Hosking Post Banks: As simple as possible - Hosking Partners
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Hosking Post
Banks: As simple as possible
1If a sign is not necessary then it is meaningless. That is the meaning of Occam's Razor.
Ludwig Wittgenstein1
How far should one simplify the investment process? Einstein’s insight that ‘everything should be
made as simple as possible, but not simpler’ presents investors with a challenge. What is the
outer limit of simple?
For those in the investment industry, simplification questions are uncomfortable. And not just
because they are hard. Complexity and fees are good bedfellows. As the late, great Jack Bogle
commented ‘financial institutions operate by a kind of reverse Occam’s razor’ 2. But at Hosking
Partners we find real purpose in the work of distilling investment thinking. Simplicity is the end
result, not the starting point.
A simple investing heuristic for bank stocks is that you should not bother. Banks are proverbial
‘black boxes’ with earning drivers too complex to understand, let alone forecast. The analytical
opportunity cost is too high and anyway they are cyclical and highly regulated. From a
methodological perspective, your author understands the temptation, but demurs from throwing
banks onto the ‘too hard pile’. Banking should be a simple business that, in the rare instances
that it is done well, delivers impressive shareholder returns.
How else, then, to dismiss bank investing? For many investors the reason not to invest in banks
is that we are witnessing a period of rapid disruption. From fintech payment companies eating
away at lucrative profit pools, through to crypto-currency backed decentralized finance or ‘de-fi’,
banks face an array of competitive threats. This whilst also dealing with the fall-out from a global
pandemic. No wonder then that banks’ valuations are – in relation to a US market - only
marginally below their 2009 GFC low.
But what if these views are not just priced in but outdated? Banks exist in a living, evolving
economy. And, as implausible as it may sound, some banks at least do seem capable of
adaptation. Over half of all consumer lending at Bank of America is now digital3. Digital
convergence is becoming an economic reality for a small cadre of leading US banks. Indeed,
provocative as it may sound, technology is arguably more of an opportunity than a threat. The
big 4 ‘franchise’ banks of J.P Morgan, Bank of America Corporation, Wells Fargo & Company
1 Ludwig Wittgenstein from the Tractatus Logico-Philosophicus, 3.328, 1922.
2 Enough: True Measures of Money, Business & Life, John. C. Bogle.
3 Hosking Partners company meeting 08/09/2020 with Aron Levine, Head of Consumer Banking at Bank of America.
2and Citigroup have seen a decade of increasing market share and are now benefiting from
increasing returns to scale – a powerful fly-wheel dynamic beloved of technology investors. With
a structural advantage in low-cost deposits and increasingly painless technology, the bank
‘bundle’ of products is starting to present customers with a compelling proposition. For
shareholders with a long-term view the cost opportunity is tantalising. What follows below is an
attempt to analyse the long-term survivability and potential earning power of banks via a
simplifying mental model we can call ‘deep reality’.
The deep reality mental model
Reducing a business to its deep reality, or economic ‘reason-for-being-alive’, is a powerful
exercise. It illuminates the relevance and longevity of a company. Indeed, in certain instances
this deep reality is so powerful that it defines the entirety of the investment decision. Using Google
as an example, the deep reality is one of a monopolistic search provider whose product exhibits
increasing returns to scale. It gets better the more people use it. And it takes virtually no capital
to sustain this flywheel. For the time being the Google search business is the proverbial magic
money tree. Likewise, the deep reality of low-cost carrier Ryanair (average fare per passenger
€31) is that the customer would be economically irrational not to use it. You might prefer a
complimentary packet of nuts and tastefully upholstered seats, but be prepared to pay up to 10x
more for the pleasure4.
For banks, the deep reality of their business model is twofold. First, people trust them to keep
their deposits safe. Second, they transform these instant-access deposits into multi-year loans
via a process termed ‘maturity transformation'. Neither of these two points is particularly
revelatory yet they are fundamental to the five-century longevity of the fractional-reserve banking
system5.
