Consolidation…and Bifurcation

Everyone knows the U.S. banking industry is in the midst of a process of consolidation that’s been going on for more than 20 years. Less well-known, however, is another long-term industry trend that is at least as profound: the bifurcation of the industry between deposit-gatherers and asset-generators. I believe that the best-positioned bank managements are the ones that understand this bifurcation trend and have adopted long-term strategies to exploit it.

I’ll get to the details in a minute, but first a brief word about consolidation. It wasn’t too long ago that banks were restricted from operating outside the states in which they were domiciled. But all that began to change in 1985, when the Supreme Court approved state legislation that set the terms under which banks could make cross-border acquisitions.u00c2 Soon, many states passed “regional compacts,” in the hope that banks in their part of the country would get a leg up in the consolidation game and be able to compete with the big banks.

Soon a wave of interstate bank acquisitions began in earnest. The pace picked up in the 1990s after most states permitted virtually unrestricted nationwide banking. The Riegle-Neal Act, passed in 1994, eliminated any remaining restrictions on interstate banking.u00c2

You know the rest of the story. There were over 14,000 banks operating in the U.S. in 1985; today, that number is below 8,000. The share of total deposits held by the 10 largest U.S. bank holding companies has risen to 43% from 17% over the past 15 years, while their share of assets has increased to 55% from 19%.

Yet despite this massive deposit share increase by the largest institutions, the U.S. banking industry remains one of the most fragmented among the industrialized nations.u00c2 There’s scant reason to expect the trend of consolidation among banking companies to stop any time soon.

But just as startlingu00e2u20ac”and much less commented-uponu00e2u20ac”has been the bifurcation of the industry between the asset and liability sides of the business. Banks can be really good at one or the other, it turns out, but not both.

Take credit card lending, for instance. Today, the top 10 credit card lenders account for 89% of the industry’s receivables. Ten years ago, that number was just over 60%. In mortgage originations, too, the share of the top 10 has jumped to 61% from 31% since 1997. Ditto home equity lending (to 66% from 41% from 2002 to 2004). In auto lending, student lending, and just about every other type of lending you can think of, the largest players account for 50% of the market.

Why are the biggest asset generators getting bigger? The main reason is that the lending business has true economies of scale. In addition, borrowers (unlike depositors) don’t care where a lender is physically located.

Yet while specialized lenders have gotten bigger and bigger, the largest banks have spent the past 20 years steadily losing market share (adjusted for acquisitions) in two other key parts of the banking business: gathering consumer deposits and small-business banking (both deposit-taking and lending). For instance, over the past eight years, the top 10 banking companies have seen their consumer deposits grow (again, ex-acquisitions) at less than half the rate of the rest of the industry. Similarly, the largest banks’ share of small-business lending fell to 21% from 30% from 1997 through 2002.

Why the erosion? In these businesses, economies of scale take a back seat to more important competitive differentiators, such as local convenience and personalized service, which big banks can have a tough time providing.

Most bank managements and boards of directors seem to have paid the bulk of their attention on consolidation. But they don’t seem to have given much thought to bifurcationu00e2u20ac”even though the forces driving bifurcation are extraordinarily powerful and carry huge implications.

First, managements of banks both large and small should recognize that certain businesses are run better nationally and centrally, while other businesses are best managed locally.u00c2 The largest banks have yet to figure out how to carry out this central/local mix optimally. This has allowed the smaller banks to continue to gain profitable market share in consumer deposit-gathering and in small business banking.

A second implication of bifurcation is that it will allow the successful national loan generators to be able to pay more for consumer deposits, since they have higher-yielding assets in which to invest those deposits. For example a successful loan generator such as Capital One has become (and will likely remain) an active acquirer of local consumer deposit-gatherers, in an effort to balance the funding of its assets.

Finally, with the absence of consumer lending opportunities (and increasingly restricted commercial real estate lending) non-loan-generating banks will see their loan-to-deposit ratios fall, their margins contract, and their overall profitability sink.

Talk all you want about banking consolidation. It’s important. But so is bifurcation. Make sure your bank has a strategy in place that can profitably manage and exploit it.

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