Why isn't Banking more Boring? Part One

In a recent interview with Elon Musk, TED’s Head Curator Chris Anderson explores the serial entrepreneurs project to bore a vast network of tunnels under the world’s cities as the next step in Musk’s vision of a high-speed transportation future. Having explained why boring deep beneath the earth has so many advantages over building up above it, Anderson asks Musk why this is possible now when digging tunnels is so vastly expensive. Musk answers that, yes, it is quite expensive and there will need to be at least a 10-fold improvement in the cost per mile of tunnel. He then goes on to explain three straightforward steps that will make this possible:

1. Replace the person-driven car with a vehicle on an “electric skate”. This allows the diameter of a tunnel to be cut by a factor of two or more, and because cost scales with cross-sectional area this will give a 4-fold improvement
2. Combine tunnelling and tunnel reinforcement, so the tunnelling machine is productive all the time. Musk explains that today the tunnelling machine is only actually tunnelling for half the time. For the other half it sits idle while the tunnel walls are reinforced. If you do both at the same time you get another 2-fold improvement.
3. Up the power and thermal limits by a factor of at least 2. This is perfectly within the limits of what tunnelling machines can do today.

As Professor Richard Rumelt explains in his excellent book “Good Strategy, Bad Strategy: The difference and why it matters”, good strategies almost always look this simple. They have at their heart a new diagnosis, the discovery of the critical factors in a situation. But more than that, they have a design for coordinating and focussing actions to deal with those factors. Much, of course, is still to be proven but Musk’s “boring” approach has all the hallmarks of a brilliant strategy.

So what is the Banking equivalent of this? How could you achieve fundamentally different economics in banking and develop a cost leadership advantage to deploy as you see fit? What are the critical factors in this situation and what might the design look like to deal with those factors?

You can go much further down than you can go up

Exploiting a cost leadership advantage in banking is, in theory, very straightforward

1. Take a bank that is dramatically more efficient than the one you have
2. Scale that bank to handle the combined volumes of both
3. Migrate the original bank on to the newly scaled second bank.

Of course this should work for any organisation in any industry, but in theory it works really well for banks because the economics of the banking business model are fundamentally based on scaling effects - scale applied to the transformations between deposits and lending (net interest margin) combined with near-zero marginal costs for additional transformation activity.

To give a sense of how this works, imagine the following scenario

• Bank A has ￡10bn of revenue per annum and a cost income ratio of 70% (profit ￡3bn)
• Bank B has ￡3bn of revenue per annum and a cost income ratio of 50% (profit ￡1.5bn)
• The total combined annual profit of Bank A and Bank B is ￡4.5bn.

Now spend ￡1bn scaling Bank B’s operations and IT systems to deal with the increased volume of Bank A and move all of Bank A’s customers and transactions onto Bank B

• The combined Bank has a cost income ratio of 50% (that of Bank B) and total annual revenues of ￡13bn
• The total annual profit of the combined Bank is ￡6.5bn and the ￡1bn investment can be paid back within 1 year
• The resulting ￡2bn additional profit per year can be invested back into the business to reduce prices, invest in customer service and brand differentiation, or a combination of both.

Of course, theory and practice are not the same. There are more fixed costs to deal with (e.g. distribution channels, head office properties, shared services) and the scaling of the target operation and IT systems doesn’t result in linear efficiency for the additional volumes.

Nevertheless something like this has happened in many successful banking mergers and acquisitions. Through an acquisition, a bank with the competitive advantage of a lower cost income ratio acquires the customers and transaction volumes of another bank and then moves them on to its more efficient operating model. The resulting cost advantage or profit improvement is the result of applying the acquiring banks more efficient operating model - the combination of organisation, locations, people, process and technology.

Setting aside other considerations, such as the regulatory environment, strategic fit and macroeconomic conditions, if it is this easy why isn’t it happening in banking right now?

There are two reasons:

1. The scale of cost advantage needs to be worthwhile and no bank today has a significant enough cost advantage (in the same geography/ with a strategic fit) to even consider it
2. It is much harder than the theory makes it sound. In fact, this is a massive understatement. More value has been destroyed by those attempting and failing than value created by those trying and succeeding.

So is it pointless to discuss it any further? Perhaps not. I think it is reasonable to expect that over the next 3 to 5 years one or more banks will emerge that demonstrate the banking-equivalent of Musk’s strategy. They will be based on a platform architecture that enables them to have both a strategic cost advantage and - crucially - the ability to leverage it in the way described above.

It is by no means a certainty, of course, but in Part Two I'll start to explore why The Boring Company of Banking might be more likely than not.