Banking on banks a rising risk

IWONDER whether my greatgrand-children will remember the days when there were banks. Banks throughout the world have been getting into a lot of trouble, paying fines left, right and centre as regulators swoop from one investigation to the next.

Has it simply become a cost of doing business as banks move into increasingly exotic lines of business in attempts to diversify their income streams from a dependency on margin income?

Taking deposits from the public (the only reason you need a banking licence) and lending them back into the economy is a relatively simple business from a regulatory perspective. It is also a relatively simple economic model. In the days when banks were banks, you simply geared up your shareholders’ capital about 10 times and took a 2% margin on your total assets. That gave you a 20% return on equity. Of course, then, you had some real interest rates to play with.

This relatively simple business of assessing credit risk (on behalf of depositors) was administered by conservative people in grey suits and blue ties — that’s why they were given licences. The banks were beyond reproach. Then governments started messing with their stock in trade, interest rates. Staid commercial and retail bankers started making way for a new breed — investment bankers. Yellow ties replaced blue ties, and then blue jeans replaced the grey suits.

The focus moved to trading and fee income. Instead of just facilitating flows in, say, foreign exchange, banks started taking positions in currencies themselves. Instead of just concentrating on optimising margins, banks had positions along the yield curve. The direction of a client deal became relevant, conflict became a possibility. Complexity compounded with every new instrument design.

The culture changed, rogue traders did deals their bosses did not understand, the trouble started — the Libor scandal, forex manipulation investigations, including our very own by the Competition Commission into possible collusion among some of our banks.

Banks went into everything. The value of merger and acquisition deals in the US alone amounted to $250bn last month — at higher levels than the heady days leading up to the dotcom bubble. Individual transactions are bigger and cheap money has inflated asset prices, particularly listed shares. A lot of money has been made and those who made it show off — fast cars, lavish parties and private jets.

Central bankers have got grumpy and they have brought out more rules and require more disclosures; perhaps just an attempt to explain to the public what the hell is going on. But wasn’t it their policy overrides that drove bankers into these new territories anyway? It matters not why, but we find ourselves in a state of reporting overload as a result.

Compliance departments are bulging at the seams and auditors are disclosing and disclaiming themselves out of the distilled essence that used to be contained in the reports we used to understand. Will Basel III and International Financial Reporting Standards ever drive behaviour in the dealing room? I doubt it. These new governance and reporting structures cost money and someone has to pay for them — us, the clients.

As bank funding becomes more expensive and complicated, so disintermediation will step into the gap. Corporates that can, issue their own debt paper already, but that’s OK because they also have serious disclosure requirements and the participants are mainly institutional.

Where disintermediated funding (debt and equity) becomes really interesting (risky) is when it falls outside the established, regulated markets. The Financial Times has pointed out that in Silicon Valley this year the money raised in so-called “private IPOs” was 35 times that raised in the formal initial public offering market, on a regulated exchange. People find a way. Shares are owned by founders, employees, friends and the public. Trading is illiquid, bid-offer spreads are wide, but evidence suggests it is the preferred market in the valley.

The focus is shifting from institutional funds gatherers towards direct interaction with the individual. Technology has been a huge enabler: there’s crowdfunding, bitcoin and barter; young new capital meets opportunity, outside of the banking system. So, where is it all headed? Will banks go back to banking, or will they become irrelevant. Or will they reinvent themselves to remain at the hub of financial flows? What will the future hold?

Technology will play a major role. Banking will come to you. Branch networks will need to become part of distribution or logistics networks going beyond the delivery of banking services. As physical money becomes virtually extinct, branch risk dissipates; brick-and-mortar structures will need to multitask.

More broadly, technological expertise will no longer live comfortably within banks. It will be outsourced at the margin and no longer be a competitive advantage. The cost per unit of add-on technology in finance will tend to zero over time.

Central banks and governments will continue to intervene and overrule as the dictates of their competitive constituencies require, delaying inevitable outcomes by interfering with what market forces get

Central bankers got grumpy and brought out more rules; perhaps an attempt to explain what the hell was going on As physical money becomes virtually extinct, branch risk dissipates; brick structures will need to multitask

to quicker when left to their own efficiency. I would far rather they went back to being referees and coaches than being on the field as players.

More regional “banks of allies” will emerge to deal with mega-project finance and social funding. Expect more of the likes of Brics, the Asian Infrastructure Investment Bank, the International Monetary Fund and the World Bank.

The revenue mix in banks will continue to diversify away from traditional deposit-taking and lending. Too much risk will eventually force a regulatory split and, having gone full circle, banks will be banks, if there is still a space for them.

Disintermediation continues to grow, particularly through vendor financing (of goods and services), steadily diminishing traditional banking market share, until regulators, again, redraw the lines. Social media becomes the dominant gateway to and from customers. “Know your client” takes on new meaning — it becomes an imperative and the core differentiator.

Beyond these trends that I expect global, SA and other developing countries will have to overcome the challenges in banking the unbanked (unsecured lending, whatever you call it) and funding small-, medium- and micro-enterprises, if they want a life. They will have to marry balance sheet strength and lower cost of capital with experience hard-gained in the trenches by those who have been there and made the mistakes. Governments will be a necessary third partner. The pricing is not sustainable and the problem is too big to tackle without them. And their re-election may depend on it.

Banking isn’t what it was, and it won’t be what it is now. The currents have changed and there is more to come. I think banks are at risk.