Thursday, March 16, 2017

Canadian Banks: The Golden Halo is Starting to Crack

CBC’s recent revelations about employee aggressive sales behaviour at the big banks represent a significant crack in the golden halo that has mysteriously persisted over top the Canadian banks.  But this revelation is only the tip of the iceberg of irresponsible behaviour that more generally shatters several myths that undeservedly prop up Canadian banks as a pillar of Canadian sovereignty and socio-economic welfare.

The Mysterious Golden Halo

What is extremely odd about the Canadian banking industry and its relationship with Canadians is that despite unprecedented profit levels that would otherwise garner immense criticism, Canadians have retained a rather bizarre love for their banks.  Canadian culture stands among a small number of industrialized nations that values fairness above all else and tends to be one of the first nations to stand up to those who exploit others for their own gain. But the exception, it seems, is with their own banks.  With few exceptions, very little criticism emerges when the big banks, one by one, report, year over year, unprecedented profit levels that are, let’s be honest, completely and utterly ridiculous – and remember, I’m a business professor.  In fact, the media in Canada tends to report the financial performance of the big banks with pride.  Like the battered spouse who retains unfettered commitment to their supposed lover despite constant and reprehensible abuse, Canadians remain committed to backing their banks despite consistently being railroaded by them. 
Although a story pops up here and there that suggests Canadian banks could do better to meet Canadian expectations, the fact remains that Canadians are highly committed to their big banks.   One study by the Canadian Bankers Association found that 84 per cent of Canadians have a favourable impression of Canadian banks with 93 per cent of respondents exhibiting a favourable impression of the bank they do most of their business with.  Although the study was full of leading questions meant to paint a rosier picture, it is not a stretch to say that Canadians have had a strong level of trust towards their banks.  That is, Canadians believe that the big banks, despite having the power to do otherwise, will behave in ways that are in the best interest of Canadians.  To add to this, Canadians consistently rate banks high on customer service surveys. Proving this point further is the level of surprise of the many reactions to the scandal revealed by CBC; as if to say that, we, as Canadians, had no idea our banks were engaging in such horrendous behaviours.
Yet, when we consider profit levels of the banks and past Canadian resentment towards companies earning similar profit levels, it makes no sense that Canadians would remain so loyal to their banks. One proxy for financial performance is profit margin, which is simply the percentage of revenue the banks keep as profit after accounting for all costs. Most of the banks are between the 30-40 per cent range while the nearest competitors, which are mainly credit unions, are between 6-12%. This might not seem so bad until you consider that the profit margin of Exxon, one of the most hated companies in the world, largely due to their profit levels, was 10% during high oil price years while Monsanto, equally despised, generates between 10-20% profit margin over the last several years.  The telecommunications industry, one of the most hated industries in Canada largely due to the market power they possess, earns profit margins of 10-15%, never really breaking 20%.  Yet even though the Canadian financial services industry outperforms many companies normally despised for their profit levels, this hatred is absent when it comes to their banks.

Why the Love?

So then, naturally, one should wonder – why the love?  There are at least five myths that explain Canada’s unfettered loyalty to their banks: 

