A Manifesto for Banking Technology
Some time ago I was approached by a headhunter about a senior role at a global investment bank. It's been a few years since I last worked in the sell-side of the industry, and yet - while I enjoyed many good experiences and learned a great deal as I grew my career in these institutions - my first reaction to the headhunter was to laugh at him, and at the ridiculous notion of wanting to return to an industry that is so badly run, has suffered so much self-inflicted pain, and has yet to demonstrate any serious attempt at self-improvement, beyond reluctantly accepting greater regulation. I keep in close contact with ex-colleagues and friends who work in or with the technology departments of most of the big banks and brokerages, and from the tales I hear it would appear that not much has changed since I stepped away from the industry.
The headhunter asked me to explain my incredulous reaction, and as I started to speak what emerged began to sound like a rant about how I believe these institutions ought to be run, how they could prosper and thrive, and how they could see off many of the dangerous threats the face.
Looking back at it now, I regard it as less of a rant and more of a manifesto. I spoke of an approach that challenges the business model, the culture and the technology of the major banks. I explained to the headhunter that if he thought that the institution he represented truly met this manifesto - or was at least prepared to accept it, and work towards it - then there might be a conversation to be had, and perhaps at the end of it a role and an opportunity for me.
It was clear from his reaction that this was clearly not the case, and so our conversation ended, but as I later dwelt on our chat it occurred to me that if I could find elsewhere a bank that was prepared to engage and embrace the change I think necessary, that perhaps I could find a role there and help to drive that change and reinvention, and make a significant contribution to that firm and to the industry as a whole, to act as a beacon and show the art of the possible to the rest of the industry.
This article is an attempt to distill my thoughts about the investment banking, sell-side capital markets and the banking industry and to describe my manifesto for how these firms ought to re-shape themselves.
What is a bank anyway?
It's probably best to start off with an understanding of what a bank is and what the modern banking and finance industry is trying to achieve.
It seems to me that a modern bank fulfills three primary purposes. Firstly a bank is a depository of assets, for example money or securities (usually these days electronic assets, rather than a vault for physical assets such as gold or banknotes). In other words it is somewhere where people feel they can leave these securities in the knowledge (or at least belief!) that they are safe and secure. Secondly banks act as intermediaries in some sort of interaction between disconnected parties, for example as a payment agent or a securities agent/brokerage. Finally, banks act as a lenders - providing cash or securities to others who need them. For each of these services banks charge some sort of a fee, though frequently these fees are intermingled, netted off against one another or in one way shape or another obfuscated in such a way as to make it difficult to truly understand the true cost of the service provided, and impossible to assess whether the the bank adds sufficient value given that cost.
It should be noted that banks provide two important social services as they fulfill these three purposes: firstly through their intermediary services they lubricate the other value-creating activities in a society. They make it easy and efficient to do business. They allow a purchaser in Manchester to buy goods from a producer in Cornwall (or more likely these days in China!). This efficiency allows human time and effort to be spent on creating things, on growing and developing society, rather than in simply the act of the transaction. Secondly, through the fundamental concept of fractional reserve banking, whereby banks can lend out more money than they have in assets, banks are able to create money, to create capital, with which to magnify the growth of economies and of society. It's for these reasons some banks that are probably "too big to fail" - the dislocation to society of the failure of a major intermediary, and the consequent withdrawal of significant capital from the economy, is more than many countries can handle, and of course the disruption of trust creates liquidity challenges elsewhere and risks further secondary failures, with even greater, magnifying effects.
Anyway - let's return to the three purposes of a bank: depository, intermediary and lender. Firstly it should be obvious that - even allowing for the magnifying leverage effect of fractional reserve banking - that any significant lending activity depends largely upon the depository function. The equity capital in a bank is never going to be sufficient to permit much lending by itself. The depository function is based fundamentally on a question of Trust - after all would you leave your money in a bank you didn't trust to look after it? The intermediary function is of course also based upon trust, but also upon the exchange of information, often as a means of establishing trust, but also to help with the decision-making process for the actual end-participants in a transaction, (e.g. "the price of the stock you want to buy is $100 - there are plenty of sellers at at that price, but nothing cheaper") and so we find that at its simplest banking is predicated upon just these two characteristics: the establishment of trust, and the exchange of information.
