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.

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