Chapter 10: Innovation and Structure in Banking and Finance
Banking has been practiced for thousands of years and, in the broadest sense, its core activities have not changed. If a wormhole swallowed up a money-lender in ancient china and deposited him behind the desk of a mortgage bank in present-day Hong Kong, his biggest obstacle would be learning to use a computer - and once he had that licked, he could go right back to work with business as usual because the basic operations have not changed. In whatever century, a farmer who needs money for seed to plant a crop still needs to borrow money and agree to terms of repayment with interest.
This also calls to mind that banking is a product with secondary demand. No customer in their right mind wants to take out a mortgage loan simply to be a debtor - they are motivated for a need for money to buy real estate. If no-one wanted to buy real estate this month, there would be no demand for mortgages. While individual companies can compete to have a larger share of the market, there is nothing that the banking industry can do to drum up demand for more mortgages in the aggregate. Furthermore, banking has been a heavily regulated industry since the British banking fiascoes in the eighteenth century, so there have been many restrictions on what banks can and cannot do that prevented virtually anything except basic banking services, and these restrictions remained largely in place until the 1990s.
These factors combined meant that until about two decades ago, banking remained a very stable but stagnant industry. However, much has changed and there has been a great deal of growth and deregulation in the industry, opening the door to innovation.
Innovation Behind the Scenes
The fluidity of capital markets in the present day means that banks stand a great deal more competition than ever before, and this has driven banks to take greater interested in investing in innovation. Currently, most of the changes in the banking industry are largely invisible to the customer. They deal with the way in which banks handle their own financing behind the scenes, particularly when it comes to managing capital reserves.
Banks are now about to invest their deposits in a broad variety of vehicles (stocks, bonds, derivatives, commercial paper, etc.) and can adjust their risk/return balance with greater fluidity. A bank with a higher risk tolerance can buy the risk of one with a lower risk tolerance, and the ability to buy and sell assets quickly enables banks to narrow their reserves and keep more of their money working.
One of the most significant innovations that is visible to consumers is the adjustable-rate loan. Previously, all loans were fixed interest and the banks absorbed the risk of losing profit (and incurring additional expense) when rates rose. But with an adjustable-rate vehicle, the risk falls on the customer, who will be charged a higher rate if the treasury rate increases. However, the benefit of falling rates also goes to the customer, whose loan rate will be reduced if interest rates fall. Another advantage to banks is that customers are less likely to refinance their loans when interest rates fall, which saves the administrative costs of closing the accounts of customers who are leaving and opening new accounts for customers who are coming in when interest rates decrease.
Loophole Mining and Lobbying
The author vaguely describes the practice of loophole mining - which is seeking ways that they can operate outside of regulatory guidelines by exploiting the letter of the law. In essence, they can get away with doing something that is prohibited, whether it be charging more or paying less (either in interest or in the fees and services they provide) than the law was intended to allow. There are a myriad of ways that bankers can do this, and regulators are generally a step behind: because it takes time for legislative bodies to amend the law, bankers who discover loopholes often have several months to make hay.
One particular weakness in the legal system are the vestiges of the previous regulatory restrictions, which prohibits certain activities to banks but permits them of credit unions or investment houses, or prohibits them of commercial bankers but not of retail bankers, etc. By subtly adjusting their operations, a bank can claim to be in or out of any of those various categories, and it's not uncommon for a single parent company to hold multiple financial service businesses and simply move capital from one to another when necessary to perform a certain activity that would be forbidden of one or the other.
Where regulations cannot be easily circumvented, bankers are heavily involved in lobbying and political campaigning to get the regulations changed in their favor. A significant amount of money is spent by banks to attempt to influence the legislative process.
Banking and Technology
Technology has always been a major source of innovation and advancement in the banking system, largely because banking depends on communication. In the ancient world, banking required moving around physical assets (coins and bars of precious metals) and writing out contracts longhand with quill and parchment. Even primitive advancements such as the typewriter, telegraph, telephone, and photocopier greatly increased the speed and efficiency of banking greatly. The modern world of digital communication has catapulted it forward, such that a transaction that might once have taken days or weeks (or months) can be completed in milliseconds.
Technology has also enabled the average person to engage in very sophisticated financial transactions. Even the poorest of individuals can have funds available at a bank account, write checks, use payment cards, arrange for electronic transfers, and so on. Those with a little extra money to invest can interact directly with the treasury and various investment markets from their computers and cell phones. A person can hold bank accounts, loans, and investments with multiple vendors without ever stepping foot in a physical bank. So there is a great deal more money and exponentially more participants in the banking industry than ever before in history.
The author focuses a bit on consumer credit, which once was very difficult to obtain. If an individual was a long-term resident in a community and knew local merchants well, the merchants would provide store credit (buy now pay later), but there was no formal consumer lending nor common credit cards that could be used with an array of merchants, even those to whom the holder was a total stranger. Even as late as thirty years ago, most of this was unheard of, and what primitive forms of it existed were available only to wealthy customers.
Banking Industry Profitability and Structure
In spite of their attempts to innovate, banks are losing on both ends. Since the 1970s, they have lost more than half of retail lending to other businesses. And with greater access to investment vehicles, customers are keeping less and less money in deposit accounts with banks but are instead investing in the money market, mutual funds, and other brokerage products. The crunch has also led to banks holding fewer loans. To maintain their capital, most loans are sold off shortly after they are executed, granting the bank a lower profit than if they held and collected the loans themselves. As a consequence, they seek to squeeze even more profit out of off-the-balance-sheet activities (such as raising fees to residential banking customers).
As a result of the competitive pressures, many of the small and local banks have exited the business, usually by merging with larger institutions. This occurred en masse in the banking crisis of the 1980s but has been continuing steadily ever since, and the deregulation frenzy of the 1990s has enabled more large financial institutions to merge. There has been both a consolidation of similar financial institutions (small banks fold into large ones) and the conglomeration of dissimilar ones (when insurance, banking, and investments are offered by the same firm). The result is that the nation has fewer and larger financial institutions.
It is suggested that this consolidation has eliminated redundancies and created efficiencies - but it also means that large banks and institutions are very large and complex, giving them significant power in financial markets and making them far more difficult to regulate. During the recent financial catastrophe, the phrase "too big to fail" was used to indicate where a single firm had become so massive that its bankruptcy would be detrimental to the national (and even international) economy.
Some statistics from 2006:
- There are a total of 7,402 commercial banks in the united states
- 3,246 have assets less than $100 million
- 3,662 have between $100 million and $1 billion
- 494 have assets over $1 billion
While there is some concern over the consolidation of the financial services industry, there is also the counterpoint that many new forms are constantly emerging (particularly in the digital space), but it is difficult for a smaller organization to be profitable due to the economies of scale making it difficult to compete with the offerings of the larger firms.
There is also consolidation on the international level - it is easy for foreign banks to enter the US market and for US markets to enter overseas markets. Currently, foreign banks hold about 10% of US bank assets and make more than 16% of commercial loans. Meanwhile about 100 US banks have branches abroad (up from eight in the 1960s) and financial institutions in the US trade in virtually every market exchange in the world. US Banks have a "strong presence" in East Asia and South America.
There's some speculation that globalization will change "the nature of banking" as US firms will adopt banking practices from abroad and vice-versa. Global business would be more efficient if there were global standards and global governance, and the author provides a handful of examples to suggest it is moving in that direction.