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The Internet and Private Banking

Lyon Hardgrave is a first-year MBA student at Wharton, whose paper, "The Internet and Private Banking," recently one top prize in the Capco/Wharton Essay Contest. Read why Hardgrave's ideas about the Internet's potential to restructure the industry caught the attention of the judges.

A Wharton/Capco Essay Submission

By Lyon Hardgrave
1st Year MBA Candidate at Wharton
Expected Graduation: May 2003
Major: Finance

529 Juniper Street
Philadelphia, PA 19147
[email protected]

The Internet and Private Banking

Of 50 leading global private banks and asset management groups interviewed by Forrester Research, 68% of executives said keeping up with the Web is their single greatest challenge. And no wonder. The Internet has torn the economics of numerous industries asunder, and the challenges it presents to private banks are no less significant. As the Internet matures, banks will need to address information, cost, relationship management and legal quandaries. The Internet will force the industry to restructure, and within a decade, its visage will be markedly different. Consolidation and specialization will redefine the roles of private bankers. Nonetheless, those who adapt will thrive as the number of high net worth individuals multiplies.

The most obvious challenge for private banks will be their need to come to terms with the information explosion wrought by the Internet. This challenge is not contained to private banking. All investment banks face difficulty defending their own value as the Internet increasingly sets information free.

In the not-so-distant past, banks were an information fortress. News flowed from corporations through their bankers to the public. The ability to control information allowed banks to charge a premium for their services. Access to the right banker offered an investor both data and the tools and knowledge to turn this raw information into investment insight. While increased bank regulation has nominally restricted the ability of banks to maintain a stranglehold on information, modern communication channels have been a more direct and significant liberator. A process initiated by the advent of dedicated financial cable television has been accelerated by the Internet. The same information that used to be the exclusive domain of the banker is now available online at little or no cost. In-depth analysis is available for free across a range of sites from TheStreet.com to CNN Money. Yahoo!'s financial site gives users free access to everything from portfolio management facilities to charting tools to options models. Real-time asset prices, once a staple of the banker-investor relationship, are now available for a nominal fee from any number of online services. Even investment reports, the crown jewel for bankers of the last generation, are now available for less than fifty bucks from several services. If an investor wants information, he will no longer pick up the phone. With a couple of dozen keystrokes, an investor can find it himself.

Robbed of the premium that came from exclusive information, the best that a bank can do is try to offer investors the easiest access to information, yet even in this regard, banks cannot compete. Dedicated financial news sites will continue to outpace even the most progressive bank. A bank's only trump card is the provision of specific information about an investor's accounts within a bank. While an investor may turn to Reuters for the latest market news, they will return to their bank to monitor the performance of their own portfolio.

Unfortunately, this service comes at a heavy cost to private bankers. Unlike retail banks, which can reduce customer management costs by moving branch and phone services to the Web, the online service of a private bank is an additional expense. Developing a Web infrastructure is extraordinarily expensive and time-consuming. The construction of Morgan Online is estimated to have cost more than $20 million and to have taken more than 24 months. Early in the lifecycle of the Web, such extravagance could be defended as a competitive advantage. Tech-savvy early adopters wanted access to their accounts, and a private bank that could promise uncommon online service could potentially win business. Increasingly, though, as banks build increasingly sophisticated online presences, and customers become accustomed to superlative online capabilities, a Web presence is less a competitive advantage and more a commoditized operational requirement no more spectacular than an accounting or check processing system. A competent web presence is now a de facto requirement of the majority of wealthy investors. Recent Forrester studies show that 60% of millionaires use the web for transactions and most want to do so with their banker's or advisor's involvement. For most businesses, integration of web technologies promise substantially reduced costs. For private banks, the web is a fiscal black hole.

Even as their own costs increase, private banks face a marketplace transformed by the economics of digital technology. Online retail banks offer better rates and discounted transaction costs, and online brokers such as E-Trade and Datek allow users to trade significant blocks of shares for less than ten dollars. Moreover, increasingly advanced forms of electronic money transfer allow investors to move money from bank to bank with minimal hassle. The forces of bureaucratic inertia that encouraged many investors to stick with their bank, even if its performance was disappointing, are slowly being clicked into history.

