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Size Matters

Who's going to shake up the U.S. market in 2006?

By the end of 2006, expect a minimum of five sizeable European banks to enter the U.S. market, predicts Don Morrison, global banking domain lead, Kanbay International (Rosemont, Ill.), a systems integrator in financial services. "If you look at Europe today, there's excess capital and they're faced with flat or low-growth opportunities," he observes. "The U.S. is a natural target for them," Morrison continues. "Where else in the world can you go out and find an abundance of banks that you can acquire and get a sizeable impact on the asset base?"

The key assumption is that the best-of-breed European banks—which generally are more efficient than their U.S.-based counterparts—will be able to migrate the acquired banks onto existing technology platforms while maintaining relatively low efficiency ratios. "They're operating in the low 40s," notes Morrison of the European banks. "Eight to 15 points make a tremendous amount of difference to the bottom line. When they look at a bank that may be in the low 50s, they've got some room to wiggle."

To stave off a purchase by more-efficient and better-capitalized banks, can U.S. banks manage an operational turnaround in time? For institutions that have been built through M&As, that's a questionable proposition. "The decision to scrap [their systems] and go to something with the efficiency they need is out of the question," declares Morrison.

The efficiency gap is a recognized issue in the industry. "No matter what's said in the press, many of the larger banks really have not integrated well," contends Bob DeLeeuw, president of DeLeeuw Associates, a division of strategy consulting firm Conversion Services International (East Hanover, N.J.). Nevertheless, DeLeeuw is sanguine about the turnaround chances of the U.S. incumbents. "There'll be improvement," he insists. "The larger banks are reinvesting and trying to finalize the consolidation and the digestion of what they did in the '90s."

As banks' IT integrations bear fruit from the implementation of the latest enterprise IT architectures, the efficiency gap is poised to narrow. "Banks are investing in better operations, upgrading their systems and finalizing their conversions," notes DeLeeuw. "That will translate into better earnings, better stock prices and, then, the ability to go acquire selectively."

Efficient Ain't Winning

Efficiency ratios are one thing, but profitability is quite another. By that measure, the transatlantic picture changes considerably. "The U.S. banks are significantly more profitable than the European banks," notes Adam Dener, partner at financial services consultancy Capco (New York).

Small efficiency advantages aren't enough to seize the market, suggests Dener. To capitalize upon efficiency requires a fundamental market shift. "It's got to be significant enough and advantaged enough that it would make a meaningful difference," Dener says.

Dener says his research shows a disconnect between concentration of assets and the efficiency of top U.S. banks, which is contrary to the usual big-bank mantra that scale is important. "Just because you have scale doesn't mean that it translates into anything," he remarks. "It just means you have scale." In fact, thus far, there even may be declining returns to scale, Dener notes. "Relative to the overall banking industry, [the larger banks] are less efficient," he adds. "They've had growth in their scale, but a reduction in their efficiency."

But from the big banks' perspective, grow they must. "The big banks need to, can and are competing with the Deutsches and the HSBCs, and some of the larger Japanese institutions," observes Gene Swanzey, associate partner at London-based strategy firm PA Consulting. "The world has gotten quite small in terms of deals, transactions and business customers, and so size does matter in the global arena."

But size doesn't always help in the local arena. "Size spawns smaller banks to come and compete," says Swanzey. "At the same time you see some of those large mergers taking place, you see a new competitive environment at the smaller level."

Although the biggest banks may not be able to adopt new technologies and organizational architectures at the flip of a switch, smaller players have become adept at figuring out what markets they can corner, and then building a just-in-time technology infrastructure to match. "You've got these really sharp operators who figure out what they're strong in and throw out what they're not strong in," says Robert Bessel, spokesman for outsourced service provider COCC (Avon, Conn.).

Furthermore, as personal computing technology becomes more entrenched, the outsiders—whether it's non-U.S. banks entering the market or small banks capitalizing on low-cost infrastructure—have a real potential to become a competitive threat to the established names. Enterprise technology accelerates and enables that process. "The expensive branch network will be something of a liability as information continues to be digitalized, and as customers become more comfortable interacting with their banks online," says Lars Skari, a Los Angeles-based VP and client executive at consulting firm Inforte (Hamburg, Germany). "We're going to see a huge increase of online banking adoption," he asserts, while acknowledging, "I don't know if 2006 is going to be the turning year for that—it might be 2010 before we get there."

If and when online banking withers the demand for branch banking, the shift will benefit the new entrants. "The entrenched providers today will have to shut and write off that infrastructure as you have the transition from analog to digital," says Capco's Dener. "Current entrants in the market have a disconnect in their cost bases that new entrants don't have."

Another source of competition may come from outside the traditional boundaries of financial services. "What would prevent someone with a good retail distribution store network, a solid brand and excellence in customer service from opening a bank?" asks Inforte's Skari. "Whose to say that the banks are the best players?"

The W Column

The ultimate outsider may be Bentonville, Ark.-based Wal-Mart. Supposing the retailer gets the go-ahead to open a bank to process its customers' debit transactions; it's only a few short steps toward expanding to a national player, despite management assertions to the contrary. What's more, it's plausible that an ailing bank could pave the way for that to happen. "If one of the medium-size banks decides they're going to throw in their lot with Wal-Mart, you'd have a national franchise out of the box," observes Capco's Dener. "It's a function of time before the guys who are sitting on a morbid bank that's going to be bought by someone else say, 'Why don't we become the financial services department of Wal-Mart?'"

Other big retail brands similarly could make a play at the consumer banking industry. "Look at Starbucks," suggests Dener. "If I were [Starbucks CEO] Howard Schultz, I'd be wondering about how to put a bank in my store."

Or, it could be manufacturers, bringing Six Sigma mind-sets and trusted brands to the fore. "Disciplines like Six Sigma scare the heck out of bankers," says DeLeeuw Associates' DeLeeuw. "Financial services has been at least 10 years behind manufacturing in that regard." Further, "The manufacturing industry is way ahead of financial services in knowing how to distribute things. So why not let them distribute?" DeLeeuw adds. "GE or GM could be the biggest bank in the world in a few years."

But don't count traditional banks out, cautions PA Consulting's Swanzey. "[Banking is] one of the leaders in technological innovation," he says. "With that, somebody will find a way to compete with Wal-Mart."

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