Deposits
The challenge of building a scaled, nationwide deposit base is immense. On the customer side,
potential disruptors not only have to offer a product that is superior to the ever-improving Big
Bank offer, but also gain enough trust to steward the depositors’ savings. Building trust takes
4 https://investor.ryanair.com/wp-content/uploads/2020/07/Ryanair-Holdings-plc-Annual-Report-FY20.pdf.
5 Fractional-reserve banking refers to the framework in which only a fraction of reserves are backed by actual cash on hand and available for
withdrawal. This powerful money-creation ability, together with systemic risk inherent posed by deposit-runs, drives massive regulatory oversight.
Whether crypto enabled de-fi or central bank digital currencies supplant fraction-reserve banking is beyond the scope of this note!
3time. Blow-ups like the Wirecard bankruptcy fiasco6, which left many customers unable to access
funds, have reminded fintech customers of the risks associated with new models. On the
regulatory front, society at large has deemed deposit runs to be unacceptable post-GFC. As a
result, the regulatory capital (up roughly 3x post-GFC) and compliance burden (immeasurably
higher) required to hold customer deposits is vast.
As yet, no Western fintech has accumulated a meaningful deposit base. In the US, a banking
licence is a requirement to take on deposits, so most fintechs have an old school ‘sponsor bank’.
Despite describing itself as a neobank, Chime ($14.5bn valuation per last round in September
2020) does not have a banking licence and relies on a passthrough arrangement with Bancorp
Bank. Echoing the deep reality of most fintech business models – reducing customer pain via
software to gain a piece of the c. 1% transaction fee - the CEO of Chime described his business
as “more like a consumer software company than a bank … more a transaction type-based,
processing-based, business model that is highly predictable, highly recurring”7. Yet in the same
interview he hinted at the fintech deposit conundrum, “we aren’t providing service to Google
engineers who earn $250k, their accounts with Wells Fargo work just fine”8.
The investment question for the big 4 franchise banks (and those smaller banks wishing to play
in this scaled-up Premier League of banks) is whether they can protect their deposit bases long
enough to transition to a digital-led model? If the answer is yes, and the evidence so far is
encouraging9, there is substantial, under-appreciated terminal value in bank equity. For instance,
will an asset-rich 60-year old transfer some / all of their life savings from Wells Fargo into a
neobank with a sexy pink card, ‘free’ stock trading and slick payment app? The answer, perhaps,
is “some will, most won’t”. And the demographics are such that for many decades much wealth
will reside with the baby boomer cohort. This doesn’t mean the franchise banks are assured
deposit supremacy but it does give them a chance to fast-follow the technology and cherry pick10.
The wonder of maturity transformation
The second-deep reality of a bank is that it transforms the instant-access deposits of, often older,
wealthier depositors into long-term loans for, often, younger, less wealthy borrowers. Maturity
6 Wirecard peak market cap of EUR €24bn left millions of customers unable to access their accounts, a salutary lesson for many young people who
relied on it.
7 Shevlin, R. (2021). If Chime Isn’t A Bank, Then What Is It?. Available: https://www.forbes.com/sites/ronshevlin/2021/05/10/if-chime-isnt-a-bank-then-
what-is-it/?sh=1a56cda64f19. 10 May 2021.
8 CB Insights. (2019). Chris Britt, CEO of Chime. Available: https://www.youtube.com/watch?v=hrWy9OjUOrs. Last accessed 25 June 2019.
9 See Appendix 2.
10 JPM offers zero cost trading, Bank of America gives Zelle free money transfer to any US account, the Wells Fargo app has a 4.8 rating on the app
store.
4transformation is an example of a societal level win-win, akin perhaps to that of Free Trade among
nations – the benefits are enormous but not obvious. And Lindy-like, the persistence of the
banking model speaks to its usefulness11. All sorts of things society deem good and essential are
enabled by bank maturity transformation. For example, a young couple’s house purchase or the
financing of a multi-year green energy project. The best articulation of the human impact of this
maturity transformation is that of George Bailey in the classic film ‘It’s a Wonderful Life’. Speaking
of his father’s thrift bank:
..he did help a few people get out of your slums, Mr. Potter. And what's wrong with that? Why...
you're all businessmen here. Doesn't it make them better citizens? Doesn't it make them better
customers? What'd you say just a minute ago?...They had to wait and save their money before
they even ought to think of a decent home. Wait! Wait for what? Until their children grow up and
leave them? [It’s a wonderful life, RKO Radio Pictures, 1946].
