The Future of Banking–Once Again

Two recent newspaper articles, I believe, put into perspective the dilemma faced by commercial banks these days. The first article is “Banks Face 2 More Years of Famine” in the Wall Street Journal.  The second is “The Incredible Shrinking Banks” in the Financial Times.

The first article deals with the disappearing “net interest margin” at commercial banks and how the Fed policy of keeping the target Federal Funds rate in the 0.00 percent to 0.25 percent range until at least the middle of 2013.

Commercial banks have historically made most of their money from the difference between the interest rates they charge on loans and the interest rates they pay on the funds they borrow. This difference is called the “net interest margin”.

This spread has, in general, been declining since the early 1960s. Two factors have contributed to this decline. First, one of the financial innovations of the 1960s was the movement of banks to engage of liability management. Classically, commercial banks had been asset managers. Bank liabilities were generally determined in local markets (because of the limitations on bank branching), were generally demand deposits, and were generally insensitive to interest rates. Thus, banks were limited in the funds they had to lend by the amount of interest insensitive deposits they had on hand and the capital the bank had accumulated. They did not manage this side of the balance sheet…it was a given. Consequently, they were asset managers.

In the 1960s as capital began to flow more freely within states, between states, and between countries, banks, especially larger banks, could not live under the constraint of their liabilities and capital. Loan demand began to exceed this constraint and so these large banks developed “market-based” liabilities that they could buy and sell at their will. Thus, we had the creation of the negotiable Certificate of Deposit, the Eurodollar deposit, and the holding company issue of Bankers Acceptances. Liability management took over at these banks.

Liability management, early on, was limited to the largest banks. But, as the financial system evolved, liability management migrated to smaller and smaller banks. I must admit to some shock in that I just went through a training session on asset/liability management for commercial banks prepared for the American Bankers Association. In this six-part program, the assumption was that every bank, even the smallest, engaged in liability management. That is, even the smallest banks could go out and “buy” funds in the open-market and thereby fund all the loans that they might find. Thus, the cost of their funds rose and well as their riskiness.

The problem is, however, that deposits that are insensitive to interest rates pay a very low rate of interest. Funds that are purchased in the open market pay “market rates” and are very sensitive to competitive rates. Thus, the cost of funds for commercial banks rose relative to the interest rates on loans. The “net interest margin” of commercial banks fell. It thus became harder for banks to earn the returns they used to earn on “classical” banking business.

A second factor that contributed to the decline in banks “net interest margin” was the increased competition that came about over the last fifty years, both nationally and internationally. “Good” borrowers could now go outside the banks limited banking region and find better and cheaper banking relationships. As the limits on branching broke down, this competition for “good” customers increased. As this competition increased, the “net interest margins” earned by the banks dropped even further.

So, commercial banks, for years, have been facing falling “margins.” Now, as the Wall Street Journal article proclaims, the Fed put even greater compression on interest margins over the past couple of years by reducing its target Federal Funds rate to the 0.00 percent to 0.25 percent range. With the new policy decision to keep this target so low for another 24 months the Fed has basically “locked in” exceedingly low “net interest margins”. The article supports this claim by looking at Treasury yields: the spread between the two-year Treasury yield and the 3-month Treasury yield is just 19 basis points (this spread was 46 basis points three weeks ago); the spread between the five-year Treasury and the 3-month Treasury is less than one percent (a month ago this spread was 150 basis points).

“For the biggest banks, this decline in the net interest margin cuts into profits from lending as well as crimping investing and trading income. Smaller banks face the added challenge of often having to pay more to attract funds.”

The thing that struck me about the Financial Times article is this: the British bank HSBC and Google have roughly similar market capitalizations. “The striking difference is that Google generates these number with fewer than 30,000 employees—not even as may people as HSBC is laying off.” HSBE recently announced that it is laying off a 10th of its workforce, 30,000 redundant employees.

Both companies deal with “information”. Finance (money) is just information. Whether it be paper or gold or 0s and 1s, it is just information. The “value” of the paper or gold or 0s and 1s comes from the ability of this paper or gold or 0s and 1s to acquire something that we want to buy. This is why information technology is such an important part of commercial banking.

What do I see for the future? I have written about this many times in many places over the last five years. You can find many of my blog posts on Seeking Alpha.

And, the author, Frank Partnoy, makes this point in his Financial Times article. Commercial banks deal with information and Google deals with information. Yet in the case of HSBC we see that Google has a workforce of less than one-tenth of that of HSBC and they both have the same market capitalization. The question is, why does HSBC have such a large workforce? Partnoy adds: “Facebook’s equity is worth more than that of most banks, yet it has just 2,000 employees.” Where is the adjustment going to come?

Because commercial banks have experienced falling net interest margins and because they have a business model that is way out of date with the existing technology, commercial banks have had to do other, riskier things to “make their money.” The commercial banks have “expanded into riskier and more complex activities, including structured finance, derivatives trading and regulatory arbitrage, which can allocate capital in distorted ways.” In essence banks have had to make up for their inefficiencies by taking on more financial risk, increasing financial leverage, and through financial innovation.

The consequence? Commercial banks, in Europe as well as in the United States, are troubled. Many banks are selling at discounts from their book values, something at substantial discounts. The inherited banking model does not seem to be working and something new must take its place. What will the new model be?

Obviously, we are in the process of working this out. One thing seems sure to me. Banks in the future are going to employ a lot fewer people per dollar of assets than they have in the past. I don’t know whether Google or Facebook are the models of the future, but information technology will have a dramatic effect on the finance industry over the next five years or so. Furthermore, banks can’t live off of recently experienced or current net interest margins. Here we might get a bifurcation of the banking industry into something like commercially orientated banks and consumer oriented credit unions. We’ll see.

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