Does Size Matter?

Have you ever taken a step back and marvelled at the sheer size of financial services firms? I am not referring to their balance sheets or income statements. Rather, I’m referring to size in its most literal sense: people, buildings, and equipment. Wells Fargo ($300B market capitilisation) has more than 260,000 employees. JPMorgan Chase ($340B) has a staff complement of 240,000. Citigroup ($172B) employs approximately 220,000 people. This stands in stark contrast to a firm like Google ($580B) with a paltry 70,000 Googlers.

Of course this is not a fair comparison. Banks, insurers and other financial services firms provide a substantially different service to Google. They are the custodians of the financial well-being of the world. They provide a store for money, facilitate payments between parties, extend credit to homeowners and businesses. It is hard to imagine how our society could function without their contribution.

The Cost of Power

By virtue of what they do, these companies exercise great power over our long term welfare. As Uncle Ben told Spiderman, with great power comes great responsibility. In this case responsibility manifests itself in bureaucracy. In order to protect against mismanagement or abuse, these companies establish specialised functions (legal, risk, compliance, audit, data management, etc.) to oversee their operations. Some of these functions are established willingly whereas others are imposed on them by way of regulation.

Many of these tasks require specialist skills. This is why these companies employ accountants, lawyers, actuaries, auditors, etc. They are the physical manifestation of a task that a bank or insurer needs doing. And successful companies employ a lot of them!

Disruption… Disruption Everywhere!

Things are changing though. Technologies are emerging that drastically alter the reality in which these firms operate. Developments in artificial intelligence and machine learning have the potential to automate many of the roles previously thought to be indispensable. Social networking companies like Facebook and WeChat are fundamentally changing how customers interact with their world. Blockchain technology is showing the potential to change the very heart and soul of the financial services industry. To be clear, what is changing is not the task itself, but how this task is performed.

So what? Change in the financial services industry is nothing new. Consider the concept of “money”. Money has evolved from being large circular stones, to gold coins, to paper bills, to streams of 1’s and 0’s stored in the ether. Why should change be any different this time around? The problem isn’t the fact that things are changing but rather the pace at which change is occurring. Things are moving so fast that even the new generation of start-ups that are trying to disrupt the old guard are themselves already at risk of being disrupted.

By way of example consider the darling of the South African banking community, Capitec Bank. Founded in 2001, it has successfully managed to disrupt the South African banking industry. It has managed this through a clear and innovative business model, clever product design, and technology integration. At the time of writing, Capitec is the third largest bank in South Africa when measured by number of customers. In banking years, Capitec is barely a twinkle in its mother’s eyes. Yet even they are now at risk of being disrupted.

Economies of Change

When things are moving this fast, the ability to pivot and adapt a business model is key to a firm’s survival. For those operating in intangible industries it is not only economies of scale that produce value, but economies of change. This is where large firms now have a competitive disadvantage. The sheer size of these organisations limits their ability to adapt and, consequently, compete.

I am not suggesting that these firms are large because of poor choices. The decisions they made were limited by the technology available to them at the time. These firms did not choose to be big. They chose to have excellent compliance and risk structures. Until now, the only way to do that was bums-on-seat. Size wasn’t the choice, it was the by-product. It is a cruel twist of fate that the consequence of these well intentioned decisions is now inhibiting these firms to compete.

So What Now?

The pragmatist in us might be tempted to say the solution is obvious: reduce the size of the organisation. If we are to believe that automation will make roles redundant, the problem should solve itself. Although that is a possibility, this path is fraught with difficulties. How does a company culturally survive the culling of 50% of its workforce? What would the monetary cost be of such an exercise? Even discounting the institutional trauma, there are the physical artefacts of size: buildings, laptops, office furniture, long term rental agreements, etc. These are all sunk costs which firms had hoped to amortise over the long term. This would represent fiscal drag which their smaller counterparts wouldn’t have.

Should we expect a Fight Club style meltdown of financial services firms? Of course not! To paraphrase Bill Gates, we tend to overestimate the change that will occur in the short term and underestimate the change that will occur in the long term. What is important is that companies realise that technology doesn’t change in isolation. As technology changes, so do the business models they underpin. If established firms fail to sufficiently adjust to this new paradigm, they risk forever following in the footsteps of those that aren’t limited by the same institutional legacy.