A lot of people would agree with the proposition that the airline industry is a commodity business. Jokes about the sector are legion. “How to make a billion dollars in the airline business? Start with $10 billion and work your way down” is one such. Then there is the quip about how everyone makes money in aviation except the airlines.
Where does one fit the banking industry? Before we answer this, it would be instructive to start with what the Finance Minister said the other day to a group of journalists waiting to talk to him after he met with heads of public sector banks.
To a question on when banks would begin to cut interest rates, he said he was hopeful they would do so in the days to come (See BL story on the subject ). Now, if you ignore the measly .05 percentage point cut in the ‘base rate’ (the lowest lending rate that a bank can charge the most creditworthy borrower) that State Bank, HDFC, ICICI, etc., announced in the days immediately following that meeting, we can say that practically nothing much has happened in the two weeks since then.
But, of course, the minister, to be fair to him, was being rather guarded in his remarks. He didn’t specify when these cuts would happen. Nor did he venture to hazard a guess about the quantum of rate reduction.
Minister’s prophecy
The phrase, ‘in the days to come’ may have meant the near term or well into the distant future. Thus the events of the last two weeks may not prove the minister’s prophecy wrong. The exchange nevertheless left a far more intriguing question unanswered.
The question wasn’t only one of when interest rate cuts would happen. Rather, it is really about what the bank chairmen told him about the prospect for rate cuts. A fly on the wall might have overheard these gentlemen briefing the Finance Minister. We most certainly, did not.
But rudimentary insights about the nature of the market for financial products and how firms respond to the environment in which they operate can help us overcome this handicap. These gentlemen could only have told the minister that, given the kind of the product market in which they operate, there simply isn’t much scope for any rate cut.
What is it about the market for financial products that constrains these bankers? Product markets can be classified as falling under one of two categories. There are products with features or functionalities so unique that no other offerings come close and, hence, they stand apart in the consumers’ minds.
Premium products
It goes without saying that the producers of such unique offerings can command a premium that people are only too willing to pay. Think of Apple iPhone, Louis Vuitton handbag, a Versace summer collection or a ticket on the Palace on Wheels, and you get a sense of the potential for premium pricing.
Then there are products such as airline seats — completely indistinguishable from one another. An airline seat for travel between Chennai and Mumbai on an Indigo flight is not substantially different from the one offered by Jet Airways or Spicejet. There is absolutely no pricing power for any of them.
Abstract concept
In general, industrial products tend to operate as commodity businesses since end-consumers expect only functionalities that can be measured objectively. In contrast, the FMCG industry promises such functionalities that are so abstract as to defy any objective measurement but nevertheless, succeed in creating a resonance in the consumers’ minds.
Deodorants are a perfect example of this phenomenon. It is impossible to objectively measure the ability of a deodorant to cast an irresistible attraction spell on the opposite sex. But deo users believe it works, objective measurement or not. So, producers can promise such an attribute and charge a premium and consumers are willing to at least give it a try. Even if the object of your adoration falls for your intrinsic qualities the producers are not going to forget to remind you that it is because of the deodorant.
In contrast, the airline industry has long since given up the battle of trying to create any abstract and yet useful value propositions in the consumer mind, around the notion of a ‘flying experience’ in travelling from place A to place B.
In general, the potential for branding is a prerequisite for pricing power. But the mere presence of such branding possibilities is not always a guarantee of securing such pricing power.
Pricing power
There are two things about the financial sector that make it unique from the perspective of market structure and pricing power. One, the financial sector is not dealing with one product but is actually in the market for selling two separate products although one doesn’t exist in the absence of the other.
There is the market for mobilising financial savings of investing public. Banks are thus offering the service of warehousing people’s monetary surpluses. They are also in the market for providing the service of financial accommodation for borrowers in need of money.
The former operates as a retail product in the FMCG space but without scope for creating value perceptions in consumers’ minds. Banks cannot promote their ‘warehousing service’ (savings) on the attribute of safety of the monies deposited. They have tried promoting it on some nebulous notion of ‘relationship’. It hasn’t impressed the average retail saver. In short, they have become much like the airlines industry, unable to compete on anything but the price.
Just as airlines can’t put prices up, banks can’t afford to bring deposit interest rates down. If cost of funds are not declining or cannot be brought down, and other costs of intermediation such as staff costs, rent, electricity etc. cannot be reduced and profits can’t be sacrificed, then there is only option left for bankers. They have to play the volume game.
No happy ending
In other words, bring down the unit cost (interest rate on loans) but expand the market size for loans (pool of borrowers). But the loan side of the business is usually static. At any given time, there is only a fixed number of industrial borrowers in various buckets of differentiated credit risk. The next additional borrower can be acquired only if the bank is prepared to assume a slightly higher risk. That game has never resulted in a happy ending for banks.
Every time banks have tried to dramatically increase their loan book, they ended up acquiring borrowers with low credit rating, leading to eventual write-offs. The recent experience of banks in dramatically scaling up volumes in housing finance, retail auto loans and consumer durables are too fresh in their memory for them to tread that path again.
You don’t need to be fly on the wall to know what would have transpired at that meeting between bankers and the Finance Minister. You could have written the script for the bankers to read out.