On Banks

Superficially, banking appears to be a commodity business. In fact, it appears to be a particularly poor commodity business, because capacity is not constrained by the need to invest in a substantial physical infrastructure. True, whatever investments are made in tangible assets are usually intended as a means to acquire more intangible assets; however, a branch is hardly comparable to an oil well.

A bank's ability to lend money (and thus produce income) is not completely and inextricably linked to the size of its deposits. In other words, loans are the result of both a bank's capacity to lend money and its willingness to lend money.

It's hard to find a parallel in tangible commodity businesses. Theoretically, this should make little difference in the long run. However, the lack of physical supply constraints in the market for loans creates the possibility for large, industry-wide mistakes. Pricing in such an industry can get very weak at times.

There's one catch here. The underlying assumption whenever the commodity business label is used is that both the demand for a product and the supply of that product are general in nature. They can't be specific, because that would destroy the involuntary nature of pricing within the industry.

For example, if all pineapples were unbranded, identically tasting fruits the demand side of the business would meet the requirement for a commodity business. However, if most pineapples take eighteen months to grow, but there is one magical plantation where the fruit develops fully in just three months, the supply side of the business does not meet the requirement for a true commodity business. The magical pineapple plantation would produce six times as much fruit per acre and thus the plantation owner would be able to undercut his competitor's prices. He would earn extraordinary profits, because the return on capital in his business would be much higher than that of the industry as a whole.

What does this fairy tale have to do with banking? It suggests extraordinary profits can come from having "sticky" customers or lower costs. The lower costs needn't be the result of lower marginal inputs. The magical pineapple plantation turned the crop over faster; it didn't need access to below market prices for any of its inputs.

The same is true of a grocery store. Two stores that buy and sell cans of soup at the same exact prices may have very different returns on capital, if one of the stores turns over its inventory more quickly, because the fixed costs will be spread over a larger number of sales.

How does this relate to banking? While a quick turnover (or some other form of operational efficiency) is the most common reason for one firm's unusual profitability in a commodity type business, there are other ways to earn extraordinary profits. Some of them are conceptually quite similar to the idea of owning a magical, one of a kind pineapple plantation. In such situations, the product appears the same to the consumer; but, the producer is actually unique (or at the very least special).

All of this helps to explain why some banks are more profitable than others. However, it doesn't address the question posed by Morningstar. So, do all banks have moats?

Before answering that question, it might be best to ask under what circumstances all banks could have moats. What could insulate an entire industry from the ravages of competition? This is the question I discussed in the podcast episode: "Nature of Competition". Why can some industries support plenty of profitable players, while others merely support a handful, one, or none?

Switching costs are one of the most commonly cited reasons for a wide moat. I think the matter is actually a lot more complicated than that. Financially prohibitive switching costs do create moats. However, most wide-moat companies don't have truly prohibitive switching costs. What they do have is a situation in which it makes little sense to switch to a competitor and/or a tendency for their customers to not actively seek to learn more about competing products.

Where the cost of a product is particularly small per cash outlay, consumers are usually apathetic about seeking out alternatives. The key here is that the amount has to seem very small to the buyer at the time the purchase is made.

If you buy a cup (or two) of coffee every morning, it does not occur to you that you are spending hundreds or thousands of dollars a year on that coffee and that you could save a lot of money by buying the cheaper alternative. However, if you're buying an appliance or piece of furniture the difference is immediately obvious and thus price is a major concern.

Generally, if a product can be sold over and over again at a very low price per transaction, profits will be higher, because the buyer will not make much of an effort to compare prices. Likewise, if a customer is billed for a variety of different products or services each amounting to only a small charge, the customer's price awareness will be lower than if the charges were combined and listed as a single item.

Where price visibility, comparability, or immediacy is reduced, greater profitability becomes more likely. People are very sensitive to price differences between large, juxtaposed numbers. If tomorrow the federal government prohibited gas stations from posting their prices per gallon, drivers would begin to become less concerned about gas prices.

There would be an uproar at first. But, over the years, gas prices would receive less and less news coverage and would fall off the list of consumer concerns. Obviously, a crude oil price quoted in dollars also contributes to price awareness. But, the point remains the same. Where prices are less visible, price competition is less fierce.

Compounding is a great way to exploit a lack of price awareness. The differences between various interest rates always seem small when placed side by side. Over time, these differences become quite large. However, the fact that no large differences are clearly visible at the time a decision is made about where to bank helps to minimize price competition between banks.

It also increases the relative importance of other aspects of banking like convenience and service. Usually, the cost to make a good impression is very low compared to the size of the assets that could result from attracting more deposits.

On the other hand, the importance of making a good second and third impression is minimal. Once a depositor uses a particular bank, they are unlikely to visit competitors. When they need to do their banking, they will go directly to their own bank (or its website).

This is very different from the environment found in most consumer businesses. Packaged goods companies have their products placed next to their competitor's products on store shelves. Retail stores are usually clustered. Whether they are located in malls or in free standing buildings, it's a safe bet the customer has to pass at least one competing retail outlet to shop at their favorite location. In most cases, the other location won't compete in every category as the customer's favorite store; but, it will offer at least some competing products. As a result, the shopper is offered the option of switching every time she makes the trip.

When someone walks into a bank, it's usually their own bank. They don't have any use for other banks (after all, their money isn't there). The cost of switching banks isn't very high. However, the amount of active effort required to make the switch is substantial.

Switching banks isn't as easy as switching toothpaste. But, more importantly, the alternative isn't as obvious in banking. We all know other banks exist. But, unless we have a reason to consider switching from our current bank, we don't even bother to check out the competition.

The result is a very narrow, very real moat.