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The Role of the Second Tier Bank

As the top tier banks solidify their positions at the top of the food chain, the middle tier is encompassing a broader range of institutions than ever before. Julie Ros looks at how electronic commerce is transforming the role of the middle tier bank.

Nobody wants to be called a second tier bank. However, if you define the middle tier as those institutions outside of the top 10 global market makers, then this market sector covers the widest band of the FX hierarchy. With the introduction of electronic commerce, this sector is not only growing in size, but more and more banks within this domain can offer better value, deeper reach and more products to their respective client sectors than ever before.

This increasingly important sector is growing daily, as the Big 10 solidify their positions at the top of the food chain. “There are probably 15 FX banks that think they’re in the top 10 – and then there are probably only about six that qualify as true global market makers,” says David Barnett, recently retired co-head of global FX at RBC Dominion Securities.

If this is the case – then there are literally thousands of banks that qualify for the second tier label within FX, even if they are considered among the largest banks in the world in terms of asset size or market capitalisation.

These mid tier banks understand their customers better than anyone else. They have developed a rich business working their particular core competency and have a loyal client base because of this.

“Second tier banks can often offer a deeper, broader, more personal approach – one that is tailored to the individual needs of their clients. These clients are generally the smaller and mid-sized ones that can get lost in the bowels of the larger institutions who may have bigger fish to try,” says John Beckert, president of Cognotec Americas in New York. “So it’s about understanding what your core competency is and leveraging upon that into other areas.”

Core Competencies

There are many different aspects and types of second tier banks, so to discuss the second tier, you need to consider their profile. They can be the specialist market maker or regional bank that specialises in domestic products either locally or globally, or perhaps it’s a boutique operation that is first tier within its own particular niche.

“What you would call a second tier bank is very different than four or five years ago,” says Richard Estes, project manager for iFX Manager at Bank of New York (BNY). “A few years ago, you would define a first tier bank as one that had a global presence, with a network of offices that provided 24-hour sales and trading services; cash and derivative products and a global clientbase. The second and third tiers lacked one or two of these qualities, because they tended to concentrate on one region or marketplace or didn’t cover all products and services.”

“Since the introduction of the euro, a lot of the second and third tier banks have disappeared. What has changed is that banks can now only afford to trade interbank FX if they have real client business – you can no longer rely on all banks as liquidity sources,” adds Estes.

“As you move into the second tier, you begin to see the importance of the relationships between banks and their customers. At the larger institutions, the philosophy is tends to be that the relationship is between the customer and the institution. But within the second tier, it is the relationship between the customer and the individual salesperson,” says Estes.

“DG Bank is relatively small in terms of its standalone balance sheet,” says Arnd Stricker, treasurer of DG Bank in Frankfurt. “But the Internet and other means of communication have given us access to markets we didn’t previously service. We try to use technology to bundle the flow of our local banks outside the region and of mid-sized customers. Technology helps us do this and it doesn’t require a lot of investment,” says Stricker.

“But the Internet requires a huge marketing effort if you want to get people in other regions to open up credit lines and click on your Web site,” he adds. “This requires a huge investment, which is why I don’t see that it is a realistic alternative outside your core markets. What added value can I offer a client in Asia? You have to define your strategy first – you need to know who your customers are and what they want – and then see how technology will help you implement that strategy – not vice versa. Technology is a new means of communication, but it doesn’t help with other aspects such as credit.”

Outsourcing

Cost is an obvious hurdle for those banks in the mid tier sector face that want to conduct interbank activities. “The battle has already been won in terms of name recognition, ticket cost, infrastructure, internal technology, human resources, credit worthiness and market coverage, so the second tier bank must carve out its niche areas of strength and exploit these,” adds Cognotec’s Beckert.

Outsourcing through e-commerce is one way to keep costs down. The second tier bank now has a global network at its disposal – which really becomes an e-marketing strategy – whether it’s price discovery, execution, commentary or advice, or even getting nostro agents for overseas settlements.

“If a second tier bank is prepared to cut its cost base and feed off the top six, then they can do similar amounts of business at low risk and low cost,” says Barnett.

As the natural barriers to entry are being erased for the second tier, these institutions can now focus on their core competencies, reaching a broader customer base at a reduced cost. “Correspondent relationships mean that a mid-Western bank can access the best Aussie dollar prices directly from a domestic Australian bank, and extend this to its customers. This has profound implications. The bank to bank deal is done without human intervention, so banks can provide pricing to niche clients, thereby expanding their portfolio of offerings, which helps lock in customers and create a revenue stream that is without risks, staff or in-house expertise,” says Beckert.