I find this disturbing - at least for the status quo - for a variety of reasons: firstly banks are not trusted at the moment, following their miserable record of behaviour in recent years. Secondly, when it comes to the gathering, interpretation and exchange of information I would argue that there are many other firms - technology firms primarily - that have proven far more adept and capable than the banks. What is more, technology now allows other means of establishing trust, without the need for large buildings with towering marble-columned atria, for example via digital signatures, encryption, blockchain and so on. In other words, mathematics and technology stand able to provide the trust where banks cannot, and those same technologies can provide superior information exchange capabilities as well. If that is not a threat to the very existence of the existing banking firms, then I don't know what is. A Google, a Bloomberg or an Amazon would be a very powerful competitor to most banks I think.
Funnily enough, the most obvious threat is not that of being consumed in one bite by a whale in the shape of Google, but by being eaten alive by the piranhas of small, specialist financial services firms empowered by cheap new technology, far more effective than the legacy encumbering the big banks. The piranhas will weaken the banks, leaving only the unprofitable and expensive rumps to wither, until they too are ready to be picked off. When you can send money to a relative without using a bank, when your firm can access the capital markets without using a bank, when you can deposit your paycheck in a peer-to-peer lender that offers better return and access to your money at lower risk, and allows a borrower to access that capital all without using a traditional legacy "bank", then what purpose will the traditional banks serve?
So, what are the issues that banks face?
In simple terms banks face an enormous legacy technology cost at a time of massively growing regulatory cost and complexity. They have invested hundreds of millions in computer systems that are now outdated - unable to offer services that consumers (or regulators) want, and unable even to respond to that demand and make the necessary changes, at least not at a a reasonable cost and within the timeframes that new entrants and competitors can enter specific sub-markets and start to redefine business models. What is more, aside from the funding side of banking technology, bank systems - like those in all other industries - tend to obey Conways Law in that they come to reflect the organisational structure within which they operate. For example an FX system for the FX department, a payments sytem for the payments department, etc. That means a complex integration between FX and payments to allow customers to make payments in a foreign currency, and often the integration is less than seamless, giving customers a less-than-ideal experience, for example increased delays in cross-border multi-currency payments. It also makes it harder for the banks to understand the true nature of their business, where profits really come from for example, and where risk really lies, which is of critical interest to regulators and the whole of society. New entrants have no such restrictions: they can shape their offering in a way that suits the customer, and can build solutions with contemporary software development approaches that are designed for adaptation and requirements that change over time.
These legacy technology products - often monolithic in their design - frequently require huge teams and budgets just to maintain, and at a time of enormous cost-cutting within banks this mandatory spend ends up starving other projects and innovation. Often banks have tried to respond to this legacy cost by adopting a simplistic "outsource" approach - whether on managed-service basis or simply hiring developers in cheap locations. In either case, while there is likely to be an immediate cost reduction, the system or platform becomes an even-more tightly sealed and impenetrable "black box", which will act to preserve itself and the supporting organisation rather than to serve the end-customer.
Occasionally there will be a push for "re-use" between systems. This will usually be motivated from a cost-cutting and efficiency perspective, though sometimes there is a customer-driven motivation as well. Often however a customer-driven re-use initiative is misunderstood - just because some customers want the combined services of different systems doesn't mean all customers do. And if the business rationale for re-use is underpinned by a cost model that assumes all customers use an integrated platform any integration project is committed to integrate or re-implement every single feature currently in use by existing customers.
I've seen this scenario play out several times in the listed securities trading businesses - there are institutional customers who trade equities, and institutional customers who trade listed derivatives. But these markets have very deep and fundamental differences, with significant technological implications, even though at face value it might appear they both involve "simply" buying and selling securities on an exchange. While there are some individual users at clients who are involved in both markets, it turns out that these are in the minority - a handful of users at relatively small hedge-funds, so while there might be a need for a simple solution for these specific users, it is not at all obvious that the enormous cost of migrating all of the specialist Equity or Derivatives functionality onto a single platform will be balanced by the cost saving of being able to shut down one of the legacy platforms. Despite this I have seen numerous attempts to follow this path - hemorrhaging investment spend, and starving genuine innovation elsewhere.