Myth #1:  If Banks do Well, Canadians do Well, Right?  It is commonly believed that if a country’s banks are doing well, it means that there is credit available to lubricate the economy, thereby ensuring a consistent level of growth.  This keeps unemployment low because Canadians have access to relatively cheap credit that can be used to spend and keep the economy growing. Banks offer credit so that businesses can invest more than the cash they have on hand, allow people to purchase homes without saving the entire cost in advance, and allow governments to rely less on tax revenue to smooth out spending. This argument has been fed to the public for quite some time with the assumption that the relationship between bank performance and Canadian welfare is linear.  That is, the more of one, the more of the other.
But the evidence suggests that despite a downturn or plateauing of Canadian economic growth, Canadian bank profit levels have increased.  That is, there is instead very little correlation, at least in the last decade, between the growth rate of Canadian bank profits and the health of the Canadian economy. Normally we would expect an uptick in economic activity when banks increase their lending. However, at some point debt levels get so high that a substantial chunk of the disposable income of Canadians is redirected to interest payments. In the backdrop of an unprecedented debt to equity ratio of 1.67:1 (where every dollar earned in income by Canadians, $1.67 is owed as debt), it’s not so hard to believe that there is no longer a close correlation between bank profits and Canadian economic growth. This wouldn’t be so bad if this was debt that Canadians actually wanted.  But as the CBC revelations suggest, the increase in debt levels is not necessarily a function of societal needs as much as it is a deliberate and concerted effort to transfer consumer money that would naturally go to other things (e.g. food, travel, etc.) to bank coffers by pushing financial products Canadians don’t need. This means that banks are no longer creating new value for Canadian society or the economy – they are simply appropriating value that already existed (i.e. transferring Canadian disposable income)

Myth #2:  Consumers Would Penalize Their Banks if Profits Were Too High. Many would argue that the invisible hand – the intangible market force of consumer freedom of choice and – is working just fine and that, at the end of the day, bank profits would be lower if they weren’t meeting the needs of consumers because the market would punish them otherwise. In the case of the CBC revelations, people using this argument would conclude that if consumers didn’t like these aggressive sales tactics, they should simply decline the offers and go to another bank. You can see this myth play out in a CBC interview with University of Toronto Finance Professor Booth where he states that eventually a bank like TD will suffer financially in the long-term if their employees engage in behaviour that is not in the best interests of consumers.  Many people falsely believe these sorts of statements across a wide range of industries and while there is evidence that this does happen, it is the exception rather than the rule.  Nowhere is the exception more pronounced than in the financial services industry.
To fully understand this myth, it’s important to relax the assumption that consumers are objective in their decision-making.  Strong evidence in behavioural economics and psychology suggests that consumers are highly susceptible to behaving in ways that are not in their best interests.  This is not an intentional behaviour or a result of ignorance but simply that consumers only have so much capacity to make informed decisions all the time and are thus vulnerable to coercive business practices – i.e. sales and marketing.  Exacerbating this issue is that Canadians are highly financially illiterate where over 60 per cent of Canadian adults rate their financial knowledge as “fair” or “poor” while 8 out of 10 Canadians lack confidence in their financial knowledge and 46 percent of national Canadian youth scored a C or worse on a basic financial literacy test.  In an environment where the market is financially illiterate, the mechanism of consumer knowledge that would otherwise deter egregious lending practices does not exist.
The employees CBC interviewed are ultimately suggesting that big banks aim to exploit the inability of Canadians to truly understand the implications of their financial decisions (I’ve referred to this in a previous blog post).  Although banks will state that they always sell products that are in the best interests of their consumers, this is simply not true, and defies business fundamentals.  If I’m a CEO of a bank, trained at a modern day business school, would I authentically meet the needs of my consumers and gain moderate profit levels or fabricate needs that don’t exist and earn superior profit levels because I know that the market mechanism won’t correct my behaviour. In fact, the CEO would more likely create consumer confusion to achieve this.  Now apply this to the thousands of bank employees who face customers everyday.  They can either fail to meet performance targets and suggest products that truly meet consumer needs or they can meet or exceed performance targets by suggesting products that will negatively impact the unsuspecting and financially illiterate consumer.  The word “unsuspecting” is key here.
I recently received a standard letter from CIBC, disappointingly from an MBA graduate of my business school.  In the letter, he’s offering me an increase in the credit limit of my visa card.  He’s trying to sell me on an increase in limit by suggesting that I could go on that trip that I’ve always wanted to go on or do the renovations I’ve been aching to do.  But he knows and exploits the fact that most Canadians struggle to understand that a credit card should not be viewed as a loan.  By suggesting that I can go on a trip with my credit card, he’s feeding off on this financial illiteracy and making me believe that a credit card is like a loan.  But in reality, consumers have, at most, a few weeks to pay the balance on their card to avoid paying upwards of 25% interest on the full balance.  So, if I were to take a trip at $10,000 and struggle to pay the loan in full, I would have to pay $200-$300 a month in interest.  This is no different from the business model of a payday loan where the idea is to sell short term credit that the consumer can’t pay back to lock them into a cycle of high interest paying debt.

