Review & Outlook

Our take on the investing, financial, & economic themes of the day

On the (Predicted) Decline of Banks

26 August, 2014 by Matthew O'Brien, Ph.D. in Commentary

Silicon Valley is trying to eat JP Morgan’s lunch.  That’s the way JP Morgan CEO Jamie Dimon put it a few months ago.  He was referring to the hot sector of the technology industry profiled recently in an opinion column by journalist Gillian Tett (Financial TimesUpstarts Prepare to Ambush the Lords of Finance”.)  Start-ups and big tech alike are vying to develop payments platforms that will facilitate everything from ordinary consumer transactions at the local coffee shop to small business loans and bond issuance.  All of these innovative services cut into territory that has traditionally belonged to banks.

Tett points out that the tremendous opportunity for disrupting conventional bank practice comes with new risks that are difficult to assess.  One common complaint about financial regulators is that they tend to fixate on the threats that led to the most recent financial crisis, just as generals tend to prepare to fight the last war.  This tendency primes regulators to miss emerging threats to financial markets that take a different shape from threats in the past.  For example, the soon-to-list Chinese e-commerce company Alibaba has developed an online money market product that has grown from nothing to $80 billion in assets and 81 million customers in about a year.  Nobody really knows how these online accounts would perform in a severe downturn, or how customers would react to technical glitches or accounting errors — or what the hasty regulatory (over)response might be.  Tett offers some salutary warnings about the effects of bank disruption, which is often treated as an unalloyed good that has the air of inevitability.

The finance blogger Felix Salmon also addressed the waning importance of traditional banks in an op-ed the other day, but his analysis strikes me as less sound (Financial Times“No Need for Banks in an Era of Intellectual Capital”), because he conflates two distinct issues: the influence of traditional banks and reliance upon fundamental security analysis traditionally employed by bankers.

Salmon observes how many big deals in Silicon Valley are coming off without the traditional (and expensive) advice from investment bankers:

It is merger season in Silicon Valley. More than $100bn in technology deals were done in the first half of this year alone, according to Mergermarket. The numbers for the second half will probably be even bigger. The year-end tally will include Facebook’s $19bn acquisition of WhatsAppOracle’s $5.3bn purchase of Micros Systems and a significant entry from normally deal-shy Apple, which has agreed to buy headphone maker Beats for $3bn.

Amid all of this, one element is missing: bankers. Investment banks are used to earning big fees when corporate clients absorb other companies. But many big deals are being completed without the buyer using any investment bank at all.

I’m inclined to agree with Salmon that “financial services companies in general, and investment banks in particular, are too big and too important.”  He also correctly observes that “I Banking” has lost a lot of its cachet among elite college students, which is probably a good thing.  When I was in college, all the Organization Kids were competing for a spot as a junior banker at Goldman.  Now, they’re moving to San Francisco and competing to get venture capital funding for their disruptive smartphone app.  The waning influence of big banks is also evident in the rise of the boutique investment banks, such as Evercore and Moelis & Co., which are driven by the personal talent and connections of their handful of dealmakers.

But Salmon also identifies –and admires — a distinct trend that is disturbingly similar to the exercise in collective wish-fulfillment that marked the mania of the dot-com bubble.

Today’s big Silicon Valley deals are not based on corporate synergies, or the amount that earnings per share will increase after the deal closes. They are not, therefore, based on the sort of thing that bankers can model. (Very few of the acquired companies have any earnings at all; some even lack revenues.)

Instead, they are based on attributes that are much harder to quantify. Will this company’s product change the way that billions of people interact? Is it run by the kind of visionary who could prove to be a lethal competitor if she is not brought into the fold today?

In situations such as these, it matters little if the acquiring company overpays.

Here Salmon sounds more like Henry Blodget during the Internet bubble than like his usual reasonable self.  Some attributes of a good investment are indeed hard to quantify, but it always matters if you overpay for an investment.  First of all, it’s not clear that absent stable earnings or even revenue, a company will be around to have any products.  Second, even if a company’s product does “change the way that billions of people interact,” it does not follow that the company is a good investment.  The classic example in this regard is the commercial airline industry.  Surely commercial jet travel has massively changed the way billions of people interact, if any business has, and yet airlines have generally been a terrible investment since the Wright brothers took off at Kitty Hawk, as Warren Buffet famously observed.

No doubt that right now investors in Groupon’s IPO are wishing they’d done a little more boring cash flow analysis, and a little less visionary introspection about how Internet coupons were going to change the way that billions of people interact.