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Quarter-End Insights

Financial Services: Bank Branches Under Siege

The rapid increase of online and mobile banking is streamlining transactions, reducing costs, and making the traditional bank branch a relic of an earlier era.

  • The role of the physical bank branch and its future as the primary delivery channel of products and services is facing change. Banks have been forced to re-examine their branch networks and their functionality in the face of macro-economic forces such as low interest rate spreads, Federal Reserve stimulus actions, and higher regulatory costs. Accordingly, digital efforts will be the biggest driver in changing how branch banking looks for the next 20 years.
  • Smart phones and cost savings are the key drivers. The increase in smartphone penetration and the cost savings available with new technologies have placed tremendous pressure on the banks to make changes to their branch networks.
  • European banks report large losses and CoCo bonds look iffy. The Royal Bank of Scotland and Unicredit reported multibillion dollar losses indicating that European troubles still are ongoing, and the growing popularity of CoCo, or contingent convertible, bonds has us concerned.


Bank Branches Under Siege: The Rise of Digital Banking
Today, there are various channels through which a typical bank customer can interact and conduct business with their bank. In addition to the physical branches, there are ATMs and telephone banking as well as the rapidly growing online and mobile banking platforms. We think that all of these channels, especially the rapid increase of online and mobile banking (also known as digital banking), is streamlining most banking transactions by completing the transaction faster and reducing costs. The common factor is that personal interaction with a bank employee is not a necessity. We think these changes are making the traditional bank branch a relic of an earlier era. We would point to two primary reasons for this shift.

First, part of the reason for this change is the rapid adoption of smartphones, especially among younger customers. According to a 2011 Pew Internet study of adults between ages 18 and 24, only 5% did not own a mobile phone, and 49% owned a smartphone. An American Banking Association study that compared branch usage with online banking showed that adults over age 55 use bank branches more frequently than any other age group. However, the ABA also found that a majority, 57%, of this same demographic is now more apt to do their banking online. The study also showed that nearly all customer segments prefer the speed and convenience of conducting their banking transactions over the Internet to visiting a local branch.

The increasing adoption of smartphones will also broaden the potential reach of banks to deliver products and services. We project that smartphone penetration in the U.S. will be 82% by 2016. As the population ages, we expect mobile and smartphone adoption rates to continue to dramatically increase as more young adults will adopt more smartphones in the coming years than older adults currently possess. Therefore, as adoption of smartphones increases, we expect the adoption of mobile banking through those devices to also increase.

Second, as banks have invested in technology, many of the transactions that used to be performed by a person in a bank branch can now be done online on a home computer or via a mobile device such as a smartphone at a much lower cost. For example, it is up to 95% cheaper to process a deposit via a digital deposit device versus using a teller. For making online or mobile payments, it is 65% less expensive to process a payment made with a smart device than one made using physical checks. With these significant cost savings, these are smart investments for banks in terms of lowering operating cost structures. The key for most customers to adopt these delivery systems into their smart devices is ease of use. As long as the interface is easy to use for customers, adoption of the applications should be an easy sell for the bank.

We think Wells Fargo (WFC) and PNC Financial Services Group (PNC) are ahead of peers in the transformation of their branch networks. For example, PNC closed nearly 200 branches during 2013 in anticipation of dramatically lower utilization and is experimenting with a couple of different smaller branch formats to test market acceptance. Wells Fargo, like PNC and other banks, has been shrinking the size of its branches and employing more digital/online/touchscreen options within the facilities for increasingly self-serving customers. In contrast, RBS Citizens, N.A, a large U.S. subsidiary bank of Royal Bank of Scotland (RBS), has not yet made significant changes to its branches or its footprint. While there is an initiative for 2014-15 to "optimize" its branches, we think RBS Citizens is addressing these issues with its branches at a late stage, when other banks have already begun this process.

European Banks Report Losses; CoCo Bonds Look Iffy
On the European side of the coin, the outlook appears challenging. The Royal Bank of Scotland reported a GBP 9 billion net loss, and its CEO, Ross McEwan, called the results "very sobering." The bank has lost all of the GBP 45 billion that it received in a government bailout and then some, and it still sees years of restructuring ahead. We were shocked by management's description of the complexity remaining in RBS' operations after six years of restructuring--RBS currently has 247 ongoing restructuring projects and 109 different credit card options, and processes 7.8 million payments manually each year--and the additional cleanup costs will be larger than we had anticipated.

