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.