An essential component of bank maturity transformation is the way in which deposits are
mediated into diversified credit risk. By mixing loans of different duration, sectors, geographies,
FICO scores and so on, the risk of one loan category blowing up and ‘bringing the house down’
is greatly reduced. This diversification is itself the result of decades of lending. And, logically
therefore, it will take decades to replicate these loan books. And en route to the end point of
replication, the disruptor would not benefit from what bankers term ‘seasoning’ – the ability to mix
and match loans disbursed at different stages of the economic cycle. If you start lending at the
peak of an economic cycle – the point, it should be noted, when capital is most freely available
for new ventures – you end up with what is euphemistically termed a ‘vintaging problem’. And if
the disruptor is not profitable, a further safety-enhancing feature of the banking model would be
lost. The profitability of established bank ‘back books’ provides a further cushion to depositors –
the top 4 US banks have combined pre-provision profits of c$150bn per annum (2020). A huge
cushion against which to set the inevitable lending mis-steps.
The lack of loan book diversification in new or disruptive lending models is telling and gives
credence to the ‘deep reality’ of a robust – for now - traditional banking model. Large scale
maturity transformation has yet to be disrupted. Newer lending models by necessity self-select
those most in need of credit. The marketing approach of ‘hey, we are new, come borrow from us’
attracts a certain type of customer! We are now into the second decade of disruptive
11 “If a book has been in print for forty years, I can expect it to be in print for another forty years [That is the Lindy Effect]. But if it survives another
decade, then it will be expected to be in print another fifty years. This, simply, as a rule, tells you why things that have been around for a long time are
not "aging" like persons, but "aging" in reverse. Every year that passes without extinction doubles the additional life expectancy”.
Antifragile: Things that gain from Disorder by Nassim Taleb.
5‘marketplace’ fintech lending models and post GCF challenger banks. And, in the Anglo-Saxon
world at least, the results have not been particularly successful.
Source: Hosking Partners, Factset and annual reports. 31/12/2020.
In China, the story has been somewhat different and the success of Ant Group is a major warning
to established banks – and their regulators. With over 1bn customers, Ant could lay claim to be
the world’s largest financial services company. Alipay provides a window into the power of a
frictionless everything-on-one-app world. That said the economy-wide implications of Ant’s
success have provoked a regulatory backlash as the Chinese Communist Party moves to protect
the maturity transformation role of incumbent banks. Almost all of the regulatory loopholes Ant
used to thrive are to be removed, with the business split up into various entities subject the full
gamut of financial holding company and bank regulation12. As the financial blogger Marc
Rubenstien has pointed out ‘the developments are a warning to financial super app aspirants
across the world’13.
Bank earning power
Lost in the short-term noise of fintech hype and pandemic loan loss concerns is the deep reality
of underlying bank earning drivers. Banks represent a claim on the growth of deposits within the
economy. Data from FDIC shows that US bank deposits have grown consistently for 70 years.
The core product of banking has ‘compounder’ characteristics. Using the Jeff Bezos investment
inversion of betting on ‘what won’t change’ (as opposed to guessing on what might), a bet on
future US deposit growth looks sound.
12 https://www.caixinglobal.com/2021-04-27/in-depth-the-rectification-and-remaking-of-ant-group-101700657.html.
13 Net Interest: The Goldman Sachs of Crypto, 30/4/2021.
6US Bank Deposits ($bn)
1974 746
1984 2,781
1994 3,541
2004 6,383
2014 11,596
2020 17,116
CAGR 7%
Source: https://fred.stlouisfed.org/series/QBPBSTLKDP.
