Monday, December 23, 2013

The Pricing of Greatness

Credit: Federal Reserve Bank of Dallas - Q2 2012

Even within the population of 12 U.S. megabanks, as defined in the Fed's infographic above, there is a deep gorge between the on-balance sheet asset size of the big four commercial bank holding companies (BHCs) in the United States (JPMorgan Chase & Co., Bank of America Corp., Citigroup, Inc., and Wells Fargo & Co.) and the rest of the six commercial banks in U.S banking's top ten.  You could add the total assets of the banking companies from the fifth position through the tenth position and they would best Wells Fargo & Co, but only tie with Citigroup, Inc. 

At 9/30/2013, JP Morgan Chase & Co led the heavyweight division at $2.5 trillion in reported assets;  Bank of America Corp. tipped the scales at $2.1 trillion;  Citigroup, Inc. was at $1.9 trillion; and Wells Fargo & Co. followed with $1.5 trillion. The combined assets of all of the rest of the banks in U.S. banking's Big Ten - Bank of New York Mellon Corp. ($372B), U.S. Bancorp ($361B), HSBC North America Holdings ($309B), PNC Financial Services Group ($309B), Capital One Financial Corp. ($290B), and TD Bank US Holding Co. ($232B) - totaled $1.9 trillion.

My list differs from the Fed's official BHC list because mine has been adjusted to exclude the bank holding companies for the entities that are primarily investment banks, insurers, or commercial finance companies.  Those would be:  The Goldman Sachs Group ($923B),  Morgan Stanley ($832B), American International Group ($541B), and General Electric Capital Corporation ($529B).

The commercial banking industry is more concentrated now than it was at the beginning of the most recent financial crisis.  By one account, the largest banks, as a group, have become 37% larger owing to the effects of financial crisis emergency bank mergers, on one hand, and the shrinkage of the number of banks as a group, as a result of banks that were allowed to fail and the dearth of new de novo banks, on the other hand.

We are rightly preoccupied and mesmerized today with the remaining Dodd-Frank Act implementing regulations.  The context of our present focus on the issue of banking market concentration is on how it is related to Too-Big-to-Fail (TBTF).   But the market concentration statistics outlined above may also give us an inkling of an emerging industry battleground once Dodd-Frank becomes a rear-view mirror issue - the oligopolistic market pricing power of the megabanks and how they could use that pricing power to turbocharge their own organic growth at the expense of their competitors, the regional and community banks.

Remember that Section 622 of the Dodd-Frank Act established a financial sector concentration limit that prohibits, with only a few very specific exceptions, banking mergers and acquisitions if the resulting company would exceed 10% of the aggregate consolidated liabilities of all financial companies.  The Dodd-Frank concentration limit does not limit internal growth (nor does the Riegle-Neal nationwide deposit cap).  This means, for the largest banks, domestic growth by acquisition is out and organic growth is in.  We cannot dismiss the potential for the muscular use of pricing power as a lever for driving organic growth in our largest banks.

Market pricing power, in an oligopolistic marketplace, is a two-sided coin.  On one side, price increases by the dominant players in a market give competitors an opportunity to "free ride" by tacitly matching the increases, or alternatively, possibly build market share, by declining to match a price increase.  This is the situation we have today in the airline industry.  Shopping airline tickets among airlines is a pretty efficient, automated process, so tangible small-yardage market share gains are there to be had for those who decline to match the price increase.  That's why unmatched airfare increases usually cause the airline initiating the price increase to shortly roll it back.

In banking, at least on the transaction deposit-taking side of the business (the fulcrum of the typical full-service banking relationship), moving one's business has always been a bit of a hassle for a customer, made more so these days with the "stickiness" created by the advent of direct deposit, debit card loyalty programs, electronic bill pay, and ATM fee rebate add-ons.  Let's add to that list the primordial allure of monthly cash payments, like that offered by the much twittered-about new Santander plus $20 account.  With minor prospects for significant market share increases due to this marketplace "friction", price increases by the dominant players in banking may be more likely to be matched than not.

For the regional and community bank competitors that's the happier side of the two-sided coin.  Slow, incremental, price increases initiated by the dominant players, and tacitly matched by other banks, could provide the entire banking industry with wider, more comfortable, operating margins to help deal with increasing regulatory burden.  

It's the other, dark side, of the coin that community banks, in particular, may need to fear and be very alert to in the years ahead.  The dark side of the coin is predatory pricing.  Predatory pricing occurs when a dominant company, or group of dominant companies, either complicitly or tacitly, try to push product prices low enough to drive smaller rival firms out of the market or a smaller segment of it.

One bank's predatory pricing strategy is another bank's "targeted promotion" campaign, right?  It is not inconceivable to think about geographically-targeted price discrimination driven, in part, by Dodd-Frank Section 622 limitations.

Here's a hypothetical... Aided by the benefits of big data and the help of brainy quantitative financial engineers, a dominant megabank player could couple a predatory pricing strategy with a dedicated staff of hundreds of account transfer concierges (to help overcome the stickiness and friction in the customer account transfer process).  You now have the recipe for a barely-perceptible, but potentially highly effective, geographic locality-by-locality process of creating organic growth for the megabanks through a pricing war of attrition.

Once an acceptable level of dominance is established in one geographic area --- the political optics of the process require that token competition is left behind --- the effort marches on to new territory.  To avoid the perception of a pattern, desirable target geographies are randomized.

Just a point to ponder about potential post-financial crisis megatrends in our industry, as you cradle a Christmas eggnog in hand while sitting in your comfortable armchair before the crackling fireplace.  Is the plausible dark side scenario unimaginable?  Let's hope so.

