Many analysts claim that tech giants are the biggest upcoming threat to traditional banks. McKinsey concluded recently that while banks had been watching FinTechs to prepare for new competition from small innovative firms, the real threat comes from tech giants, the likes of Amazon and Facebook.
At the same time, some argue that banks can still rely on major advantages to defend their business franchise: their financial strength and size as well as their reputation and client base.
We analyze below these arguments by making a comparative analysis of a few basic figures of major traditional banks and tech giants.
For this analysis, we have selected 6 of the largest US and European banks (BNP Paribas, Deutsche Bank, HSBC, Citigroup, Bank of America, JP Morgan) and 6 tech giants (PayPal, Facebook, Amazon, Apple, Google, Alibaba).
When you compare the profitability of tech giants with that of traditional banks, you see that both show relatively comparable figures. After annualizing Q3 2017 performance for comparison purposes, tech giants would generate an average USD 17.3 billion net profits versus USD 16.4 for banks.
These figures, however, do not show two important developments: first, the formidable growth rate of tech giants, as most of them grow at high double digit rates; second, and most importantly, profits booked by tech giants are to a very large extent cash profits, while banks usually report book profits, of which substantial parts have not necessarily (yet) translated into cash.
Banking is by all standards the highest leveraged industry in the world. Largest banks show an 8.5% average solvency, versus 53% for large techs.
One should note though that gross solvency (being defined as the ratio of equity to total balance sheet) does not take into account so-called risk weighted assets. Banks report a different solvency, their Tier 1 capital ratio, which is the ratio of the bank’s core equity capital to its total risk-weighted assets (RWA). RWA are much smaller than total assets.
The fact that banks weigh differently, for instance, a loan to an investment-grade sovereign than an unsecured loan to a small corporate or an individual logically explains this. That results in lower capital requirements for certain types of assets, hence the difference between gross solvency as calculated above and weighted solvency as reported by banks.
The high leverage of banks is also justified by the implied support from their respective central banks in case of liquidity disruption. This is a fundamental aspect of their business. Banking is the only industry that can rely on a lender of last resort: central banks. In a scenario where banks cannot refinance their balance sheets in the financial markets, for instance in exceptional circumstances like those that prevailed during the 2008 financial crisis, banks — if they are considered as systemic — can always park assets with central banks in exchange for refinancing and liquidity.
Of course, such refinancing option comes at a cost. First, central banks will charge a premium for refinancing in order to act only as a lender of last resort. Second, central banks are ready to play the role of lender of last resort in exchange for strict regulations aimed at controlling risks taken by banks in order to prevent liquidity crises. Regulations generally result in higher costs of doing business. Consequently, they reduce returns on equity.
But let’s also not forget that leverage is necessary for banks to achieve decent returns to investors. If banks did not show the high leverage that characterizes their business, invested equity would have to increase correspondingly, and returns on equity would reduce in due proportions.
While banks can usually raise short-term cash in the interbank money markets where liquidity is abundant, the 6 tech giants we have selected sit on a staggering war chest of a combined USD 267.5 billion of cash (or liquid short-term securities, which can be traded for cash).
The large banks we have selected usually show strong credit ratings, between BBB- and A+ (by S&P). That enables them to attract liquidity (interbank money market) and deposits, and to access debt at very attractive conditions, a necessary condition to justify the high leverage we outlined earlier.
But the selected tech giants show even higher ratings than banks, from A+ to AA+. Two of the analyzed tech giants are not rated (Facebook and PayPal), but they are hardly leveraged, and based on their financials, it would be reasonable to expect that they would obtain a rating of at least AA+ (equivalent of the rating of the US). That means that tech giants, which are not very leveraged compared to banks, could easily attract liquidity and access debt at very attractive conditions if they needed to.
Next to the money and debt capital markets, tech giants also have access to equity capital markets at even more attractive conditions. The selected tech giants show an average market capitalization of USD 391.5 billion in November 2017 with a Price Earning (P/E) ratio of 23, compared to an average market cap of USD 179 billion and a P/E ratio of 11 for banks. That means that banks could, in theory, attract equity equivalent to 11 years of net profits when tech giants can raise that bar to 23 years. That shows that investors’ appetite for tech giants is much higher than for banks.