Myth #3:  There is Enough Competition in the Banking Sector to Curb Profit Levels.  Many people argue that there is sufficient competition in the banking sector to correct behaviour.  There are 6 big banks and dozens of credit unions and other financial institutions.  There is no better point to refute this myth than the recent revelation that the aggressive and unethical sales tactics, once thought to be isolated to TD, has now been found to be ubiquitous across all banks.  Whenever negative externalities such as compromised consumer welfare do not get corrected by the market mechanism of competition, especially when there are hundreds of credit unions around that do not engage in these practices, it is fairly safe to conclude that the power of the banks prevents competition from doing its job.   When the six largest banks in Canada – TD Canada Trust, Bank of Montreal (BMO), Scotiabank, CIBC, Royal Bank of Canada (RBC), and National Bank of Canada (NBC) – claim roughly 80 per cent of total industry assets, they determine standard practice in the industry, no matter how egregious.
Another outcome of this imbalance of power in the financial services sector is the fees banks charge for their services.   For instance, banks charge consumers hundreds of dollars to discharge their mortgage even though the mortgage’s term had ended.  This non-interest income (income that doesn’t come from loans) is easy money and with no market mechanism in place to bring the fees down (i.e. competition), there is no incentive for banks to reduce the fees. The Canadian Bankers Association (CBA) has recognized the opportunity associated with yielding their market power to diversify into other services and have been quite successful in lobbying a sleepy federal government to weaken or prevent regulation for bank diversification in insurance.  The focus on non-interest income (e.g. insurance, fees, wealth management, mutual funds) is largely due to the fact that they are not subject to market cycles and, more importantly, because the CBA has been quite successful in ensuring weak regulation in these areas.
Consider the banks’ recent strategies in wealth management, which now accounts for around 10 per cent of bank profits (RBC made $763 million in 2015 and TD made $600 million).  Unlike a decade ago when long-term funds owned by big banks made up 25 per cent of all new mutual fund sales, banks’ shares in mutual fund sales in 2015 increased to 57 per cent.  This strategy of vertical integration has afforded banks lucrative margins because they are essentially cutting out independent mutual fund companies. Although bank executives claim an “open architecture” where their own financial advisors are free to go beyond their own bank’s funds for investment purposes for their clients, critics disagree, including several independent mutual fund companies witnessing an explicit exclusion of their funds at the branch level.  This would be like Loblaw’s saying that there is no conflict of interest when deciding how much shelf space their PC brand should get relative to non-PC brands. The reality is that consumers of mutual funds now have a larger percentage of funds originating from the bank than from outside the bank. The point is that banks can only dominate these sorts of industries because of the market power they already possess, which is now being expanded to other areas.