These challenges of managing legacy platforms require sophisticated technology and business leadership, but this is something that is frequently lacking in large organisations (in any industry). Power and prestige are measured in terms of team size, budget and rank, not in terms of understanding the customer, being able to respond to change, or building adaptive systems and processes that are resilient and flexible enough for the future. Budget is fought for in an annual process that bears little relation to the genuine cost of developing or maintaining a platform. The budget bun-fight lasts so long (4-6 months is typical!) that actual long-term thinking and planning is limited to a maximum of 9 months ahead. Now of course projects should be short-term and agile and responsive, but they nevertheless ought to fit into a road-map that has a longer-term outlook, and that enjoys some consistent longer-term funding and planning. Compensation - bonuses - is typically determined not by genuine contribution towards these important long-term-value-creating goals, but instead upon short-term deliveries that must be completed within the year. Any longer term incentive is tied to corporate share prices that most people in big institutions have little opportunity to influence in any material way, and are thus they are little influenced by the stock price when it comes to their decision-making.
So there is a leadership deficit, and as a result an organisational culture that is not suited to meet the existential threat faced by the incumbent banks. I suspect this has come to pass because the industry has - very literally - a license to print money, (fractional reserve banking again) and this, coupled with the growth of the global economy has led to such vast sums of money flowing through the system, that it has never demanded great leadership or management skills in order to generate significant profits; it has never needed to learn operational excellence in order to succeed. When a trader earning millions for her bank is promoted to run an entire Equities division with several thousand front-and back-office staff despite never having previously managed more than 4-5 people on their desk; when a top salesman who has spent his career building the trust of prospects and developing relationships across the industry is now responsible for product development, despite having no understanding of how products are developed, how they work or how services are operated, is it any surprise that these big firms are struggling to adapt? These firms are complex beasts, too complex for any one person to understand the detailed operational model by which their existence is really manifested . This is why top-down-mandates to "re-use" systems rarely work; this is why blunt "outsource to somewhere cheaper" approaches yield only short term savings but lock in long-term fixed costs and operating models. This is why there are destructive annual budget processes, with crude, huge swings in spend that undermine any sense of strategy. These are the only tools the senior leaders have with which to manage the organisation. This would be bad at any time, but at a time of so many threats to so many business-lines, it is suicidal.
How then can the major banks change and adapt in order to continue - perhaps even thrive - into the 21st century?
It seems to me that banks need to adopt fundamental change in a number of different areas in order so survive and thrive.
First and foremost they need a deep cultural and leadership change. They need to recognize that technology is not just an enabler of their business, it is their business. They are providers of technology services (information and trust) to clients and if they do not become technology experts at every level and in every role in the organisation, then other firms - technology firms - will inevitably supplant them. Some firms delude themselves that they've achieved this. For example, they have leaders who say to themselves "I programmed once, so I understand technology, but I've progressed to becoming a Trader now". This completely misses the point - it suggests that Trading is superior as a skill and a role to technology. Banks need leaders who value service provision, operational excellence, technology, information and trust. These are the fundamental skills that underpin all of the activities of a bank.
Secondly banks need to simplify. They need to focus on simple-to-understand, customer-centric, end-to-end services that serve their clients. Clients want to borrow money? That's a service. Clients want to buy stock? That's a service. Any time a service confuses or complicates the simple depository, lender or intermediary functions of a bank it should be discarded or simplified to ensure that the complications are completely and totally ring-fenced. An approach such as this would make management of banks - understanding profitability, risk, etc - vastly easier, and it would help to reinforce trust by enabling transparency of fees and value, and reducing the scope for conflicts of interest. As an example, banks frequently run proprietary trading books if only to "provide liquidity to clients". The problem with this is that the bank tries to present it's service as that of an intermediary ("we'll help you buy this stock"), but the actual transaction is as a counterparty ("we'll sell you the stock you want because we currently own it and don't think it's worth as much as you do"). The way of doing this is to recognise that the business problems are best addressed by looking at the fundamental business goal that they are trying to solve for, from the perspective of the customer, and optimise all parts of the solution for that goal. The question is not "how can I improve an existing function?" but "what is the customer trying to achieve, and how can I make the best, simple, end-to-end service that achieves that?".