“Now everybody gets picked up first and everybody has access to market commentary at the beginning of every day. The Internet is a tremendously powerful tool, because it gives the client in Milwaukee access to the same services as clients in London. So it extends the quality of services in a cost effective and scaleable way,” he adds.

“I think we’re going to see a lot more outsourcing within this tier as more banks extend their core competencies beyond their traditional reach. For those that already have a global network in place, they can empower the local sites to offer a richer service because they no longer rely on a disjointed support service from the home office – they can offer a 24-hour service from each centre,” says Beckert.

John Key, managing director of Debt Markets, FX & Liquidity at Merrill Lynch in London, believes that more and more banks will outsource their FX altogether. “There has been a pattern emerging for some time now,” says Key, “Whereby a number of banks have exited the market making business and now source many of their retail client services from the wholesale suppliers such as Merrill Lynch. E-commerce is allowing them to efficiently provide a range of products and services cross border.”

“The issue comes down to where is the easiest place to deal?” he adds. “The mid-tier bank has a fixed line of credit, and we provide the clearing or custodial services – which makes it easy to deal with us. The ties are more about the relationship, which is bound by the products and services that you can offer.”

Partnerships

Since there are many different kinds of competencies – geographic, product range, market segment, relationships – banks will often have a collage of niche areas to leverage upon. It is these core competencies that even the largest institutions identify as necessary complements to their own businesses.

A top tier bank like UBS/Warburg Dillon Read recognises the importance of maintaining relationships with its smaller counterparts. For the past 18 months, WDR has garnered partnerships with about a half-dozen small and mid sized banks in an effort to leverage their niche areas of strength.

Through its partnership arrangements, WDR provides small and mid-sized banks with pre-trade services, wholesale prices, risk warehousing and post-trade value-added, while in return, the smaller banks provide a deal flow that the larger institution may not normally see.

“The combination of these relationships and the Internet-based products are an important way of allowing banks to efficiently focus on core competencies across the whole organisation,” says Simon Jagot, WDR’s managing director and global co-head of Treasury Products.

“What do we look for in partners? Those institutions with limited client base overlap, good credit quality and good reputations,” says Jagot.

Partnerships are also growing among those in the mid-tier market. DG Bank is in the midst of implementing a joint venture partnership with Rabobank, which will create a single system to handle structured finance, international finance, capital markets/treasury, equities and mergers and acquisitions.

Similarly, the Bank of New York entered into a relationship with derivatives experts Susquehanna about four years ago. “This relationship provides us with a world class capability in currency options,” notes Estes, who adds that this partnership, together with the custody business the bank purchased from JP Morgan, has become an important part in how it approaches the business.

Other banks are looking into the idea of founding a common investment bank with partners in Europe, while others are said to be partnering with vendors to create a banking network for a pooled base of corporate customers. “I believe we’ll see focused partnerships. Implementation of that strategy is the second key to success,” Stricker adds.

Henri Nummisalo, first vice president, global head of FX and options at Merita-Nordbanken Group in Finland says the Internet is already forming a large part of its business strategy. Nummisalo says the Merita-Nordbanken is the leading Internet bank in the Nordic region, and that the bank already has 1 million end users of its Internet services and around 4 million payments are being done monthly.

“Cost efficiency is key to the business, because the number of transactions is not increasing, while spreads are narrowing. The Internet is a handy way to bring products to customers at a lower cost,” says Nummisalo.

“While the goal now is to be a one-stop shop for customers, in three years’ time, the key will be the ability to provide multibank access to all your services on a single Web site,” says Nummisalo. “Banks are just brokers, so those that provide a faster, more efficient service, will be in a winning position. You will have to have the relationships and a global product base to survive.”

“We’ve been very supportive of multibank initiatives,” adds Estes. “As you look at consolidation in the industry from mergers and the euro, you see an evolution in the business. We felt we had to use technology to be pioneers in this field, in order to be a survivor three to five years down the road.”

The idea of virtual trading rooms is also something that has arisen since the introduction of Internet-based offerings. RBC DS Global Markets, the global trading unit of Royal Bank Financial Group, which introduced one of the first Internet-based autodealing services, says that a number of regional US banks are now using it as a virtual trading room for spot/forward FX, and a range of swaps.