Myth #4:  Canadians are Heavily Invested in their Banks.  In what I consider to be a comedic article at best and absurd article at worst by CBC’s Don Pittis, the author noted that Canadians rely on Canadian banks as a substantial part of their investment portfolios. He and many others have noted that because so many Canadians are dependent on the profits of banks for their own financial future, it’s great that banks perform well.
There are so many things wrong with this argument that it’s hard to know where to start.  Fundamentally this is essentially “Robbing Peter to Pay Paul”.  To understand why, first consider that The Conference Board gave Canada a C grade on income inequality when ranked against 17 peer countries with income inequality increasing over the past 20 years.  Since 1990, the richest group of Canadians has increased its share of total national income, while the poorest and middle-income groups has lost share.  As alluded to in Myths #1 and 2, banks exploit those most vulnerable consumers by strapping them with unneeded debt and generating returns from this behaviour for those wealthy segments of the population with money to invest in the banks.  This is because lower-middle income levels are least able to benefit from investment in the banks yet generate some of the more high-margin returns for banks due to the higher interest rates and fees they pay.  Back to my example of marketing credit cards as temporary loans to take luxurious trips, those consumers most vulnerable to these messages are those who are more financially illiterate, which are the same consumers who don’t have low-interest secured lines of credit from which they can draw to pay off their visa cards when they miscalculate their ability to pay their visa.  On the flip side, the middle-upper income levels are most able to benefit from investment in the banks yet are most resilient to exploitative lending practices.  By taking money from poor Peter to pay rich Paul, Canadian banks are essentially engines of income inequality as they search for ways to exploit consumers to benefit investors. 

Myth #5:  Canadian Banks Did Not Succumb to the Financial Crisis.  We often hear that Canadian banks must be pillars of moral decency because they were able to weather the storm of the 2008 financial crisis.  The international community praises Canadian banks and no doubt Canadians feel a sense of pride as a result.  But it’s important to note that the survival of the big banks had nothing to do with the behaviour of the big banks.  To be brief, as Stephen Gordon at MacLean’s Magazine noted, “it was lucky for us that the financial crisis occurred when it did”.  A few more years, and we would have succumbed to a similar fate as the US.  Turns out that Canadian banks were following the same path of the US banks, they were just a bit behind.  Canadian banks were increasing their holdings of the same dodgy asset-based commercial paper that brought down the US banks at an unprecedented rate and were making it easier and easier to obtain mortgages. 

Canadian Banks:  A Symbol of What’s Wrong with Capitalism

The basic tenet of capitalism is that it is meant to be a system whereby those businesses that effectively find ways to earn revenue that cover their costs (i.e. profit) would both generate and attract additional capital that could be used to grow the business.  This is an attractive system because, in theory, it is meant to reward those businesses that find ways to effectively meet society’s needs.  Adam Smith’s notion was that it would be much better than benevolence if members of society aimed to specialize in addressing a societal need and then, those who did it best, would be rewarded with profit that could be used to grow the enterprise and spread this innovation to more segments of society in need.
But today, many large businesses have found a way to profit without having to do the hard work of meeting societal or even consumer needs.  Nowhere is this more prevalent than in the Canadian banking industry.  In Canada, what explains bank level profits is not their ability to meet consumer needs, it’s their ability to exploit consumers, build market power, and reduce regulatory burdens.  Unfortunately, capitalism has been railroaded from what was once a promising (although not perfect) system of meeting societal needs to one where businesses appropriate value from society by fabricating needs that did not exist before (e.g. convincing Canadians that they need additional financial products with higher fees) and by shifting Canadian disposable income to bank coffers (e.g. increasing credit levels where and whenever possible).  
Fundamentally then, what was once a very important mechanism in Canada that exemplified the greatness of capitalism (i.e. banks were rewarded for providing Canadians access to legitimate and much needed credit to meet their needs and generate economic activity) has now turned into an important illustration of the dark side of capitalism (i.e. banks are being rewarded for appropriating societal value for profits). 
Bank executives have already responded by indicating that they do not and will not tolerate any behaviour of their employees where they sell products consumers don’t need.  Take it from a business professor at a business school where a substantial chunk of middle and senior bank employees graduate from, this is bullshit!  Like the Wells Fargo fiasco last year where the CEO tried to make this out to be an isolated incident, I suspect that big bank executives will try to relegate this to some kind of extraordinary but contained problem that is not in any way representative of the entire bank.  Again, this is simply not true because it overlooks a highly institutionalized organizational culture – supported by incentive systems, bonus structures, reward systems, etc. that predict behaviour.

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