In good company.
I have long thought that the gigantic mega-financial institutions of the late 20th/early 21st century significantly overshot the synergies and economies of scale ostensibly underpinning their business model, to find themselves firmly positioned in the realm of diminishing returns and unmanageable complexity. The foundations of this thesis are built on my interpretation of the application of Coase’s Theory of the Firm in the context of massive advances in ICT (Information and Communications Technology) and the business of modern finance. (Indeed, more recently I have articulated this thesis at the Park Paradigm with respect to the specific examples of Citigroup and ABN Amro.)
I’m not suggesting that no economies of scale make sense in banking or financial services more generally, only that they are subsumed by complexity within these ‘integrated’ financial behemoths. I even have some sympathy for the seductive logic underlying integrated business models, however in my view the theoretical benefits of an integrated model - while possibly intellectually robust on paper - are impossible to exploit in reality. It ignores what I describe as corporate entropy: ie in any corporate process there exists an inherent tendency towards the dissipation of useful energy.
Indeed - sticking with the chemical analogy and without writing a book about it - it would be fair to say that giant bank mergers are at best an (intrinsically unstable) intermediate product in the reaction coordinate and to make any sense need to be followed by a subsequent division into multiple new end products (which individually release the benefits of economies of scale and synergy without the instability engendered by excessive complexity.) So Citigroup (or UBS or HSBC or RBS/ABN Amro, etc…) should naturally “decay” to form multiple specialist firms that are more focused and efficient than the multiple firms that had been combined first to form these giants. Until now however, it seemed that my point of view was not shared by many (any?) of the leaders of these mega-institutions, nor more generally by senior executives in the industry.
So I hope you will understand why I was exhilarated to read Luqman Arnold’s recent letter to the Board of UBS, in particular his thoughts on the integrated model:
Still, there are two clear disadvantages of the integrated model:
- Increased complexity, which places a greater demand on the competence of the Board and management, as has been amply demonstrated by the proprietary trading losses
- Conglomerate and complexity valuation discount and potential contamination of the valuation of the most valuable business, Wealth Management, by the lower rated and more volatile business, Investment Banking.
I’ve never had the pleasure of meeting Mr. Arnold but the little I know about his new venture Olivant (gleaned almost entirely from press coverage and their website) lead me to believe that we share (at least some significant) views of how both to best structure what I would call a modern merchant banking operation - combining operational advice with investments - and the latent problems and opportunities of the current financial services industry paradigm.