Where there are embedded, incumbent industries, networks and accepted practices which may in themselves not optimize for the customers' goals, then processes and systems should be designed in a way that permits both interoperability with the status quo and enables (actually drives) a re-engineering of the business process towards that bigger/fuller goal. An example here might be the discovery, distribution and charging model of investment research which currently makes it difficult for the customer to find good and useful research, and for which they are charged in an opaque and complex manner. Other examples might be the lack of fungibility of clearing complex derivative products, leading to closed-markets and little incentive for market participants to offer better services or pricing to customers. These are both examples where a bank's individual approach - acting on its own - may not be sufficient to change market practice, and where the solution may need to accommodate the existing - broken - models. Any new solution should at the very least be easy to adapt to an alternative market structure, and ideally help to drive such change, earning respect and trust from customers in the process.
This brings me onto my third recommendation. Banks need to become adaptive and flexible. They are competing in a technology and information business, and the pace of change in technology is so high that any approach that solves only today's problems, and doesn't put in place a culture of change, adaptation and flexibility will survive only to fail tomorrow instead of today. Burdened with yesterday's costly monolithic, inflexible technology and service offerings, banks should be driving to decommission these platforms and businesses even more aggressively than their new challengers are trying to do them out of business, and replace them with new, flexible and changeable platforms that can be integrated and combined in a myriad of new ways, as yet un-thought of, but in a manner that does not repeat the tight coupling and inflexibility of the past. Banks do have some significant incumbent advantages - knowledge and understanding of their clients, relationships with businesses and people across the world. They should use these to pilot and prototype new solutions and services and prove out new models far faster than their competitors ever could. The key to this culture of change, innovation and adaptivity is to allow failure rather than punish it. It sounds ironic, but a culture that isn't afraid to fail is one that can generate new ideas and that can adapt in a changing world. The key is to "fail fast" - to experiment, to try new ideas, and quickly distill the good from the bad and move on. This clearly is a challenge to the current annual budget-process approach to technology funding within banks, and also to the incentive models, both of which strongly favour "in-year" delivery rather than a multi-year strategy, fulfilled with many short-term experiments and periods of discovery. To succeed at this, banks will need not only an even deeper leadership- and culture change but also an effective "fitness function" that allows technologies, line-of-business and service experiments to fail in order to incrementally evolve those that are successful. "Adpative and flexible" should not just be a description of the technology, but of the organisation itself. "Evolution by natural selection" should be a guiding principle here for resilient, effective, profitable services.
Finally, although some firms have recognised some of these challenges, I know of no-one who has accepted the complete, holistic and comprehensive threat being faced or of anyone who is prepared to respond in the way I suggest. Some firms have responded in a small way - for example adopting Agile processes in some parts of their technology function, or have made small-scale FinTech acquisitions, without changing their own culture. I know of no-one who is conducting a full-scale, customer-centric review of their businesses and services, putting technology as the driver of change; I know of no firm that is adopting Lean and adaptive processes throughout their business. Many firms are responding only by lobbying for greater regulation of the various FinTech industries. While greater regulation is no-doubt a competitive disadvantage for the major incumbents, even if applied more widely to FinTech it would not be so burdonsome as it is on the major banks. Simple end-to-end services, offering greater transparency, require less regulation, and suppliers like this find it easier to comply with regulation when it is needed. Resisting the inevitable hurricane of change is a weak and futile response, and will make the collapse even more painful when it comes.
Banking comprises three types of function: depository, lending and intermediary services. In turn these are predicated upon two fundamental characteristics: information and trust, both of which can now be effectively accomplished with technology.
Banks are under an enormous existential threat from technology companies eating away at profitable services, whilst they themselves are encumbered by high legacy costs, incapable management structures and cultures, growing regulatory challenges and an erosion of trust.
To survive, banks need fundamental change:
Leadership and cultural change that recognises that technology is not simply an enabler but it the fundamental service being offered.
Be prepared to be bold... throw out the old, and build new, simple, transparent end-to-end services that can be combined in flexible and easy-to-reconfigure ways that serve the goals of the end customer.
Flexibility and adaptation are a necessary part of continued, sustainable success. Encourage experimentation with services, accept failure as a cost of of this, but try to fail fast in order to learn and drive further change. Structural change to budgetting, decision-making and incentives are necessary in order to allow this.
Related articles and reading
The Financial Times, "Could banks go the way of record stores, bookshops, taxi drivers and travel agents?", a selection of articles: http://bit.ly/29o64RF
The Daily Telegraph, "How fintech companies have brought on a revolution": http://bit.ly/1sMRaZc
Wired, "Beyond bitcoin. Your life is destined for the blockchain": http://bit.ly/1t95smT