UniCredit (UCG) also reported a staggering loss of EUR 15 billion, one of the biggest in the bank's history. In short, regulatory pressure both from Italian regulation as well as plans by the European Central Bank to scour banks' books anew for additional problem loans have prompted banks to take corrective action. UniCredit is the primary example at this stage, but we wouldn't be surprised to see more large losses from other banks in the future. Mario Draghi, president of the European Central Bank, has argued that these types of cleanups help credit flow to companies that need capital rather than deny additional loans because of a shaky balance sheet.

That said, banks do appear to be reloading their balance sheets with another shaky asset: the so-called CoCo bonds. These bonds are contingent convertible capital in that the bonds will convert to shares if the banks get in trouble. Banks like them as a way to build capital without issuing equity, but the securities are called "death spiral" securities because if a bank's capital weakens, the bond will convert, thus putting additional pressure on the stock price. In short, they appear to be a questionable security, but with projected issuances in 2013 at around $30 billion-$40 billion (and virtually all in Europe), they remain a relatively small part of the industry's capital structure at this stage.

Our Top Financial-Services Picks
Longtime favorites such as Capital One Financial (COF) and Berkshire Hathaway (BRK.B) are reappearing on the list this quarter. We've added Standard Chartered (STAN), as we think this is a bank that has been unduly punished for its emerging-market exposure that should recover in the long run. Other reappearing favorites include Aegon, which we still see as attractive.

Top Financial-Services Sector Picks
Star Rating Fair Value
Fair Value
Aegon $11.00 None High $6.60
Berkshire Hathaway $143.00 Wide Medium $100.10
Capital One $90.00 Narrow Medium $63.00
Standard Chartered GBX 1,630 Narrow High GBX 978

Data as of 3-14-14

Aegon (AEG)
We believe that the market does not fully understand the company's operations, which is ultimately being reflected in its share price. While the firm generates more than 70% of its profits from its U.S.-based Transamerica franchise (with the rest coming from the U.K. and the Netherlands), investors continue to treat it like it is a European heavy insurer with limited growth opportunities. The company has also received little recognition for its turnaround efforts in the aftermath of the financial crisis, which have involved derisking its business and making a gradual shift toward a more fee-based revenue model. As such, Aegon has been trading at around 0.5 times book value, not much higher than the 0.4 times book value seen on average between 2009 and 2012, and well below the average price/book multiple of 1.2 times from 2003 to 2008.

Berkshire Hathaway (BRK.B)
We remain impressed with Berkshire Hathaway's ability to generate growth in book value per share in excess of its benchmark, believing it will take some time before the firm succumbs to the impediments created by the sheer size and scale of its operations, as well as the longevity of Warren Buffett and Charlie Munger. The company's shares continue to trade at a discount to our fair value estimate, providing investors with the potential for double-digit upside from today's market prices. We would also note that Berkshire has effectively created a floor under the company's stock price by announcing that it would buy back both Class A and Class B shares at prices of up to 120% of reported book value (book stood at $134,973 per Class A share and $89.98 per class B share), implying downside protection for investors at prices 10%-15% below current trading levels.

Capital One Financial (COF)
We think Capital One is undervalued because of the following factors: loan growth in automotive and commercial lending is not being considered in valuation, and the firm's credit quality is underappreciated, as total nonperforming loans represent only 1.5% of total loans. Capital One is still a top-five credit card issuer in the world, but it is also a misperceived company in transition. Credit card loan growth will be challenging as Capital One repositions its portfolio to more traditional commercial bank lending. However, Capital One has good prospects for loan growth in automobile lending with its national platform, and commercial lending done locally in high-density markets like New York and Washington, D.C. In addition, funding is not an issue as CapOne completed the acquisition for $83 billion in online deposits from ING's U.S. operations (now called CapitalOne 360) during 2012, which has significantly helped liquidity, adding lower-cost funding.

Standard Chartered PLC (STAN)
We think that the market's excessive focus on the slowdown in Standard Chartered's near-term growth has created an opportunity for long-term investors to buy into the name at an attractive valuation. While we expect revenue growth to be under 6% in 2014 as the company pulls back in South Korea, compared with an average of 14% since 2007, we think that the narrow-moat trade bank's competitive advantages, built on its huge low-cost deposit base and network across fast-growing markets, remain intact. Moreover, we think Standard Chartered has managed its exposure to a slowdown in China well--its direct exposure to mainland China is less than 5% of total assets, and its exposure to commercial real estate (the segment that typically shows the biggest losses in a property bubble bust) in Hong Kong and Singapore combined is less than 15% of shareholders' equity (as of June 30, 2013). We think that the bank will continue to outearn its cost of equity, even in this more difficult environment, and that its market price, at 1.1 times book value and 11.9 times forward P/E, looks compelling.

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Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.