E-Marketing

Once a bank has established its core competency, the question becomes how to deploy it. How does the mid tier bank get its message to different regions, or a different tier of customer?

Marketing via the Internet is largely about helping the customer to find you. “Whether it’s through hot links to different search engines, home pages that provide video camera coverage to the corporate sales guy or providing online credit applications – or maybe it’s about different applications of marketing than we know today – it’s a more scaleable approach to marketing,” says Beckert.

Not only does the Internet enable smaller institutions to reach a wider, deeper range of customers, but it also encourages clients to trade more often. “People that never needed a service such as E-Trade now can’t live without it,” notes Beckert. “They may have traded four times a year before E-Trade, but now they’re trading four times a day from their living room. They’re trading because they can – and this affects the trading patterns of the client, who is willing to pay for the opportunity. Technology has created a momentum in and of itself.”

Key to Success

E-commerce represents a change in strategy for everyone. “Ultimately, e-commerce helps these mid tier institutions focus on their role – which is increasingly as credit intermediaries,” adds Merrill’s Key. “Retail investors are becoming more and more sophisticated. We’re seeing a heightened awareness and demand for a breadth of services among retail investors. Part of this is a globalisation issue. Globalisation means individual investors require a wider breadth of services. If mid tier banks can reinvent themselves from market makers to focus on the bank to client relationship, then they will survive longer.”

“E-Commerce allows you to be where you need to be, so if you have developed a regional expertise, you can expand globally without adding significantly to your costs,” says Beckert. “So each bank in each tier needs to ask itself: How do the barriers coming down affect me? The right next move in e-commerce may be profoundly different for a second tier bank with a small corporate base than it is for one of the big guys. The appropriate strategy will be different for both sectors.”

“If banks can provide customers with prices and services over the Internet, then they get a cost-effective infrastructure. This follows the same model that banks have already put in place internally with their own branches. But instead of having a centralised dealing room in London and branches around the world – the big banks can leverage off relationships with smaller banks to gain entry into the local or regional markets,” says Barnett.

“A second tier bank can’t compete with tier one on name recognition, ticket cost, infrastructure, internal technology, human resources, credit worthiness or market coverage,” adds Barnett. “So to succeed as a niche player, you have to develop a high customer retention rate and high profit margin. The answer is to become low cost producers of FX.”

“The FX market is extremely decentralised,” adds Jagot. “A large number of banks will continue to survive with small shares of the market, but they need low cost infrastructures to do so. The Internet makes it easier for them to stay in the game, by outsourcing risk and distributing their product to their client base without constructing expansive branch networks.”

“The key to success in this business will base itself on partnerships and alliances between banks, where each partner brings her own core competency to the table,” says Fabian Shey, managing director, head of global e-commerce, Treasury Products, at Warburg Dillon Read in London.

The Future

“What will happen in the e-commerce space? Banks will give liquidity services in FX and fixed income away for free. They won’t charge margin or fees, but in return, they will get a piece of the value-added – clearing, settlement and structured solutions. The role of smaller institutions is becoming more greatly defined. There was a period of confusion when people thought the term bank meant market maker. That concept is going away, as banks become more like brokers,” says Key.

So will these banks eventually get disintermediated? “The answer lies in stickability. I still bank with the same bank that I started with 30 years ago in New Zealand,” Key adds. “It takes a lack of service or an inability to provide services to lose your client base. If mid tier banks can supply the product in a better, more cost efficient manner, then they have a very good chance to hold on to and even grow, their client base. But it means having to completely rethink the role that they play and the way that they play it.”

Nummisalo adds, “Today, banks are reassessing their global operations – asking if they really need multiple trading rooms in Europe, and if they can run a 24-hour service from a single location. Soon, we will see trading and value-added services done by mobile technology – and in the future, when CLS takes on a bigger role and customers no longer need credit lines, the market will again change dramatically.”

“There will be two tiers of banks – the WalMart’s of FX that offer any service, 24-hours a day, and lots of research. Then there’s the group that will not be all things to all people, but will instead focus on servicing the client segment,” says BNY’s Estes. “For the latter, it won’t be volatility that drives the business, but increased volumes in client business.”

“If you believe the consolidation trend will continue, then how will the smaller institutions survive? They won’t if they cannot adapt and see their role changing,” Key says. “But if they recognise that they can get services from a wholesaler like us, they can take advantage of their long standing relationships with retail investors. It comes down to cost efficiency. “

Profit & Loss

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