Price surveillance should be a new frontier in terms of data collection by bank regulators, as bank geographic product pricing behavior is presently opaque because it is proprietary.

Thursday, December 5, 2013

He Can be Boston Proud...

...of the fine work produced in such a short time by the authors of the International Peer Review of OCC Supervision of Large and Midsize Institutions.  Hailing from the Commonwealth of Massachusetts, Comptroller of the Currency, Tom Curry, now has the opportunity to reflect, in the operations of the agency he leads, the example of resolute resilience and courage (as exemplified by Boston's 2013 post-Marathon experience) and the 'roll up your sleeves' hard work of reestablishing the preeminence of a major league championship team (in the tradition of the 2013 World Champion Boston Red Sox).  All without growing a beard, if he chooses not to.

Last month, the National Bank Examiner ran a story called From Hubris to Humility, applauding the Comptroller's efforts to improve the post-financial crisis bank supervision process for large and midsize national banks by initiating a third-party peer review by highly respected members of the global bank supervision community.  Today, Comptroller Curry released the report to the public and also formally accepted it on behalf of the Office of the Comptroller of the Currency (OCC).  

While prudently keeping his options open regarding the specifics of implementation, he set a goal of having implementation plans in place within 120 days.  I say prudently, because in government life, it is in the details where you find all of the devils of frustration and many of the speed bumps.

The 23-page report of the International Peer Review of OCC Supervision of Large and Midsize Institutions endorsed several of the bank supervision initiatives taken by the OCC since the financial crisis and emphasized the importance of their effective implementation across the agency.  The authors also noted the highly motivated, experienced, and professional staff who were "eager to respond promptly and fully to the numerous questions posed" by this outside third-party review team. 

The peer review team made seven key recommendations:
1. Revise the mission and vision statements and the strategic goals to make safety and soundness of institutions the OCC’s primary objective, consistent with compliance with applicable laws and regulations, including those regarding fair access and fair treatment of customers.
2. Enhance risk identification by expanding the role of Lead Experts (LEs) and ensuring that they have the capacity to provide meaningful input into the supervision of large institutions through review of examination papers and through the initiation of horizontal reviews.
3. Better integrate the systems for assigning supervisory ratings to institutions (CAMELS ratings) and the Risk Assessment System (RAS), make examination ratings more forward-looking, and devise a more flexible approach to the consequences of certain ratings downgrades.
4. Move examination teams and subject matter experts from individual bank locations to shared OCC offices in the field, where practicable, to improve internal communications, sharing of information among examination teams, and workforce flexibility. This will facilitate horizontal supervisory reviews and help to address staffing shortfalls, particularly in specialized skill areas, by allowing specialists to work on several institutions over a shorter period of time.
5. To further address staffing shortfalls, devise a program to use retirement-eligible staff as mentors and explore how to accelerate the integration of private sector experts into the examination force.
6. Enhance the scope and consistency of supervisory planning, risk assessment and intervention by enhancing the existing peer review process to involve all relevant Examiners-in-Charge (EICs) and Lead Experts, and by elevating key supervisory decisions such as material acquisitions to the Committee on Bank Supervision (CBS) and/or Major Matters Supervisory Review Committee (MMSRC).
7. Ensure that the Enterprise Governance function commences its proposed work on documentation of quality management practices as soon as possible and that the OCC utilizes this to determine the standard and consistency of practices it wishes to put in place across the agency.
While, on the surface, these recommendations look rather straightforward, a few, in fact, create existential angst.  For example, the first recommendation of setting the safety and soundness of institutions as OCC's primary objective.  Well, it's going to be interesting to see if OCC is any more successful in redefining its dual mandate - charter and supervise - as the Federal Reserve has been in redefining its dual mandate of price stability and full employment.  A marketplace-responsive and technology-sensitive national bank charter is a key component in the architecture of keeping banks, like ships, "centered in the channel" and for helping keep the "shadows" out of shadow banking.   A potentially sclerotic national bank charter, made so by mission redefinition, could be as much a danger to systemic financial stability as any possible neglect of bank supervision responsibilities.

OCC's own dual mandate is one reason why I urged last year that the Comptroller consider upgrading of the OCC's Licensing function to Executive Committee status in the National Bank Examiner story entitled License to Heal.

The remaining peer review report recommendations abound with complicating issues, but they are all fundamentally sound.  In fact, some restate longstanding, seemingly intractable, internal concerns.  Hopefully, these report recommendations can be implemented with a minimum of bureaucracy while retaining, and not diffusing, accountability.

A couple of incidental observations on the peer review report:

Interestingly, it seems that the innovative way now-Senior Deputy Comptroller Jennifer Kelly and Deputy Comptroller Bill Haas built the framework of supervision for midsize banks (literally a start-up operation several years ago) shows it to be a better model for large bank supervision rather than vice versa.

Again, through this report, we have a clarion call to revisit the CAMELS rating system, or more properly, the Uniform Interagency Financial Institutions Rating System (UIFIRS).  Getting the federal bank regulatory agencies to sit down and make this rating system responsive to modern risk management and preventive intervention principles seems like trying to make peace in the Middle East.  Adopted 34 years ago, in November of 1979,  and only lightly tweaked since, the UIFIRS is ripe for a sorely needed overhaul (or perhaps a re-imagining, replacing, and scuttling the old system after some statutory linkages are severed).

I echo the Comptroller's thanks to Jonathan Fiechter and his team of global bank supervision experts for creating a quality report within the time-frames established.  It is a template for change for the better.