Nancy Bush is a veteran bank analyst. The following does not constitute investment advice, and the views and opinions expressed in this piece are those of the author and do not necessarily represent the views of S&P Global Market Intelligence.
As I prepare to leave my long career as a bank analyst, I wish I could say with absolute certainty that I know everything that I ever need to know about banking. There are a few things that I do know, with no equivocation. I do know that the success of a merger depends upon the emergence of a clear culture and a relentless focus on both costs and the quality of the acquired credit book. I do know that CEOs who constantly state publicly their need to acquire other banks in order for their own banks to be more profitable are both ill-advised and dangerous. I know that bank branches will continue to have value, even after my own generation has passed from the scene and millennials rule the earth. And I know without any doubt that the current expected credit loss model known as CECL is the dumbest accounting convention in the many years of my career. (Yes, dumber even than mark-to-market.)
But this I do not know: What is scale, exactly, and how is it achieved within the context of the banking industry? That should be an easy question to answer. After all, the definition of scale is pretty straightforward and should be subject to measurement. Investopedia defines economies of scale as "cost advantages reaped by companies when production becomes efficient." Sounds simple enough, and when applied to an industrial company — one that makes stuff — it often is.
My observation, however, is that any attempt to apply the concept of scale to the banking industry goes immediately, well, squishy. For one thing, the banking industry does not make widgets, it supports the flows of money throughout the economy and promotes the ability of individuals and businesses to access those flows. So there is immediately a problem with measurement. Can those flows be measured by the number of products any one entity uses? Is scale best measured by the costs of supporting one customer — or a cluster of them (i.e., a branch)? Can scale be measured by product? So many questions, and so few answers.
I must admit that my skepticism on the issue of scale in banking has deep historical roots, and dates back to my early days as an analyst. Those days coincided with the onset of the merger wave, beginning in the mid-1980s and reaching its peak in the mega-deals of the late 1990s. The biggest deal makers — Ed Crutchfield of First Union, Hugh McColl and then Ken Lewis of NationsBank, John McCoy of Bank One, all the dealmakers on the West Coast (Security Pacific and Wells Fargo & Co., primarily), and on and on — all justified their manic deal-making activity with the need for scale.
Frankly, at that point there was some justification for that claim. While Crutchfield came to be rightly reviled for wasting shareholder value on some of his later deals, it must be remembered that he was the pioneer of the common deposit platform and the costs of developing that technological leap forward indeed needed to be spread over a larger deposit base. But at some point, both for Crutchfield and for his fellow merger pioneers, the pace of deals became so frenetic and the integrations so botched that follow-on transactions did not gain scale — and whatever cost saves were achieved were overwhelmed by the operational issues that eventually revealed themselves and in the end cost shareholders billions of dollars in plunging stock prices and reduced dividends.
In searching the web for articles on scale in the banking industry, I found a 2018 blog on the website of the Financial Services Forum — an advocacy group for the nation's largest banks — titled "When Bigger is Beneficial: Scale Economies in the Banking Industry" that elaborated on the advantages of size. Sean Campbell, the group's director of policy research, wrote: "There is good reason to think that the banking industry may exhibit increasing returns to scale. Information technology is a key input into the production of banking services. Loans and other banking services are increasingly produced by organizing, cataloging, and analyzing data with information technology."
Campbell proceeds to present a number of scholarly studies that buttress this view, including a couple that rebut the notion that the 'too big to fail' advantage enjoyed by America's largest banks plays a part in this issue of scale advantage. And I get what he's saying — it seems logical that bigger would be better when it comes to spreading costs across a larger and more diverse customer base. But there are two problems with this approach.
The first is that the Ed Crutchfield argument for technological advantage no longer holds water — indeed, the costs of technology have been declining for all consumers (including banks) for years and formerly sophisticated technologies are now sold "off the shelf" and are available to even the smallest of banks. These applications can measure and drive efficiencies in ways not possible even a few years ago, as well as meet the product demands of both retail and business customers.
The second problem is this — it just doesn't square with the reality of what I see in the numbers consistently quarter after quarter.
Yes, Bank of America Corp. CEO Brian Moynihan continues to drive remarkable efficiencies in his company through the migration of customers into the use of digital and mobile technologies and through an ongoing rationalization of the branches that are needed to support these changed behaviors and preferences. And while his bank's overhead ratio is much improved from that of the bad old crisis days, it's still high at roughly 57% and will need to come down further to move the profitability needle. Ditto for Citigroup Inc. as it tries to craft a larger domestic depositor base.
But the collective efficiency and profitability of the largest banks pale in comparison to the metrics of the growth community banks of the Southeast — that group in the $5 billion to $25 billion size range that is sometimes driving scale through deals and customer focus (Pinnacle Financial Partners Inc.) and sometimes driving it just by sitting still and being really good at lending (ServisFirst Bancshares Inc. of Birmingham, Ala., comes immediately to mind). These banks are the most profitable and highly valued in the industry not just because they are the most efficient but because they enjoy revenue niches and client loyalty that the largest banks can only dream of — and in many instances cannot achieve because they are just too big and too slow-moving.
So my parting thought is that scale in the banking industry is not all it's cracked up to be, and that it is a necessary but not sufficient ingredient of bank success and profitability. I hope that the generation of bank analysts behind me — soon to become the inheritors of the title "elder analyst" — will continue to explore the issue and will be more rigorous in demanding proof of the achievement of scale efficiencies than my generation has been. Answers are needed, and push-back on the conventional wisdom is required.