Global Equity Income

Banks Income investing in a disrupted world

Information for investment professionals

11.19 |

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Income investing in a disrupted world A series of viewpoints by Jonathan Crown and Georgina Hellyer, portfolio m anagers, Global Equity Income

The technological revolution has led to a heightened level of disruption across every industry. Against this backdrop, where can you find firms that deliver sustainable and growing dividend streams? The Global Equity Income team continues to find plenty of attractively priced dividend stocks with the “quality income” attributes we desire. However, in this age of disruption you do not necessarily find companies with sustainable market positions, healthy cash flow generation and sensible capital allocation where you used to. In this series we will explore various sectors to identify areas we believe are fertile for quality income stocks and those that should be avoided. We hope you will enjoy seeing “under the bonnet” of an investment process that has delivered successfully for Columbia Threadneedle for more than a decade.

11.19 |

When banks met FinTech …

Global Equity Income | November 2019

By Jonathan Crown

The arrival of new entrants in the sector has left the incumbents struggling to keep pace. How can traditional banks remain relevant and where do the opportunities lie for investors?

For decades banks have benefited from a customer inertia that has provided a cheap and stable source of funding and enabled a high margin payments revenue stream. These are now at risk from FinTech entrants trying to establish themselves as platform providers for payments, deposit accounts and other banking services.

A recent McKinsey study estimates that payments account for around 30% of global banking revenue1, and this is where Payment Service Providers (PSPs) with modern digital architecture are moving in. On the back of technological advances such as instant payments, as well as regulatory changes such as Open Banking in the UK and the Payment Services Directive (PSD2) in the EU that came into force at the start of 2018, PSP numbers have increased dramatically2. They are focusing on areas such as payment processing for merchants and overseas payments and foreign exchange services.

Adoption will take time, as seen with contactless cards, but there is growing interest (Figure 1). Digital banks such as Revolut and Monzo offer savings on overseas spending and transfers where the customer enjoys the cheaper interbank exchange rate rather than the exchange rates offered by traditional providers.

Figure 1: Global Google Trends search data for Monzo and Revolut 2014-2019

Source: Google data. Numbers represent search interest relative to the highest point on the chart. A value of 100 is peak popularity, a value of 50 means the term is half as popular. Zero means there was not enough data for this term.

1 McKinsey and Company, Global Payments Report 2019 2 Bank of England, Quarterly Bulletin, Q1 2019

Traditional banks are also getting hit by Account Information Service Providers, also known as aggregators, which are able to access banks’ customer data and, with permission from customers, move their funds and products around to find the best rates. Open Banking came into force in the UK in January 2018 and by May this year 127 regulated entities had enrolled, of which 81 are third party providers such as aggregators. Continuing technological improvements and greater awareness will drive greater adoption.

These are just a couple of examples of FinTech entrants nibbling away at high margin revenue streams and trying to wrestle away ownership of the customer. There are instructive roadmaps for how this process might develop in other industries such as travel, where Booking.com and Expedia have inserted themselves between the hotels and the customer and can take around 15%-20% of revenue if they collect payment from the customer3. The large hotel chains have responded with loyalty programmes to increase their share of direct reservations and offset pricing pressure. The small players are more challenged.

The real risk is one of the larger tech organisations, with brand power and a treasure trove of behavioural data, entering the space. So far, within developed markets big tech has not done this, likely because they already face enough regulatory challenges. However, Facebook’s proposed launch of digital currency Libra suggests it has an eye on this space. The Chinese tech giants look to be further ahead with Ant Financial (owned by Alibaba) operating one of the largest mobile and online payments systems in China4.

Where can you bank on dividends? This is still a fledgling technological revolution, however, and the commoditisation of banking services is far from a given. While banks don’t have stellar reputations, they do have established brands and are trusted as safeguards of customers’ money and data. This level of trust is not there for new entrants. This gives banks an opportunity to leverage their customer data and reposition their business models. In addition, the proliferation of FinTech competitors chasing the same customers (Figure 2) has led some to partner with established banks which have the large customer bases that the entrants covet.

Generally, we focus on larger banks as they have sufficient scale to shoulder the increasing regulatory burden and rising IT costs. Those with the best digital offerings will over time take high value customer market share from peers, and smaller banks will waste away. A behavioural shift is also required that puts the customer at the centre of the proposition, rather than relying on inertia. While banks may be reticent to offer advice given past mis-selling scandals, they will need to provide more personalised offerings in order to increase customer engagement. Small banks are poorly positioned, and we believe an incremental roll-up acquisition strategy no longer makes sense. We see banks eschewing small acquisitions and viewing their digital bank as the customer acquisition vehicle.

3 Citigroup/Columbia Threadneedle calculations from company disclosures 4 CNBC, Alipay parent Ant Financial says services to surpass payments business, 14 November 2018

Figure 2: High flight-risk customers are few in numbers but represent nearly 45% of bank profits

Source: Bain & Company, Salesforce and MaritzCX Open Banking Survey of UK customers (n=>4,000)

Countries such as the US and Singapore offer solid asset growth in developed markets without undue pricing pressure. We have a preference for the larger US banks as they are best positioned to take greater share of a fragmented market due to their superior digital offerings. The Singapore market is reasonably consolidated, but we identify clear differences in digital capabilities between banks. Both markets offer supportive regulation and though they will be watching the European experience of Open Banking closely, any adoption is likely to be later, giving incumbents the opportunity to solidify their positions. Indonesia and Brazil, meanwhile, have some of the most attractive high dividend yield bank stocks within emerging markets, offering appealing nominal growth and attractive market structures. Focusing on those banks with strong deposit franchises and a track record of sound asset quality is key. These attributes enable them to generate strong risk-adjusted returns and compound book value at high rates. China, however, faces some difficult challenges as it looks to liberalise the financial system and big tech enters the more profitable areas. This makes for a rapidly evolving financial system where the sustainability of dividends is tough to gauge. Consequently, this is a country we avoid. We also steer clear of low growth countries with fragmented markets and unhelpful regulation. Europe stands out here, as on top of the cyclical issues it faces far higher structural challenges due to the Open Banking regime. That said, we find relatively attractive pockets in northern Europe with consolidated industry structures and sophisticated digital offerings. Japan remains challenged, where the cyclical appears to have become structural.

Big dividends but a need to tread carefully Bank stocks have struggled over the past decade and the building structural challenges have the potential to strip away the profitable parts of the industry leaving behind only a commoditised balance sheet provider generating low returns. Income investing is about avoiding the land mines, so it is imperative to focus on the safer neighbourhoods and players with the best digital offerings in order to find “quality income” bank stocks that offer high, sustainable and growing dividend streams. With all this in mind, maybe it’s time for the author to reconsider his primary bank account which he has had since his first day at university!

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