Gradually then suddenly - the future of banking

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

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That’s from Ernest Hemingway’s 1926 novel, The Sun Also Rises.

"Where a grain landed in green, little impact was likely, but one falling in red could trigger a slide - and potentially a chain reaction of slides.”

It captures a perception deeply embedded in human experience. When a catastrophe happens, it is sudden. But with hindsight, the warnings were long evident.

We see this theme echoed in technology, with Roy Amara’s famous dictum: “We tend to overestimate the effect of a technology in the short run and underestimate the effect in the long run”.

So too with the idea of tipping points.

Is banking in the gradual phase or is the sudden one imminent? Are we at the point where we are underestimating the long term impact of fintechs or artificial intelligence or machine learning or data harvesting and manipulation – while we obsess over each new startup?

We never know when the actual tipping point is until it happens.

Critical moments

Banking in 10 years, even five, is going to look dramatically different to today. Remember – it’s barely more than a decade since the iPhone appeared and today mobile banking is the most pervasive channel for accessing services.

In many markets in Africa, it is the only way to bank.

What will be the critical moment? Bigtech? Amazon’s forays into financial services continue. In China, payments are already unimaginable without bigtechs Tencent and Alibaba.

Will it be government policy? A major contributor to the 2008 global financial crisis (GFC) was the decision to repeal the Glass-Steagall Act, introduced after the Great Depression to isolate retail banking from higher risk investment banking.

Post-GFC hindsight brought back a version of Glass Steagall. Now, under Donald Trump, with the GFC scars yet to heal, that safeguard is again being wound back….

The point

The banks we have today have been shaped by global regulation, facilitated by the Bank of International Settlements, which through four waves of its Basel program has determined the relative value of different assets using “risk weights”.

For example, the relatively light risk weight applied to residential mortgage assets in recent decades has meant more banks – especially in Australia – have shifted emphasis away from business towards households.

So what of 2019? Have we seen developments which, with hindsight, we may look back on and say “that was the point?”.

Science gives us an insight into this – although it doesn’t tell us the answer. In the discipline of “power laws” the state which exists prior to a massive change is called the “critical state”.

As Mark Buchanan writes in his book Ubiquity - The Science of History, there is no "typical" catastrophe – be it an avalanche, landslide or market crash.

Studying what happens when sand grains are piled up until the edifice collapses, he found some collapses “involved a single grain; others 10, 100 or 1000. Still others were pile-wide disasters involving many millions that brought nearly the whole mountain tumbling down. At any time, literally anything, it seemed, might be about to happen."

Buchanan writes that such was the situation in the 1987 stock market crash.

"Some argued that computer trading was to blame, and that once the problems were fixed it could never happen again. But recent mathematical research suggests that sudden upheavals are far from highly unlikely. In fact, they may indeed be inevitable."

His research showed power laws held across multiple human endeavours and market situations.

"But how can this pattern operate when the market is made up of thousands of people making individual decisions?” he asked. “The same mathematical footprints can be found in many other areas of human endeavour."

The sand simulation colour coded the pile, from green for shallow slope to red for steep. As grains were added, fingers of red began to striate the pile. Where a grain landed in green, little impact was likely, but one falling in red could trigger a slide - and potentially a chain reaction of slides.

Sudden change

When we look at industries, underlying the complexities is the insight of the power law – even relatively insignificant events adding up until there is sudden change.

The media industry is a classic case study. The old triumvirate of print, radio and television appeared solid. Then the internet arrived, then social networks evolved, then data harvesting became both ubiquitous and sophisticated. In a market where incumbents thought they were impenetrable – until audiences and advertisers deserted them.

Where is banking? In 2019 there were the seismic forces of the economy, technology, regulation and competition. Some might argue customers override all but customer demands are a factor of innovation and competition.

The economy is an overarching force. Banks are a leveraged play on economic growth. With developed economies globally moribund and Trump’s trade war undermining activity, revenue growth relies more and more on winning market share and lowering costs.

For example, in the European Union, long term negative rates, slowing economic growth, Brexit and burgeoning regulatory requirements have seen major banks cut staff numbers by a fifth since the GFC.

No defence

Regulation – be it on behaviour or capital – will reshape institutions. How much leverage will regulators and policy makers allow banks to have? It is getting less - as new capital requirements demonstrate.

How can bankers be remunerated? Human capital is a finite resource and is subject to the same market forces as anything else. Remuneration will shape who works where and how they work and what they focus upon.

How will banks respond to broader social issues and climate change?

Consider what the Australian Financial Services Royal Commissioner Kenneth Hayne said recently regarding company law:

“Directors must act in the best interests of the company. ‘Best interests’ is not one-dimensional - it is not determined only by share price movement or ‘total shareholder return’ over a period,” he said.

“’Best interests’ does not present a binary choice between the interests of shareholders and the interests of others (customers, employees or society). The longer the period of reference, the more the interests of all affected by a company's actions will converge in pursuit of the long-term financial advantage of the enterprise.”

“Second, international opinion is now firmly behind the need for all entities with public debt or equity to respond to climate change issues in their governance, their strategy, their risk management and their metrics and targets and, importantly, to record their responses to the issues in their financial reports.”

Hayne was blunt: the kind of relativism which conflates science and “belief” is no defence in the face of the law.

New bank

Or consider technology.

CB Insights’ latest analysis of Amazon’s financial services strategy is a stark reminder of the potential scale of new competition utilising an armoury of innovation. Bigtech won’t attack banking with a “new bank”.

“It’s hard to claim that Amazon is building the next-generation bank,” CB Insights said. “But it’s clear that the company remains very focused on building financial services products that support its core strategic goal: increasing participation in the Amazon ecosystem.

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Source: CB Insights

This means Amazon built and launched tools that aim to increase the number of merchants on Amazon, and enable each merchant to sell more; increase the number of customers on Amazon, and enable each customer to spend more; continue to reduce any buying/selling friction.

None of this - the tech, the regulation, the competition, the environment - in itself spells the end of banking – but which is a new grain of sand falling in the “red zone”?

Another lesson from power laws is that even if we can never know in advance the fatal grain, the more grains are added, the more likely dramatic change is imminent.

And 2019 was a year in which many grains of change were added.

Andrew Cornell is managing editor of bluenotes

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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