Profit from the structural advantages that banks enjoy in this market.
Morningstar, Ganesh Rathnam, 28 June 2006
When the government sets up a commission to study the abnormal profitability of a certain industry, there's a good chance that industry has an entrenched economic moat. Such a study was set up by the U.K. Treasury in 1998 to study the extraordinary profitability of U.K. retail banks. That study, completed by Don Cruickshank in 2000, suggested several measures that would transfer some of that profitability from banks' coffers back to its customers, including individuals and small-and-medium enterprises. According to a paper by Jonathan Ward, some of the measures suggested include making it easier for customers to switch banks, limiting service bundling (Microsoft anyone?), providing information on competitors' products and services, and making mandatory minimum interest payments to business account deposits. Despite these potential profit-reducing recommendations and the global downturn of 2000-02, profitability at U.K. banks is back to pre-2000 levels.
An Oligopoly
As my colleague Jim Callahan pointed out in an earlier article, we believe that nearly all banks have an economic moat. And, in our opinion, banks such as Lloyds TSB, Barclays, and Allied Irish Banks have wider economic moats than the average U.S. bank because they possess large market share within their country's oligopolistic banking markets.
Arguably, size provides a huge competitive advantage in consolidated markets. Unlike the fragmented U.S. market, five banks dominate the U.K. (Lloyds TSB, Barclays, HSBC Bank, Royal Bank of Scotland, and Halifax Bank of Scotland) and four banks dominate Ireland (Allied Irish Banks, Bank of Ireland, National Irish Bank, and Ulster Bank), controlling well over 80% of market share. Counterintuitively, net interest margins are about 1 percentage point lower than the average of U.S. banks. Deeper analysis suggests that while these banks don't compete with each other on price, the net interest margins' low level prevents new entrants from earning an economic profit while maintaining the incumbent banks' high profitability. In other words, these dominant players seem to exercise their oligopoly powers tacitly to prevent new competition from breaking into their market.
In fact, we think that in a regulated industry such as banking, firms in a consolidated market have to try hard not to have a wide moat. We would hesitate to confer wide moat ratings only if banks with a dominant market presence failed to leverage that advantage to consistently generate economic profits or there was evidence of irrational competition among the existing banks. Neither of these is a factor when examining the U.K. market.
Product, Service, and Relationship-Based Banking
The U.K. and Irish banks have built high switching (or inconvenience) costs for customers by focusing on product, service, and relationship-based competition rather than price-based competition. Banking infrastructure plays a big hand in shaping the competitive dynamics. Unlike the U.S. market, banks in the U.K. and Ireland have nationwide platforms. A customer switching cities or counties in the U.K. need not switch banks as would a customer of TCF Bank moving to San Francisco. Unsurprisingly, customer churn rates are in the low to middle single digits, and market-share figures tend to stay constant over time. In addition, all these banks have heavily invested in customer relationship management software that helps banks gain "wallet share," industry speak for selling multiple products to a single retail customer. For example, an average Lloyds' customer buys 2.5 out of a possible 7.5 retail products from Lloyds.
Aside from basic retail and commercial banking products, each of these banks has other businesses that meet customers' needs. Lloyds has Scottish Widows, the third-largest insurance and pension provider in the U.K. Barclays has a credit card operation, an investment-banking arm, and an asset-management arm, providing financial products to supplement plain-vanilla checking accounts, savings accounts, mortgages, or corporate loans. Empirical evidence suggests that the more products a customer owns from a single bank, the less likely that customer is to switch banks.
These banks seem to realize the futility of competing with each other on price (by raising deposit rates or lowering loan rates). Instead, they primarily compete for customers by offering services and managing relationships. For example, Allied Irish Banks has about 1,600 relationship managers with a portfolio of retail or business customers, and each manager is compensated based on increasing the profitability of his portfolio. Moreover, Allied Irish Banks has agreements with universities to be the sole bank on campus. The bank then forms a relationship by offering student loans and continues a banking relationship with those individuals well after they've graduated, possibly acquiring customers for life.
Too Big to Fail
Despite regulators' concerns with these banks' profitability, there may not be much that regulators can do about it. Banking stability is crucial to maximizing an economy's growth. Banks need public confidence in their solvency to operate smoothly and prevent runs on deposits. Deposit insurance takes care of this problem, essentially by forcing taxpayers to subsidize bank failures. Therefore, banks and their shareholders inherently face a moral hazard: If they take a huge risk and it pays off, they win; if not, taxpayers lose. As the U.S. savings and loan crisis of the mid-1980s suggests, the combination of competition and deposit insurance may not be such a hot idea. Why deregulate and encourage outsized risk-taking by banks, putting the whole economy in jeopardy? Having banks earn economic profits while monitoring their risks might be the lesser evil.
In aggregate, the leading banks in the U.K. and Ireland control more than 80% market share in their respective countries. In contrast, Bank of America, the largest retail bank in the U.S., controls only about 10% of the deposit market. In the event of failure of one of these U.K. or Irish banks, the cost to the economy and taxpayers would be staggering, not to mention unintended consequences of triggering a liquidity crunch and causing other banks to fail if one goes under. Therefore, it is in the best interests of regulators to ensure that these banks don't fail.
Conclusion
We believe that the above three factors mainly account for the extraordinary profitability of Lloyds TSB, Barclays, and Allied Irish Banks. Over the past five years--a period that has included economic shocks and major stock market downturns throughout the developed world--returns on equity have remained solid. Lloyds has averaged a 20.5% return on equity, Barclays 17%, and Allied Irish Banks 19.7%. More importantly, we believe that these three banks will continue to see outsized profitability for years to come. Anytime these stocks trade at a discount to our fair value estimates, we think that it's wise to seriously consider an investment.
