The Nature of the Bank

Ronald Coase, who died this month at the age of 102, was a remarkable thinker.

Born in 1910, he came of age just as big business (or more precisely, big corporations) were coming into their prime. These organizational structures were ideally adapted to the technological, economic and cultural environments of the "late industrial age." And his seminal paper "The Nature of the Firm," published in 1937, explained why. While Frederick Taylor and Alfred Sloan designed frameworks (and spawned new industries of business education and consulting) for managing the modern mega-corporation, Coase helped us understand their evolutionary success in the context of the environment in which they operated: an environment characterized by high growth, (mostly) abundant resources, standardization and perhaps most importantly, information scarcity and (relatively) high transaction costs.

His key insight – that companies existed to reduce informational and transaction costs - created a robust intellectual foundation validating and encouraging the pursuit of ever larger - and thus transactionally efficient – corporations. The M&A bankers of the late 20th century owe him an enormous debt of gratitude.

In the 20th century, banks and other financial institutions, when not constrained by regulation, took full advantage of these conditions, with the leading players in almost every country growing into massive, vertically integrated firms and enjoying, for the most part, tremendous success. Essentially firms that deal in data and information (money just being a specific form of same), banks enjoyed particularly strong Coasean advantages for most of the 20th century as the larger they grew, the more transactions they processed or mediated, the bigger their informational advantages. True efficiencies of scale.

Further, especially in the latter half of the century (and continuing today), the systemic and regulatory context favored continued growth: the too-big-to-fail phenomenon which we are so familiar with today. These advantages, as predicted by Coase's theory, were further buttressed by the spread of "first generation" information networks – railways, airlines and telephony – as integrated banks were able to take full advantage of these to lower internal transaction and management costs and expand geographically and in the scope of their activities. The global megabanks we know today were a predictable, perhaps inevitable, outcome arising from Coase's theories given the underlying market environment.

Then, starting in around 1971 (with Intel's launch of the 4004, the first microprocessor on a chip), our fundamental technological and economic paradigm began shifting.

This happened slowly at first, and accelerated through the nineties and 2000s as the continuous exponential progress of the technology of the Information Age began to be assimilated by our societies (cf. Moore's Law, Metcalfe's Law, etc.). This shift has profound consequences for businesses, some of which I believe can also be predicted through application of Coase's thinking. And as banks and other financial institutions inexorably become increasingly "digital" businesses, I believe these consequences will manifest themselves ever more acutely.

The highly regulated nature of banking affords the industry some temporal respite from these fundamental and emergent systemic forces driving optimal organizational structure – acting as a brake or dampener with respect to the speed of change – but is unlikely to provide a sustainable safe harbor from the "natural" underlying forces driving our economy and society.

While Coase postulated that the ability to profit from reduced transaction costs favors the growth of firms, he also suggested that there was a countervailing force – the increased costs of managing complexity – that would ultimately slow and finally limit growth. In other words, in any given environment there was an optimal, maximum size of the firm.

The global financial crisis of 2008 violently exposed these "complexity" costs and, TBTF aside, highlighted that perhaps we were close to, if not past, the Coase optima for the largest banks. Applying "Industrial Age" management structures and theories, even when amplified by the deployment of early "Information Age" technologies, is no longer sufficient to overcome exponential increases in complexity that naturally emerges both within the firm and in the system. Further, as transaction and information costs continue to decline exponentially, the relative advantage of the firm (versus the marketplace) in Coase's framework declines almost to zero.

I believe that these two forces – increased complexity costs and decreased transaction cost advantages – will inevitably lead to a fundamental redefinition of the "optimal" corporate structure and size in banking. They will favor banks that disassemble their vertically integrated model into more flexible, adaptable and resilient networks of businesses and operations – some enjoying and focused on harvesting ever larger economies of scale and others more nimble and profiting from their ability to adapt to market conditions and customer expectations at speed.

Ronald Coase gave us some wonderful tools to understand the world in which we live. He will be missed. But his work lives on. For anyone in a position of leadership in banking and finance, his "Nature of the Firm" should be required reading. And in the Information Age, it's just a click away.

Sean Park is the founder of  Anthemis Group, an investment and advisory firm focused on reinventing financial services for the information age.