Can you build a tier‑1 bank from scratch?

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?

I’m not sure you can or should want to build a new tier‑1 bank today to com­pete with, say, Gold­man Sachs

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. 

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