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Morningstar, Ganesh Rathnam, 28 June 2006
When the government sets up a commission to study the abnormal profitability of a certain industry, there's a good chance that industry has an entrenched economic moat. Such a study was set up by the U.K. Treasury in 1998 to study the extraordinary profitability of U.K. retail banks. That study, completed by Don Cruickshank in 2000, suggested several measures that would transfer some of that profitability from banks' coffers back to its customers, including individuals and small-and-medium enterprises. According to a paper by Jonathan Ward, some of the measures suggested include making it easier for customers to switch banks, limiting service bundling (Microsoft anyone?), providing information on competitors' products and services, and making mandatory minimum interest payments to business account deposits. Despite these potential profit-reducing recommendations and the global downturn of 2000-02, profitability at U.K. banks is back to pre-2000 levels.
An Oligopoly
As my colleague Jim Callahan pointed out in an earlier article, we believe that nearly all banks have an economic moat. And, in our opinion, banks such as Lloyds TSB, Barclays, and Allied Irish Banks have wider economic moats than the average U.S. bank because they possess large market share within their country's oligopolistic banking markets.
Arguably, size provides a huge competitive advantage in consolidated markets. Unlike the fragmented U.S. market, five banks dominate the U.K. (Lloyds TSB, Barclays, HSBC Bank, Royal Bank of Scotland, and Halifax Bank of Scotland) and four banks dominate Ireland (Allied Irish Banks, Bank of Ireland, National Irish Bank, and Ulster Bank), controlling well over 80% of market share. Counterintuitively, net interest margins are about 1 percentage point lower than the average of U.S. banks. Deeper analysis suggests that while these banks don't compete with each other on price, the net interest margins' low level prevents new entrants from earning an economic profit while maintaining the incumbent banks' high profitability. In other words, these dominant players seem to exercise their oligopoly powers tacitly to prevent new competition from breaking into their market.
In fact, we think that in a regulated industry such as banking, firms in a consolidated market have to try hard not to have a wide moat. We would hesitate to confer wide moat ratings only if banks with a dominant market presence failed to leverage that advantage to consistently generate economic profits or there was evidence of irrational competition among the existing banks. Neither of these is a factor when examining the U.K. market.
Product, Service, and Relationship-Based Banking
The U.K. and Irish banks have built high switching (or inconvenience) costs for customers by focusing on product, service, and relationship-based competition rather than price-based competition. Banking infrastructure plays a big hand in shaping the competitive dynamics. Unlike the U.S. market, banks in the U.K. and Ireland have nationwide platforms. A customer switching cities or counties in the U.K. need not switch banks as would a customer of TCF Bank moving to San Francisco. Unsurprisingly, customer churn rates are in the low to middle single digits, and market-share figures tend to stay constant over time. In addition, all these banks have heavily invested in customer relationship management software that helps banks gain "wallet share," industry speak for selling multiple products to a single retail customer. For example, an average Lloyds' customer buys 2.5 out of a possible 7.5 retail products from Lloyds.
Aside from basic retail and commercial banking products, each of these banks has other businesses that meet customers' needs. Lloyds has Scottish Widows, the third-largest insurance and pension provider in the U.K. Barclays has a credit card operation, an investment-banking arm, and an asset-management arm, providing financial products to supplement plain-vanilla checking accounts, savings accounts, mortgages, or corporate loans. Empirical evidence suggests that the more products a customer owns from a single bank, the less likely that customer is to switch banks.
These banks seem to realize the futility of competing with each other on price (by raising deposit rates or lowering loan rates). Instead, they primarily compete for customers by offering services and managing relationships. For example, Allied Irish Banks has about 1,600 relationship managers with a portfolio of retail or business customers, and each manager is compensated based on increasing the profitability of his portfolio. Moreover, Allied Irish Banks has agreements with universities to be the sole bank on campus. The bank then forms a relationship by offering student loans and continues a banking relationship with those individuals well after they've graduated, possibly acquiring customers for life.
Too Big to Fail
Despite regulators' concerns with these banks' profitability, there may not be much that regulators can do about it. Banking stability is crucial to maximizing an economy's growth. Banks need public confidence in their solvency to operate smoothly and prevent runs on deposits. Deposit insurance takes care of this problem, essentially by forcing taxpayers to subsidize bank failures. Therefore, banks and their shareholders inherently face a moral hazard: If they take a huge risk and it pays off, they win; if not, taxpayers lose. As the U.S. savings and loan crisis of the mid-1980s suggests, the combination of competition and deposit insurance may not be such a hot idea. Why deregulate and encourage outsized risk-taking by banks, putting the whole economy in jeopardy? Having banks earn economic profits while monitoring their risks might be the lesser evil.
In aggregate, the leading banks in the U.K. and Ireland control more than 80% market share in their respective countries. In contrast, Bank of America, the largest retail bank in the U.S., controls only about 10% of the deposit market. In the event of failure of one of these U.K. or Irish banks, the cost to the economy and taxpayers would be staggering, not to mention unintended consequences of triggering a liquidity crunch and causing other banks to fail if one goes under. Therefore, it is in the best interests of regulators to ensure that these banks don't fail.
Conclusion
We believe that the above three factors mainly account for the extraordinary profitability of Lloyds TSB, Barclays, and Allied Irish Banks. Over the past five years--a period that has included economic shocks and major stock market downturns throughout the developed world--returns on equity have remained solid. Lloyds has averaged a 20.5% return on equity, Barclays 17%, and Allied Irish Banks 19.7%. More importantly, we believe that these three banks will continue to see outsized profitability for years to come. Anytime these stocks trade at a discount to our fair value estimates, we think that it's wise to seriously consider an investment.
