Are banks like Kodak? Or capable of adapting to a new world?

Come the new year and the tenor of most commentary is inevitably what does the future hold? In the financial services sector that speculation tends to fall into two categories: for markets like Australia, with a healthy system where banks dominate investment portfolios, the question is can their performance continue to sustain expectations for dividends and capital growth.

In other markets, particularly Europe and the US, where the financial crisis was concentrated, the future gazing tends to be more existential. Do traditional banks have a future? The question is not just operational but fundamental; that is will other kinds of organisations render traditional banks less consequential or even obsolete?

"What is emerging is new participants are partnering with traditional banks, not disenfranchising them."

Weighing the arguments, many commentators seem to believe the era of conventional banks has passed. That even as economies grow, the share of revenue banks will harvest will fall, diverted by new technologies, non-bank brands and even entirely new ways of thinking about how financial systems are structured.

I don’t think that’s right. There is no doubt new technologies and new business models will change the nature of banking. They already have. To say nothing of the normal creative destruction of capitalism in uncertain times.

Yet all those elements which threaten to leave banks still producing analog film in a digital world can also work in their favour, whether that’s technology, access to large customer bases and regulation – which many think is aimed at breaking up banks.

This existential question though is perfect for pontificators. It’s a fascinating subject, best summarised – and later paraphrased by Bill Gates at Microsoft – by Ed Furash for the Bankers’ Roundtable two decades ago when he said “banking is essential for a modern economy, banks are not”.

The last couple of years have seen a proliferation of new start-ups and non-bank organisations offering banking-style services, particularly in payments but also in lending. Peer-to-peer platforms such as Uber and AirBNB have facilitated a rapid encroachment upon both the taxi and hotel markets, markets which – like banking – have historically had relatively high barriers to entry.

Peer-to-peer lending, where platform managers bring borrowers and lenders together, is theoretically similar.

Then there is payments, where an enormous amount of start-up and high profile activity is concentrated. Apple, the world’s leading consumer brand, is now in the mobile wallet sector, if only in limited markets.

Sometimes the platform allows a new way to think about the market. Car insurer Guevara has in effect brought back the old mutual model of insurance where the community looks after its individual members, in this case creating the “community” via new technology. The technology pools risk and indeed refunds surplus money if the “community”, of similar risk profiles, comes in under estimates on claims.

Guevara has an element of LinkedIn about it too as customers can recruit their own network. Peer-to-peer lending has a similar ethos, particularly when it crosses into crowd-funding.

Historically, because the banking system was the fundamental source of payments and funding in a capitalist economy, and banks leveraged their own capital – so-called core capital is typically around 8 per cent of lending indexed for risk – banks could earn gross returns a few percentage points in excess of growth in gross domestic product.

Moreover, as economies became more sophisticated, utilising more financial products, the banking system’s share of the economy grew.

In ANZ’s major report “Caged Tiger: The Transformation of the Asian Financial System”, the key argument was around this “deepening” of the financial systems in the region. Caged Tiger argued the Asian financial system is on track to be bigger than the US and Europe combined by 2030.

The report argued Asia’s financial institutions will become increasingly important in global finance and Asia will become home to many of the world’s largest financial centres. That should mean a growth in opportunity for the banking system. If banks are not managing asset managers themselves they are offering platforms to aggregate them. They may not directly underwrite equity issues but will distribute them. Even if they are not lending directly to fund growth they are advising.

Yet as Furash noted in the early 90s, while all these activities are necessary they are not necessarily performed by traditional banks.

Indeed one argument for why banks won’t do all this is because regulators don’t want them to. One of the enduring challenges for the global financial system is to end the corrosive impact of institutions being too big to fail.

The argument is national and global: regulators will continue to push up prudential standards like minimum capital until it is too expensive for banks to be too big. So banks will sell off businesses, pull out of some markets all together, scale down riskier activities. By definition then, they won’t clip the ticket on as much economic activity as they once would have.

That’s true. However it is also true regulators are running a parallel track on making sure risks in the financial system don’t simply migrate from one sector – banks – to another – shadow banks.

While the collapse and near collapse of major banks was one fault line in the financial crisis, another was counter-party risk and the collapse of market makers – involving institutions which were not banks.

What is likely is regulatory pressures will lead to banks being smaller and more specialised but indeed, particularly when it comes to deposit taking and payments, regulators have demonstrated a preference for these activities to reside in extremely tightly regulated and prudentially robust organisations.

Even where governments support the creation of new rivals, such as WeBank in China set up because the existing banks are not lending enough to SMEs, the new institutions tend to be bank-like.

What is emerging – and this is currently the case with Apple Pay – is new participants are partnering with traditional banks, not disenfranchising them. That shows a recognition by banks and others, such as Visa and MasterCard, that start-ups are actually a source of innovation and vitality.

Here at ANZ, one of the most innovative new payment products is FastPay2, a merchant payment application for smart phones developed by South African firm Thumbzup, a text book disrupter.

But Thumbzup founder Stafford Masie, a serial entrepreneur, says it’s a mistake to see disruption as mutually exclusive to traditional banks. “I think what we’ve done too long is underestimate the role of banks,” Masie says. “I think the role of banks moving forward is not disintermediation. I think the role for banks is [taking advantage of the] great opportunity that is presented by technology.”

There is no doubt traditional institutions in many fields are vulnerable to disruption but there is no looming Kodak moment for traditional banks where their major product simply ceases to exist in a viable form. (And remember fellow traditional film company Fuji was actually a leader in digital photography at one point.)

The typical approach to disruption and disintermediation is for a new attacker to see a revenue pool with wide margins they can service at lower cost. That happened with mortgages in Australia in the 90s.

Big data, online distribution, social networks, these all offer the opportunity to undercut incumbents. But large incumbents also have advantages, notably economies of scale, regulatory imprimaturs, lower cost of capital and diversification of risk. Managing and integrating new technology on a wide scale favours institutions with the wherewithal to spend a lot of money – even when they have legacy systems to cope with.

Moreover, consumers – retail and corporate – are not necessarily eager to give up tradition. As Australia steams ahead with tap’n’go and tap’n’PIN payment cards, en route to using smart phones in a similar way, the US market has just backed away from introducing Personal Identification Numbers (PINs) to go with those new-fangled chip cards just being issued. Americans will continue to sign for card purchase although presumably not for ATM withdrawals.

The power of habit and incumbency is an intangible barrier to entry for new players and technology.

But the lesson of mortgages is apt: home buyers can now finance their purchase around 2 percentage points more cheaply than in the past because competition between lower cost mortgage originators and banks eroded margins.

This is the more likely scenario in the future: banks will continue to dominate the major financial markets but in competing with or partnering with non-bank innovators, product costs will come down. And no doubt some institutions won’t make the transition.

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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