The Outlook for Banks: Part 1


This is the first part of a two-part transcript in which'sDavid Kuo chats with banking expert Ralph Silva from Silva Research Networks to discuss the outlook for the global bank sector.

They discuss the outlook forBarclays (ISE: BARC.L) following the LIBOR debacle and the future of (ISE: LLOY.L) after the enforced sale of 600 branches to the Co-operative Bank. They also discuss whether (ISE: HSBA.L) can recover from its money-laundering scandal in Mexico. In the second segment, Ralph also highlights three banks that he thinks could emerge stronger from the financial crisis.

You can read the second part of the transcript here. You can listen to or download the full podcast here.

EDITOR'S NOTE: What follows is a lightly edited transcript of David Kuo's conversation with Ralph Silva.

David Kuo: This is Money Talk, the weekly investing podcast from The Motley Fool. I am David Kuo, and my guest today is no stranger to viewers of the BBC, the CNN, CNBC, and Bloomberg. He is a fundamental analyst with a special interest in global banks. He is Mr. Ralph Silva, CEO from SRN, otherwise known as Silva Research Networks. Welcome to Money Talk, Ralph.

Ralph Silva: Yes, hello.

David: I'm ever so sorry you couldn't join us in person in our studio today, because you are a little under the weather, but it is still good of you to join us on the phone. Thank goodness for telephone lines, to talk about banks which are suffering very badly, and in some cases worse than you, Ralph. So some of these banks are suffering so badly, in particular Lehmans and Bear Stearns, but we won't dwell on those two banks, because things have moved on since 2007, and I'd like to start with Barclays, if I may. Is Barclays, in your opinion, still a good bank?

Ralph: Well, the bottom line is, they are. They're a good bank because they're serving their customers, giving their customers what they need, and they seem to be seeing an increased number of new customers coming in the door, whereas many of the other banks are actually seeing a decrease in customers, but you have to ask yourself, the basic fundamental question is, what actually is a good bank versus a bad bank? Now, if we're looking at a brand perspective, then Barclays is clearly a bad bank, because it's no longer trusted, but if you look from a revenue perspective, and a customer service perspective, then Barclays is. So really, to answer that question, you've really got to decide what is and what isn't a good bank.

David: But as far as Barclays is concerned, I mean let's dwell on this question about trust. How can Barclays regain the trust of investors, customers and also the regulators, and the final one, the regulators, is probably the most important of all, because it was the lack of trust between the regulators and Barclays that caused the demise of Bob Diamond?

Ralph: That's right, and the bottom line is, seven years. That's what it takes to rebuild a financial services brand after a problem such as Barclays had. We've seen that dozens upon dozens of times, but it takes a considerable amount of time. We're not selling T-shirts, we're not selling iPods -- we're selling financial services. There's an emotional connection between the customer and the bank. Now, if this was strictly retail, if Barclays was strictly a retail bank, it's not seven years -- it's closer to 10 years before people forget, so this is a long-term process to get the brand back into place. However -- and this is a big however -- if the rest of the organizations that were under the LIBOR investigation actually come out and have the same problem, then Barclays might actually get to a recovery point from a brand perspective, before the rest will start the deterioration afterwards, so there might be some light at the end of the tunnel here. But of course, they're going to have to depend on some of the other banks going through some pain as well.

David: So how much can we read into this defection of customers? Because we keep on hearing in the press about how the retail customers are defecting from Barclays, and going to the likes of say the Co-Op, or some of the building societies like Nationwide, because they see them as being ethically holding a much higher moral ground than Barclays?

Ralph: Yes, and we have seen that in retail banking, and we continually see that in retail banking, but you have to remember that Barclays, the majority of the money comes out of investment banking, in the corporate banking area, and we're not seeing that level of defections within that particular environment. If this was Lloyds Banking, I would say that this is a big problem, but because it's Barclays, they are going to lose some more retail customers, but retail is not the future of Barclays. In fact, retail's not the future of banking, to be honest with you, so losing some of those customers isn't going to hurt them that much.

David: So am I reading into what you're saying, that Barclays may eventually jettison its retail banking, and say, we're not really interested in operating on the high street, but instead we are more focused on the investment banking side?

Ralph: I don't think it's just Barclays. I can safely say that, for every bank in the U.K. -- let me rephrase that, every bank in Europe -- we're going to see the diminishing emphasis on retail banking, and an increased emphasis on wholesale and investment banking -- why?-very simple reason, most people would prefer to do their banking when they're buying their groceries. They prefer to do their banking online, they prefer to do their banking on eBay. There are a hundred different options to do retail banking, and a lot of those other options are far more trusted. We have the odd situation in the United Kingdom right now where used car salesmen have more trust than bankers. As long as that situation continues when people have a choice for retail banking, they're going to pick Tesco or Waitrose versus Lloyds or Barclays, and that's why the future of retail banking in Europe is actually a big question, and I personally believe that we should only invest in organizations that have strong corporate or investment banking operations, because that's really the only future for financial services.

David: So is, in fact, Tesco's strategy for going into retail banking, and of course recently we saw that Marks & Spencer was tying up with HSBC and operating retail banks within the M & S stores -- is that the way forward for retail banking in the U.K.?