Large banks have built over many years strong brand names. Most of the banks we have selected have achieved worldwide recognition. But tech giants are not lagging behind in that respect.
The balance of power seems indeed to be alarming for banks when we look at the respective client base of tech giants versus that of traditional banks.
Tech giants have successfully attracted massive numbers of users and clients over just a few years, the biggest of which being Facebook with more than 2 billion users globally, while the biggest bank by number of retail clients seems to be Citi with around 200 million customers worldwide. The numbers of customers are generally in a ratio of 1 to 9 for large banks versus tech giants (based on the partial figures we have collected, the selected largest banks would have an average of almost 70 million customers while the average number of users of tech giants would be in excess of 600 million each).
Furthermore, tech giants keep increasing their client base at a very fast pace, while banks struggle to manage their existing clientele as they keep up with increasing regulations. For example, it took Citi 200 years to acquire 100 million clients while companies like Alipay (the mobile and online payment solution of Alibaba) have more than 500 million users. Even the less-known Kakao Bank in Korea (digital-only bank) has recently acquired one million clients in just one week!
More importantly, mainly thanks to their technology, tech giants have developed their client base internationally over the last decade, while traditional banks have built their respective client base within the borders of a limited number of countries. Citi for instance has a large market share in the US. BNP Paribas has leading positions in France, Belgium or California. Other banks will similarly be focused on some geographies, but their market shares are not really significant anywhere else. Tech giants have developed their franchise across borders and have reached significant market shares in all countries with few exceptions.
This cross-border client base will be their most valuable asset when they will try to enter the financial services space. Indeed, international capital flows have increased dramatically in recent years. According to the OECD, cross-border capital flows rose from about 5% of the world GDP in the mid-1990s to about 20% in 2007, and about three times faster than world trade flows. Bank and tech companies increasingly operate in a globalized world where capital controls have reduced in the last few decades. In that context, the ability of tech giants to serve their customers across borders, which is very much embedded into their cultural DNAs, will be a formidable asset when they start offering basic financial services.
The question is then whether bank clients would stick to their traditional banks or would be ready to adopt financial services offered by tech giants. It seems that the answer to that question is increasingly clear. A recent study prepared by MuleSoft shows that nearly 30% of customers in traditional banking markets like the UK, Germany, Belgium and the Netherlands would consider using banking services provided by companies like Amazon, Google, Apple and Facebook. Customers indeed believe that banking services offered by tech giants would bring greater convenience and a more personalized approach.
Judging by their financial strengths and their huge and growing client base, tech giants are real potential contenders of traditional banks and could disrupt the financial industry in a way that even banks have not anticipated and that could reshape the entire financial industry for years to come.
For instance, Facebook is launching its peer-to-peer payment solution by leveraging its more than 2 billion client base and by exploiting its unprecedented ability to connect peers at very large scale and in real time. Amazon has already started to extend credit to suppliers having built up a track record of selling goods through Amazon, by leveraging its ability to collect, process and interpret large amount of data in order to offer better terms of financing than banks.
Their technology improves on a continuous basis and gives them a real competitive advantage over banks in terms of infrastructure, data processing and customers’ digital experience. Furthermore, more and more banks are becoming dependent on some tech giants, for instance the cloud-based infrastructure of Amazon Web Services for data storage and processing.
Things would certainly get more complicated for tech giants if they ever wanted to adopt the business model of a universal bank, with all its downfalls in terms of regulations, higher leverage and increased risk profile. We doubt that tech giants would have that ambition. At the end of the day, they do not need to try to mean everything for everyone, as many banks have tried to do for (too) many years. We reasonably assume that tech giants have probably already made a conscious choice to focus on profitable niches where they can exploit their formidable strengths and agility in order to offer convenient services to customers and generate superior returns to their shareholders.