Russian citizens he wants to rough up a little – someone has to suspend their US accounts and put a stop on money transmission lest they try to repatriate their liquid cash). Courts issue subpoenas (they’re referred to as Court Production Orders here in the UK) for documentation and records so these not only have to be actioned, they must be followed to the letter.
I’m sure at this point, some bright spark would pipe up something about automation, IT and even daydreaming about AI coming to the rescue for all of these manual operational activities. And to a degree, it is possible to automate an awful lot of the routine and repeatable processes and processing. But that then lands you slap-bang into another unavoidable overhead – IT system design and maintenance. Bank IT is a train wreck. While you can move away from office buildings stuffed with clerks and data inputters, you merely squeeze the balloon and move that (in a different form) to data centres, software developers, testers, code versioning and release management, capacity planners, security and firewall systems (and their patching), virus checking, data loss prevention, backups and backup testing, disaster recovery sites and disaster recovery testing – on and on and on it goes. None of this is frictionless or zero cost.
Regulators and politicians have for decades mulled over how to answer the conundrum of how to achieve financial inclusion that doesn’t land the entire population into the maws of the banks. They usually start with the product design — and arrive at a conclusion that a basic bank account is the answer. Probably at some stage, a post office bank account is mentioned. In many ways, this approach is logical. But it is also completely wrong. You have to start with what you are willing to tolerate in respect of the quantity and complexity of the operations for servicing — because this determines your costs. Even the most straightforward of bank accounts products presents a demand for operational capability and capacity (for the reasons explained above). You then need to answer — and answering it is unavoidable, someone has to do the admin work — who pays for this and on what basis? What is your source of revenue to cover your operational costs?
If you’re not in the business of credit creation, then you have a big problem on your revenue side if you are trying to offer a full-reserve bank account. You still have a cost of goods (or services) because of all that operational overhead. The minute you start trying to charge – even on a not-for-profit basis – for the costs of providing the bank account service, you’ll deter the poorest in society unless you subsidise them in some way. And you’ll face some pretty unwinnable competition from traditional banks who can provide a subsidy on their bank account product by being willing to run some credit risk on the asset base they’ll accumulate through funds held with them on deposit. If the basic bank account provider limits the quantity and complexity of their operations (to keep the bank account product costs as low as possible), they’ll also lose out in terms of their service offer because the traditional banks can offer gewgaws and cover the costs of those through high profit credit products like loans and credit cards.
And any new entrant is just that – a new entrant. They’ll have all their start up costs. The competition (the established banks) have depreciated their IT and design costs decades ago. And, too, it is a bizarre notion that the Fed or the post office can set up a basic bank account then freeload on the traditional banks’ legacy infrastructure without paying even the marginal cost for utilising it.
For a start, bank systems have been value engineered to within a inch of their lives – there is little slack in the system to accommodate additional transactions on any serious scale. It would also amount to appropriation of private property. For instance, an ATM service is likely to be within the product feature set of even the most basic of basic bank accounts. But an ATM is a piece of property sitting in a fixed physical location for which it needs to either own the ground it sits on or pay rent. It also has its own servicing and maintenance costs, of course. No court would tolerate anyone — even the Fed or some other “social” enterprise – using these assets for free. In the same way as just because you’re hungry it doesn’t mean you can come round to my house and stick your hand in my biscuit tin (sorry, cookie jar for US readers), just because you don’t like the traditional banks doesn’t mean you can take their assets, just like that, with no compensation.
Returning to our original topic of Alibaba, but – you might say – Alibaba has a mass payment system, so surely they or someone else like them could do that, too? This was the inference in the Yahoo Finance article about how Alibaba would be the most disruptive entry in to the financial services industry in 2018.
No, all Alibaba have got is a walled garden Money Transmission system. But that’s not an interoperable Payments System. You have to sign up to Alibaba’s service – and then you’re limited to Alibaba’s pool of other service users.
As soon as you set foot (or you want to send your money) outside of their platform, you need to interface to the legacy players. I don’t see any Alibaba teller windows to pay my cash or checks into. I don’t see an Alibaba ATM I can get my money out of. Even if I did, I don’t have an Alibaba card to put in it. An Alibaba check book? Oh wait a minute, you mean I have to use their app because they don’t offer them – and so does the person I’m sending my payment to? How do I get my money into Alibaba in the first place – can I route my salary payment into my Alibaba account – no, only if my employer is also signed up to the Alibaba service too. Oh, unfortunately, Alibaba don’t offer payroll bulk clearings… so that’s fine for a Mom and Pop store and their couple of employees, but what about if I’m China National Petroleum – or social security? And who is doing Alibaba’s Identification and Verification / Know Your Customer? It looks like anyone can open an account in any name on their service, no questions asked. I’ll bet if I try to set myself up as Xi Jinping, I can do – so they’ve outsourced the fraud and money laundering checks to the legacy players. And can I have a joint account to pool money with my spouse and see what they are up to? Nope.
These are all basic use cases for any bank account type of product and Alibaba doesn’t support any of them. You need bolt-ons or you need the traditional banks. Okay, Alibaba could enhance its service offer to include these things – but then how does it do the charging for them? And how, if it moves from a low-cost no-frills service, does it compete with the credit creators (the traditional TBTFs) who can cross subsidise?
Anyone can start a service and throw money at it to try to unseat incumbent players (such as Uber is trying to do). But if it doesn’t have a viable business model, it’ll only last so long. And let’s not forget, the competition (the established banks) have very deep pockets and monopoly positions of their own to keep them afloat.
Unfortunately, and sorry Yahoo Finance and Alibaba, the big banks aren’t going anywhere anytime soon.