February 23, 2016

The Case Against Big Banks: Losses in Lending & Brokerages

Within this paper we will examine the past, present, and future environment of big banks with a focus on institutions with multiple avenues of revenue, including consumer, community, commercial, and corporate. These include banks, such as J.P. Morgan, Bank of America – Merrill Lynch, and Wells Fargo; in addition, we will analyze the brokerage/trading industry. Although the market appropriately discounts banks by the regulatory laws imposed post-2008, we believe future competitive risk stands to eliminate more revenue. Our analysis will determine a bearish outlook on the largest lenders and brokerages while turning our attention to the newest platforms available. This conclusion will begin with an examination of the current regulatory laws and a focus on exploring the present and future environment of lending. Then, we will analyze the brokerage & trading industry as it is currently stands. Lastly, we will propose appropriate ideas for our views.

As we turn our attention to big banks, we should understand the reasoning behind regulation. The primary issue is the national and global spillover effects from the failure of banks that are too large. The governing agency of the respective banks wants to avoid situations in which it must decide between supporting a bank or allowing it to collapse. If banks believe they will be saved in times of catastrophe, banks will be encouraged to engage in high-risk actions because of government protection. This has led to a current state of regulation that is consumed by depositor insurance, reserve requirements, and lending limits. In part there are healthy rulings toward providing security to consumers and the nation, but banks are having a difficult time adjusting. In order to focus on core operations, banks are closing hundreds of branches, stripping down human resource projects, and losing billions of dollars in deposits. As an example, Morgan Stanley is engaging less within risk markets such as commodity/foreign trading and focusing on wealth management while firms such as J.P. Morgan scale back operations and even charge certain accounts interest for holding deposits. While regulation is creating difficulty, the issue of adaption for big banks will be greater because the primary perpetrator for revenue decline will be the introduction of a competitive landscape, primarily in the crowd-funding space.

Our two example cases in introducing the competitive landscape will be Kickfurther and Loanatik. Both businesses intend to operate in the crowd-funding space with a focus on retail investors. As an introduction to both businesses, Kickfurther is a platform engaging in raising capital to fund inventory for small businesses. Similarly, Loanatik is a platform that hopes to raise capital to crowd-fund mortgages. Yes, that sounds awfully risky already, but what we would like to note is the shifting industry. Platforms such as the two above are creating accessible markets and more importantly, retail investors are finding better returns and both can compete in a space largely dominated by big banks. This accessibility is step one of two in creating competition for banks. The second step will be the proper tools for retail investors, but first, we should understand further issues for banks.

What we would like to examine now is beyond the scope of lending and turning our attention toward the trading arms of big banks. The conclusions we infer are evident in today’s conditions and our beliefs are that it is just the beginning. At the start of the 21st century,

technology shifted toward software development, specifically making computer programming a desired skill-set. 15 years later, firms are now developing/specializing in the creation & implementation of algorithmic portfolios. The range is from: removing human emotion in a strategy to exploiting arbitrage through high frequency trading. These firms rely heavily on intelligent individuals to design ideas on the fastest systems. This leads to banks experiencing a decline in trading profits and many are eliminating divisions altogether. In addition, we should note algorithmic trading’ subset of artificial intelligence: machine learning and within it neural networks. Machines are becoming increasingly smarter demonstrated recently by Google AI’s defeat of Go’s world champion. As these networks become increasingly adaptive, robo-advising may altogether defeat mutual/low performance funds. Newer generations are already investing within platforms such as Wealthfront, becoming trusting of them instead of traditional fund managers. So with specialized trading firms and AI, the case against brokerages/banks grows.

In circling back to the second step mentioned before, what retail investors now need is the right tools to compete. Brokerages have largely remained the same after the introduction of electronic communication networks with standard $7-10 transaction fees and margin rules. Now, Robinhood, a stock-trading app that has raised $66m is disrupting the industry. It currently operates with a $0 buy/sell transaction fee and has recently rolled out the ability to instantly use funds from sold stock without the need to have cash settle for a 3-day period. This effectively has created margin capabilities and will attract many millennial and future retail investors. This culminates the start of a new standard in traditional financial markets and aligns with our view of a decline in the current monopoly of brokerages/banks.

As for how one may speculate on profiting from our theory, we may automatically assume a short on big banks. This may be appropriate for large banks such as Wells Fargo, J.P. Morgan, and Citi, but may not be realistic for banks such as Bank of America, Goldman Sachs, and Morgan Stanley. The latter have been battered in value, show resilience, and preparedness, respectively. The former are banks acting as a safe haven for now and may prove to encounter a difficult environment so a short may be plausible. What we recommend is investing within the platforms mentioned, specifically, Kickfurther and Robinhood. Kickfurther requires a minimum $20 investment into an offer, providing an easy way to try out the platform. On the other hand, Robinhood is essentially free minus the risk you engage in for participating in the financial markets. As always we advise consultation with a professional and invest what could reasonably be risked. Thank you for reading. Sources: Business Insider, Wikipedia, Kickfurther, Loanatik, Robinhood *Author is invested within the Kickfurther & Robinhood platforms