Banks that can take advantage of this underlying earning driver and also deliver returns on their
existing francise might, perhaps, meet the ‘exceptional’ business definition. In Q4 2019 – the last
non-Covid impacted quarter - JP Morgan delivered a 19% return on tangible equity. This was
achieved with the US 10-year treasury yield averaging 1.8% over the quarter and the 2 year
1.6%, i.e. despite the headwind from a shallow yield curve and a widespread view that inflation
and rates would stay low indefinitely. Should the economy improve and recently muted loan
growth match that of deposit growth, the investment outlook for franchise banks could be
exceptional.
Take Wells Fargo, a storied 169-year old banking franchise that is a relative latecomer to the
digital cost opportunity. If we assume that over 5 years CEO Charlie Scharf can hit his target of
achieving a peer-level cost base, some balance sheet growth as regulatory shackles come off
and a return of excess capital via share buy backs, then Wells Fargo presents a 25% IRR
opportunity, before any multiple improvement that would surely follow a reasonable level of digital
transition.
WFC return calculation (five year)
Share price @ Q2 2021 45 12x the 2022 earnings forecasts
Cumulative $ dividends per Assume a 33% pay-out ratio vs 50%
11.2
share historically
12x 2026 earnings of $9.8 per share; 50%
Share price @ Q2 2026 118 cost:income ratio, 20% reduction in share
count, normalised net charge offs
Versus a market cap today for JPM and
Market cap bn @ Q2 2026 393
BAC of 461bn and $343bn
Total IRR 25%
Source: Hosking Partners estimates.
7The ‘what if’ question
Beyond the simple earnings recovery type scenario, outlined for Wells Fargo above, there is a
bigger industry prize. For the major banking franchises, with generations of accumulated
depositor trust, the opportunity is to transfer this trust into a largely non-physical business model.
Whether this is done via completely new digital banks detaching from mothership – for instance
JPM launching digital only Chase in the UK or Goldman Sach’s Marcus brand – or through the
steady transformation like Bank of America, the franchise banks are going digital. Mobile-led
customer engagement, cloud-based infrastructure (no internal IT departments!) and dramatically
lower physical infrastructure costs present not just a multi-year earning runway but the tantilising
prospect of digital lock-in of the huge existing customer bases. The ‘what if’ question here is ‘what
if banks transition, what would their earning power be?’ The ‘steady-state’ cost:income ratio for
scaled digital consumer banks could, perhaps, settle in the 20-30% range, a dramatic change in
underlying profitability. The winner-take-most nature of digital networks and regulated,
oligopolistic market structure suggests that while some of this benefit would be passed on to the
customer, returns on equity would more than double and at the same time a hard re-rating
beckons. Setting the stage, perhaps, for a rehabilitation of value investing?
Django Davidson
May 2021
8Appendix 1.
US Banks vs US Stock Market
Large Capitalization Banks - Relative Price-to-Pre-tax Pre-Provisioning Income
1.4
1.2
1.0
0.8 Initial Rate Cut
x
2019
0.6
Current
0.4
0.2 First Pandemic-
Related Rate Cut
0.0
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
Recessions
Source: National Bureau of Economic Research, Empirical Research Partners Analysis. Large-Capitalization Banks. Relative
Price-to-Pre-tax Pre-Provisioning. Income. Price-to-pretax income used for the market; capitalization-weighted data. Mar 1999
to Apr 2021.
Appendix 2.
US Banks Market Share Data
Source: Data compiled Sept, 18, 2020. N/A = not applicable. Data is based on the FDIC Summary of Deposits filings as of 30 June
2019, 30 June 2020. Ranking based on deposit market share. BB&T Corp. ad SunTrust Banks Inc. completed their merger-of-equals
transaction on 6 Dec 2019. Prior year data reflects FDIC Summary of Deposits filings by both BB&T Corp. and SunTrust Banks Inc.
for the twelve months ended 30June 2019. Tickers are show for the home country stock exchange. S&P Global Market Intelligence;
FDIC.
9Contact Details
Hosking Partners
2 St James’s Market
London SW1Y 4AH
Tel: +44 (0)20 7004 7850
info@hoskingpartners.com
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Opinions included in this material constitute the judgment of the author at the time specified and may be subject to change without notice. Hosking is
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