Tag Archives: technology

The Future of Retail Banking

Future of Retail BanksUSA Today ran a story in March on the changing nature of retail banking in America.  This sounds kind of boring, perhaps, but it has broad implications both for bank clients and, potentially, for investors.  The gist of the story is that banks are closing retail branches in small towns.  A lack of traditional banking services is not a rural phenomenon, however, with substantial populations of people in urban areas who do not use traditional banks.  For an informative interactive tool that allows you to explore the populations of people lacking key financial services, see here.  There is a substantial population of people who have little or no access to traditional bank services (the under-banked or the un-banked), and it would seem that this population is likely to continue to grow if banks close their smaller retail branches.  The solution, I believe, is that online banking services will serve the under-banked and un-banked, just as they have in the developing world.

In general, poorer households hold little if any assets in savings accounts and primarily use banks to cash checks.  Banks don’t make money from check cashing, so they have a hard time profitably serving these customers.  With interest rates at or near record lows, even bank clients with meaningful levels of savings provide little in the way of income to banks.  And banks, not surprisingly, are focusing on wealthier clients as the way to boost revenues.  The goal is to sell more profitable investing and financial planning services to wealthier clients.  As the large banks try to move up-market in terms of products and services that they offer, it seems likely that an increasing number of less-wealthy Americans are quite likely to have less access to traditional bank services.

What does the future of retail banking look like?  First, it seems inevitable that serving less-wealthy clients in physical branches will continue to be a relatively unattractive business.  Second, check cashing and payday lending businesses—alternatives to traditional banks–will probably continue to grow.  Lisa Servon, a professor of Urban Policy, argues that payday lenders provide a valuable service and that the industry is unfairly demonized.  If people need to borrow money and don’t have access to a traditional bank, a payday loan may be worth the cost.  Third, the increasing role of online banking and bill payment among the middle class reduces the time that customers spend in physical branches.  There are a range of perspectives on the future of retail banking (see here and here).

My belief is that physical retail bank branches will largely disappear.  If you really want or need to go to a physical branch – to access your safety deposit box, for example – you probably don’t mind driving.  Otherwise, what does the retail bank really provide that you cannot get online?  Bank analyst Dick Bove actually makes the case that quality customer service at branch locations is not necessarily even a good sign for investors.  He posits that bank employees generate more revenue for the bank by spending their time “selling products”, rather than by trying to solve problems for customers.

As the systems for mobile banking expand, this could dramatically help the un-banked and under-banked as well as displacing retail banking services for the more affluent.  In the developing world, for example, mobile banking (banking services provided via mobile phone) is already a dominant force.  Businesses can pay their employees via mobile banking, entirely removing the need to cash a physical check.  The M-Pesa mobile payment business now serves seventeen million people in Kenya alone.  Mobile payments were the fastest growing form of payments in China in 2013, totaling $1.6 Trillion.  There are also a host of non-banking firms that are providing services that look like banking. There is no obvious reason that some or all of these types of services cannot expand into the U.S. to serve the un-banked and then move up-market to replace some or all retail banking services to more affluent customers.  The current situation reminds me of a number of cases of technological innovation discussed in The Innovator’s Dilemma, the ground-breaking book by Clayton Christensen.  The book argues that new technologies first succeed not by displacing entrenched providers, but rather by first meeting the needs of an un-served population.  After the new technology has proven its worth, it then moves up-market to disrupt the traditional business model.  The current state of mobile banking is in serving the developing world, where people often have little or no access to traditional banks at all.  The enormous growth in these businesses suggests that the future is to move up the food chain.  Mobile payment technology and usage is growing in the U.S., albeit slower than expected.  Accenture projects that as much of 35% of retail banks’ revenues could be lost to a range of online services providers by 2020.  Given that retail banks in the U.S. are seeing their traditional businesses struggle along with  less use of their branch offices, coupled with a growing population of potential clients who the retail banks do not serve at all, mobile banking looks to me like the future of retail banking.

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Low Beta Market Sectors

With U.S. equity markets near their record highs and a bull market run that is starting its sixth year, the potential for a correction is a growing concern.  In addition, U.S. equity prices look fairly high when viewed in terms of the PE10 ratio.  Another factor that concerns some market watchers is that volatility (as measured by VIX) is at very low levels, reminiscent of 2007.  This type of complacency has historically been followed by increasing volatility, as levels return to their historical average, accompanied by a sell-off in higher-risk assets as investors adjust their portfolios to mitigate the effects of higher volatility.

Investors seeking to remain invested in equities at a target level but who want to reduce their exposure to market swings and to mitigate the impact of a rise in market volatility have historically been well-served by increasing their allocations to low-beta market sectors.  In this article, I will review the defensive value of low-beta allocations as well as examining the consistency of beta over time.

Beta measures the degree to which a security or a portfolio responds to a move in a benchmark index such as the S&P500.  A portfolio with beta equal to 80% (also written as 0.8) tends to go up 0.8% when the market rises 1.0% and vice versa.  Beta may be thought of as showing whether a security amplifies the moves in the benchmark (beta greater than 100%) or damps the moves in the benchmark (beta less than 100%).

How Beta Varies by Sector

The SPDR Select Sector ETFs provide a convenient way to break out the sectors of the U.S. equity markets by dividing the S&P500 into nine sectors.  These sectors illustrate how much beta varies.

Low Beta Market Sectors - 1

Betas and 10-year average annual returns for major sectors and indexes

The S&P500 has a beta of 100%, by definition.  Some readers may be surprised that emerging market stocks have beta of almost 140%, which means that emerging market equities tend to go up (down) 1.4% for every 1% gain (drop) in the S&P500.  Even before the market crash of 2008, emerging market stocks were high beta—this is not a new phenomenon.