Lower transaction fees and better rates are not a new phenomenon. Private banks have responded to this threat in the past by focusing on their core strength, maintaining relationships. When a high net worth individual approaches a private bank, he does so well aware of the increased costs. The close and devoted stewardship of a private banker is worth the expense to many wealthy individuals and families. Yet the Internet is complicating even this most hallowed strength of private banks. There is confusion about the best way to integrate new communications channels into the client relationship process. Email is a premiere case in point. Email has become the primary form of business communication for many individuals. Private banks have not been slow to adopt this channel, but its implementation as part of a relationship management strategy is tricky. As a phone call is some degrees less personal than a face-to-face visit, email is many degrees less personal than a phone call. Does any private banker want his exclusive communication to a client sandwiched between a piece of spam and a free financial newsletter? Moreover, when several thousand identical emails can be launched with the press of a button, will a customer ever feel that an email is truly personal? Yet if a banker is not willing to take advantage of the immediacy of email, will the customer not start to find other conduits for real-time consultation?

As vexing as these questions are for private bankers, they do not even begin to match the headaches caused by the legal ambiguities of the Internet. Offshore banks, in particular, face legal risk. One risk is related to marketing, as described below:

If a bank is not licensed in a territory, it clearly can't mail leaflets into it, or advertise on television locally. But the Internet jumps these barriers, to the extent that a bank cannot (and of course doesn't in fact want to) prevent a prospect in a regulated country from seeing its publicity. If the prospect then approaches the bank of his own accord, is the bank to turn him away because he found their publicity on the Internet? The answer to this question probably depends on the regulatory regime applying to the offshore bank in question.

The marketing risk, while relatively straightforward, implies some less-defined and more dangerous operational risk. Some courts, particularly in the U.S., have started considering arguments that accessing a corporate web site from a computer in a state can legally be treated as if the business had a corporate presence in that state. Issues of interstate commerce and offshore-based Internet gambling have triggered this debate, and it is unresolved. The EU continues to wrangle with liability questions prompted by lawsuits against both Yahoo! and Ebay for offering information or products illegal in certain European countries. Imagine the difficulty faced by private bankers whose online presence might expose them to a patchwork of national regulations and the necessity to monitor the physical locations of their online customers to avoid potential liability for actions taken by those customers. This is not a tangible danger at this point, but the Internet is in its infancy, and until the law catches up with the complexities of modern communication, a legal risk will remain.

Private banks are confronted with so many challenges, that it is tempting to script a eulogy. This would be a mistake. As it has in the past, the private banking industry will adapt to the realities of a wired world. Nonetheless, the challenges created by the Internet are too great to allow the industry to emerge unscathed. The private banking industry will be transformed, and although it will thrive as a whole, many individual players will not.

There are currently over 4,000 firms competing in the private banking space. The challenges outlined above will force two distinct trends. First, a wave of consolidation can be expected. The costs of building and maintain a competitive Web presence, while staring down less expensive upstarts, are simply too large to allow small firms to survive. Those that do not consolidate will either die or become participants in a second trend towards specialization. To survive, small private banks will need to define and defend a value-added niche. The aftermath of this revolution will be a new industry structure similar to that depicted below.

The backbone of this new structure will be a series of clearinghouses. These behemoths will provide the meat of private banking services through outsourced relationships. Three premier examples are depicted in the diagram. Market data and research clearinghouses, most likely existing investment banks, will provide financial data. Information technology clearinghouses will provide software that will allow private banks to build a Web presence from modular components. The result will be a sophisticated and relatively low-cost online presence that will look branded and unique, although it will be little more than a custom veneer slapped on an assembly of clearinghouse services.

Relying on the clearinghouses themselves and forming a second layer will be a series of niche specialists. Probably formed from existing private banks, these firms will focus on superior knowledge of a very small area of expertise, such as offshore tax protection, trusts, or inheritance protection. While they may continue to service customers themselves, these institutions will primarily rely on providing services to the front-line of the restructured industry, the relationship managers.

