Could New Technology Threaten Bank Profits?
Forget the Royal Commission. An even greater threat to Aussie banks lies just over the horizon in the form of new high-tech competitors that can price financial products at levels that our banks find impossible to match.
The Royal Commission has monopolised the market’s focus regarding the banks over the last few months. There are likely to be some enduring implications for the major banks in terms of increased regulatory impediments to their competitive positions, and potentially some ongoing brand equity damage.
However, the challenges confronting the major banks extend well beyond the implications flowing from the Royal Commission. One of the issues we believe gets little focus but has major implications for the long-term outlook for investor returns is the potential for technology to dramatically change the cost of financial products over the next 5 years.
Labour related expenses make up just over 50 per cent of the cash operating cost base of the major banks, with an aggregate annual cost of A$20 billion over the last reported 12 months of reported results.
Source: Company results
A large proportion of the labour costs relate to the middle and back office processing of transactions, which, despite the heavy investment by the banks in technology over the last five years, remains a very manual process. Improvements in the capabilities of technology through continued advancement of artificial intelligence will progressively provide an alternative to manual processing of transactions, leading to significant improvements in speed and a reduction in errors, while reducing costs.
Given the scalability of technology relative to human labour, the cost base becomes incrementally fixed rather than variable. This also has the potential to radically change the competitive dynamics of the market because the incremental profit generated from the extra dollar of revenue is significantly higher in a business with a predominantly technology delivered product base. A shift in thinking from pricing products on the basis of average costs to marginal/incremental costs could see the price of financial products fall dramatically, materially reducing the profit pool for the industry.
The high variable capital requirements that are set for Authorised Deposit-taking Institutions (ADIs) by regulators will continue to put a floor under loan product pricing, but the component of pricing that reflects the current high marginal cost of middle office staff is likely to come under significant and sustained pressure as technology replaces the bulk of these costs.
Late last year, NAB announced plans to cut 6,000 Full Time Equivalent (FTEs) positions from its head count over the next 3 years as it steps up its annual investment in technology, automation and its internal capabilities by around 50 per cent. While the headcount reduction would be offset by the addition of 2,000 new roles, the net 4,000 reduction in FTE’s equates to around 12 per cent of NAB’s total employee numbers as at the end of FY2017.
Over the last 5 years, the number of full time equivalents employed by the major banks has been relatively flat. The exception has been ANZ which has scaled back its previous expansion into Asia and Institutional business.
Source: Company results
Technology offers cost reduction potential that would step change the productivity of banking operations. However, it also presents a competitive threat in that it could allow a new competitor that starts with a clean sheet of paper to build an operating platform that, upon achieving sufficient scale, can economically price products at levels that cannot be matched by the banks in their current form.
The question is whether the major banks can restructure their operating cost bases and processes quickly enough to prevent any new entrant from reaching a scale position and fundamentally changing the competitive landscape in Australian banking.
The Montgomery Funds own shares in the Commonwealth Bank of Australia and Westpac. This article was prepared 14 June 2018 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade the Commonwealth Bank of Australia or Westpac you should seek financial advice.
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