Ralph: It is the only way forward for retail banking in the U.K. The only real product that you can't get outside of a bank right now is mortgages, and Tescos are probably going to provide mortgages within the next 12 to 18 months, and that's the last real product that's going to go away from the financial services organizations, and why? Because Marks & Spencer and Tesco don't necessarily have to make money off of financial services. When you buy a car and you get a loan from the car company, they make money on the car, which means they can provide preferential pricing as compared to the large banks that need to make money off of this. So the products are not going to be more expensive; they're going to be better suited; they're going to be better targeted and they're going to be better serviced, because these and other types of organizations can service customers better than banks can. Why? Because they have to.

David: So why is Richard Branson diving headlong into retail banking, then, given that you're painting this relatively gloomy picture, or this gloomy profitability of retail banking?

Ralph: Yes, it's an interesting setup, but I just think that putting a bank into the Virgin enterprise is actually supportive of Virgin products. It's using financial services to support your other products, is what it's all about, which is why the Co-Op makes sense, which is why Tesco makes sense, and all these other organizations make sense. I see financial services as a utility -- let me rephrase that; I see retail financial services as a utility, and the organizations that have products and services that need financial services to support those are going to be the purveyors of those services, instead of the financial services organizations. Their time is done; retail banking, on the high street, is done.

David: So who is going to invest in these banks, then? Because, I mean, if you have the likes of Lloyds Banking Group, we'll go into Lloyds Banking Group in more detail later, but if you have the likes of Lloyds Banking Group, and maybe Royal Bank of Scotland trying to resurrect its high-street presence, and jettisoning its investment banking, who is going to invest in these retail banks, then?

Ralph: I would invest in the retail banks that are willing to work with the other industries. I will invest in any organization, if Lloyds were to form a relationship with Virgin, or any other organization that sells products and becomes the bank end of those products, of those industries, then I think there's a future in those. Other than that, I think retail banking is a short-term buy from an investment perspective; I say in five years, it will keep going down for five years, and you're not going to be able to make any money off of it in 10.

David: Good grief!

Ralph: I don't see, I'm telling you it first, because I think it's a good thing. I think it's a very positive thing, that the industries that know the customers best should help them with their money. Clearly retail banking in the high street right now does not know their customers -- we can see that by turning on the television news any time we want. Tesco understands their customers better than Lloyds does, so they should help their customers with the money, instead of Lloyds. But Lloyds, not so much Lloyds, but Barclays and the other banks, know that business is better -- that's where they should focus.

David: So in fact, if I read further into what you're saying, it is that if you are going to be operating a retail bank, you are not going to be able to make money from your main banking business, which previously used to be investment banking. You're going to have to make that retail banking product stand alone. So therefore, the days of free banking are over, as far as the U.K. is concerned?

Ralph: Well, yes, absolutely they are. They have to be over; we can't have the only country in Europe not to charge for banking products. The margins are simply too small, which is the other reason why non-traditional organizations are going to get into this business. Why? Because we can't make any serious money off of retail banking anymore, because everyone's so competitive in this environment, so only the organizations that don't necessarily need to make money offer the financial services, are actually going to put investment into putting those products into place. Also, this is a very important point, about 15 years ago it would cost about one hundred million of British pounds to put the banking system up and running. Today that same functionality will cost you less than five million. The infrastructure to retail banking has gone so cheap, if you want to call it, off the shelf and so easy to implement, that the barriers to entry are all but gone.

David: So are you saying, in fact, you don't need economies of scale? Would that therefore explain why the regulators are saying to Lloyds Banking Group that you have to sell off 630 of the branches that you bought when you acquired HBOS? You're going to have to sell these branches to the Co-Op, in this case? Lloyds can actually survive without having these 630 additional branches?

Ralph: Actually, I think the European government did them a favor.

David: What -- did Lloyds Banking Group a favor?

Ralph: I think they did, by forcing them to do this. They reduced the size of the organization, they got rid of 600, and let's face it, not the most profitable branches they've ever had, because they didn't have to do the most profitable branches. They're a small and more effective organization now, and that's been a good thing. But the economies of scale do matter -- let's be very clear, they do matter. Let's realize, GE, Apple, a dozen, two dozen companies out there have much more money than any of the banks out there. The big corporations already have significant resources, significant scale, and remember with financial services, it's all about scale in terms of the amount of liquidity that you have, and many non-traditional financial services organizations have as much, if not more, liquidity than the banks themselves.

David: But I want to challenge you on your assertion that you don't really need that huge economy of scale and that the cost of operating a bank isn't as high as it used to be before, because wasn't that part of the reason why we saw the consolidation of so many of the building societies? Because these regional building societies just could not survive in the marketplace. Just relying on retail depositors to deposit their money, paying them a little bit of interest, and then using that money for relending out to mortgage borrowers, just wasn't a viable business plan.

Ralph: That's right, and that just proves the point -- it's the fact that, even if the building societies with, let's face it, superior customer service, couldn't make it with the volumes that they had, they had to get bigger. Why? Because they had to reduce their prices. There's only so far you can reduce your prices in the banking industry. Once you get to zero, which is what we're very close to here in terms of the margins, then you cannot provide any lower prices, but guess what? If you're selling cars, you can actually take a hit. You can actually go below zero on your loans, can't you? Because you're making money elsewhere, and that's why we're going to see increased pressure on prices from nontraditionals, which is the reason why scale alone isn't going to make a difference, because there is a bottom, or the lowest-possible price that you can charge, and once you get to that point, you can't do any better.

That was the first part of a two-part transcript in which's David Kuo chats withbanking expert Ralph Silva from SRN to discuss the outlook for the global bank sector.

In the second part of the transcript, Ralph highlights three banks that he thinks could emerge stronger from the financial crisis.Just click here to continue reading.

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