There are three U.S. equity sectors with betas well below 100%: consumer staples (XLP), healthcare (XLV), and utilities (XLU).  It is often believed that low-beta equities have very low average returns.  In fact, a well-known but now widely-discounted model of equity returns (the Capital Asset Pricing Model, CAPM) assumes that beta of an equity or asset class corresponds directly to expected return.  High-beta asset classes have high expected return and vice versa.  Low-beta equities have historically substantially out-performed what would be expected on the basis of CAPM, however, and the past ten years is no exception.  These three sectors have all out-performed the S&P500 over the past ten years.  The return numbers shown here are the arithmetic averages, including reinvested dividends.

Low Beta Asset Classes in 2007-2008

The first question that is worth asking about beta is the degree to which beta corresponds to losses in really bad market conditions.  In the table below, I have tabulated beta calculated using three years of data through 2007 for each of the funds above, as well as the returns for each of these in 2008.

Low Beta Market Sectors - 2

Beta calculated through 2007 vs. 2008 returns

The three sectors with the lowest betas going into 2008 (consumer staples, healthcare, and utilities) had an average return of -22.3% in 2008, as compared to -36.8% for the S&P500.  An equity tilt towards these lower beta sectors could have reduced losses in that year.

Consistency of Beta through Time

The astute reader may notice that the betas calculated using ten years of data through May of 2014 (shown in the first table) are, in some cases, quite different from the betas calculated using three years of data through December of 2007 (shown in the second table).  Beta varies through time.  The betas calculated using three years of data through May 2014 provide an interesting contrast to the three-year betas through the end of 2007.

Low Beta Market Sectors - 3

Comparing betas for two 3-year periods

We are looking at two distinct 3-year periods, separated by almost six and a half years and, in general, low-beta sectors at the end of 2007 remain low-beta today and high-beta sectors back then are still high-beta.  The two most notable exceptions are international equities (EFA) and the technology sectors (XLK).  These changes notwithstanding, the three sectors with the lower betas in 2007 also have the lowest betas in 2014.

There are a number of factors that will determine whether any sector will weather a broad market decline better than others.  Beta is one important factor, but there are others.  In 2008, the financial sector suffered disproportionately large losses—well beyond what would have been expected on the basis of beta alone.  The underlying drivers of the 2008 market crash were most severe in the financial sector.  Small-cap stocks, by contrast, fell considerably less than the beta value of this sector would have suggested.

Low-Beta and Asset Allocation

Low-beta asset classes have historically provided some protection from market declines and increasing volatility.  There are a range of other considerations that potential investors should consider, however when creating a portfolio.  The selection of individual asset classes should be made with consideration of the characteristics of the total portfolio, including desired risk level, interest rate exposure, and income generation.  The target for total portfolio beta is primarily determined by an investor’s total risk tolerance.  A target beta level can be achieved both by choosing how to allocate the equity portion of a portfolio among sectors and by varying the balance between equity (stocks) and fixed income (bonds) investments.  Fixed income asset classes tend to have very low—even negative—values of beta.  In my next blog entry, I will explore these two approaches to managing beta at the portfolio level.

History suggests that low-beta sectors can provide some protection from market downturns.  The length of the current equity rally, and the substantial increases in equity valuations in recent years, are motivating some investors to consider their best defensive alternatives to protect against the inevitable reversal.  The question for investors to ask themselves is whether they are best-served by reducing portfolio beta by reducing their exposure to equities, by shifting some portion of assets from high-beta to low-beta sector, or both.

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*Very* Sobering

Guest post by Contributing Editor, Robert P. Seawright, Chief Investment and Information Officer for Madison Avenue Securities.

New York magazine has a fascinating article (from last month) examining the truly terrifying economic analysis of Northwestern’s Robert Gordon. Continue reading

The X-factor for Unemployment Rates

With unemployment staying fairly high and steady, despite massive economic stimulus, many are wondering what it will take to create more good jobs in America.  One explanation is simply that the fastest growing and most innovative American firms simply don’t need all that many employees.  Even industries that have historically needed lots of workers are becoming automated.  An excellent book that explores this theme is Race Against the Machine, by two professors at MIT.  An article that provides a summary of the book’s thesis is available here. Continue reading

Harvard’s Michael Porter Shares His Economic Outlook

Harvard Business School professor Michael Porter is a familiar name to almost anyone who has graduated from business school in the last twenty years or so.  He recently gave an interview on CNBC in which he shares his analysis of the U.S. economy.  Porter is best known for his work in competitive strategy, a field in which he is considered the preeminent expert, so his views of what ails the U.S. economy and how we can get back on track are of considerable interest.  He has analyzed the forces that provide one country or region with relative competitive advantages vs. others and he applies this perspective in his commentary. Continue reading

Sector Watch: Spotlight Telecommunications Stocks

The telecommunications industry is evolving quickly.  Recent data suggests, for example, that half of all adults in the United States have a tablet or smartphone.  There are many countries that have an average of more than one cell phone line per person.  In the developing economies, cell phones have allowed much broader access to voice and data services than would have been possible if the traditional fixed-line infrastructure needed to be built.  Ten years ago, Nigeria had only 100,000 phone lines.  Today, Nigeria has 100 Million cell phone accounts.  The ways that people use telecommunications are also expanding.  For people with little or no access to banking, mobile money services can provide the essential roles of banking.  The continued convergence of banking with telecommunications has substantial implications for both. Continue reading