Private banking customers will continue to value relationships above all else, and they will interact with a series of firms dedicated to relationship management excellence. Complete with the traditional oak-framed trappings of existing private bankers, these firms will exploit the Internet, their service providers, and their core client-handling excellence to provide a full-range of private banking services to their customers. To the customer, the private bank of the future will look just as exclusive as that which exists today, but rather than attempt to maintain a full range of in-house services, relationship managers will leverage the Internet to call on their network of service providers.

This new dynamic is perhaps best illustrated with an example. Imagine a customer with assets in multiple countries looking to protect himself from the tax effects of the sale of several of these assets. He approaches his private banker looking for advice. The banker is intimately aware of his client's portfolio, but cannot independently offer the best strategy. Instead, he activates his network, pulling in experts in law, international tax, and asset protection from several different niche firms. Leveraging broadband and Internet broadcast technology that will be increasingly powerful over the next several years, the private banker is able to welcome the client to his office for a virtual meeting between the experts and himself. The client is able to access world-class expertise within the comfortable and confidential confines of his private banker's auspices. Returning home, the customer can check on his portfolio at any time, utilizing the sophisticated interface he considers unique to his bank.

In short, the private bank will be transformed into a faceplate for a network of underlying financial service providers. The private bank will manage the customer relationship, and it will therefore dictate the nature of the service providers it wants in its stable. The service providers, particularly the clearinghouses, will benefit from economies of scale. Groups of experts will merge with similar groups of experts to build the influence necessary to effectively negotiate with private banks. However, the wave of consolidation will not be limited to the service providers. Private banks will face their own turmoil.

To fully understand the forces that will drive consolidation, it is necessary to consider another phenomenon that is occurring concurrently with the emergence of the Internet. The phenomenon is the explosion in high net worth individuals. Sprectrem estimates that the number of households with wealth above five million dollars will surge from 1.3 million in 2001 to an eye-popping 3.9 million in 2004, and households with wealth between one and five million will grow from 7.9 million to 10.5 million over the same period. The vast majority of these individuals will have had no prior experience with private banking. They represent an incredible opportunity for remarkable profits for private banks, but their ignorance of the industry means that the industry will need to begin to market itself in new ways.

Private banks will need to focus on a market niche and ferociously build a brand within that space. Private banks will no longer be able to try to be all things to all people. A bank will need to define its core market and focus its efforts on that segment. Segmentation will take place along the lines of wealth (<$1 million, $1-$5 million, >$5 million), age, financial sophistication, desire of the customer to independently manage his money, and technological savvy. A retiring investment banker will require a wholly different approach from that of a newly minted and financially unsophisticated software entrepreneur. The expense of marketing to all of these groups and maintaining the service alliances required to meet their disparate needs will force banks to define themselves narrowly. Moreover, during previous years, when the number of new millionaires per year was manageable, it was possible to develop individual marketing approaches. This will not continue to be the case. Private banks will increasingly depend on creative marketing and a cast-iron brand name to win new business. The explosion of wealth will make private banking look more and more like other consumer businesses, where brand is king, and weaklings are devoured. The number of faceplates will dwindle, until each niche is ruled by its own set of oligarchs.

That day is a long way off. The full impact of the Internet is yet to be felt. Global Asset Management, recently purchased by UBS, noted that not a single full-service customer has decided to stop paying for their service and use online tools to pick their own investments. Nonetheless, it would be foolhardy to hope that the core structure of the private banking industry will be untouched by the Internet. As went the previously staid worlds of investment banking and law, so will go the world of private banking. Within a decade, consolidation and specialization will roil the industry. The survivors will be those firms that position themselves to build a brand and leverage the unprecedented alliance-building opportunities provided by the Internet.

As difficult as the future looks, there is one shining bright silver lining that must not be forgotten, namely five million or so new millionaires in the next three years. For those firms that survive the shakeout, profits will be handsome.

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