There is no doubt that financial services is entering an exciting brave new world.
Fortunately, one doesn't need to get all stargazy to explore the situation.
We can already see the major drivers at work today: regulation, technology and demographics. These drivers can’t be denied or neutralised. They are actual necessary features of modern life.
Free market conservatives, Luddite reactionaries and self-interested incumbents in the cosy oligopoly will resist and whine, but will ultimately be overwhelmed.
Surprise, surprise, there is a political angle driving the evolution of banking.
Underpinning global finance at present is the biggest experiment in forbearance ever attempted, as the unreformed debt junkies are kept alive by the methadone that is quantitative easing.
Regulatory policy changes are brash (witness the leverage ratio), with scant regard for unintended consequences. Politicians and commentators have a sneering insouciance towards the views of the banking industry along the lines of 'well they would say that, wouldn’t they?'
Despite the industry’s self-interested lobbying, ever more features of the regulated banking industry are reminiscent of a centrally planned economy. Has market-making become the preserve of Gosplan?
Technological changes are the most fun to look at. There can be a look of muted joy on people’s faces as they use their phones to ping a payment to a friend, or quickly check their investments online. But financial technology is not a niche; it is ubiquitous.
The tipping point has been achieved: the internet is everywhere and users assume full e-service from their providers. This is particularly important for banking, an information industry that provides intangible services.
Unshackled from the historic need for reams of paper, strong iron vaults and armed guard staffed stagecoaches, banking is finding modern ways of providing trust, transactions and capital flows.
The incumbents’ network of physical access points, armies of clerical staff and shaky, unreliable IT infrastructure are beginning to look like hobbling liabilities rather than positional assets. Then again, concerns about the resilience of IT platforms to hacking and fraud affect new entrants and incumbents alike.
In retail financial services, technology is enabling fragmentation of supply.
Regulation has to be pro-innovation according to the UK’s chancellor of the exchequer George Osborne and is encouraging this fragmentation trend, by lowering barriers to entry and stimulating competition. In many ways, this is progress.
For example, the established mutual banking model can now be reinvigorated with the help of modern tools. Quasi-oligopolistic cosiness can be banished with the arrival of dynamic new brands, business models and value propositions. But the fragmentation of banking could lead to a chaotic cottage industry with lower value for customers and more risk for society.
The notion of marketplace or platform lending — the concept of eBay for money — is appealing and in vogue. As it becomes more mainstream over time, the profile of this kind of credit provision should improve, but it is not clear that depositors are ready or willing to become equity investors. Will marketplace lending be seasoned by the next cycle of credit losses, or devastated?
Wreck-it regs
Wholesale banking, on the other hand, is far more affected by regulation than technology or demographics.
Failures in bank risk management during the subprime crisis have resulted in regulation and supervisory oversight that reduces the attractiveness of many of the easily lucrative activities of yesteryear.
Few management teams can deliver the rigour and attention that the new rules require; few shareholders — especially Europeans — have the stomach, or risk appetite, for the volatility and uncertainty now clearly inherent in the wholesale banking industry. So most of the biggest European players are pulling back or pulling out.
It seems there will be fewer banks in the wholesale markets, with a narrower set of activities and far, far smaller balance sheets.
Risk capacity will continue to shift into the shadows of the hedge fund and private equity industries. Starved of balance sheet, investment bankers will once again become merchant bankers. Liquidity will continue to seep out of the traditional market making banks and into liquidity traps, such as asset managers and clearing houses or exchanges.
Investment banks are not popular with politicians, but reduced levels of competition and liquidity in the wholesale markets are not a positive development for anyone.
One redemptive hope is that, with technology reducing frictional costs to zero, wholesale markets can blossom by industrialising retail access and paring down bid/ask spreads.
Across retail and wholesale financial services, whether it be payments, investments, lending or advice, major change is certain.
The industry is not blessed with an ideal starting point: it is still digesting the conduct and credit damage from the last decade, while attempting to deal with the new economic challenges and the necessary modernisation (or is it reinvention?) of its business model.
The speed, breadth and nature of change at the moment has resulted in new risks.
We will have a brave new banking industry, but we won’t know how it will behave through the cycle. There will be failures due to innovation. Innovative systems will be overloaded, hacked and fraudulently manipulated.
Regulatory arbitrage will engender financially unsound businesses. Severe liquidity crunches will occur. New industry structures will become unruly.
We should certainly be utopian and think about all the wonderful new ways there are to use finance to improve our lives. Processing is free; connectivity is infinite; capital flows to the right place with zero friction.
But finance remains an industry centred around risk and risk management. Better a brave new world than a naive one.
The FIG Idea is an occasional column taking an offbeat look at the weird world of banks. It is written by a market professional with more than 20 years involvement in the FIG market.