Banking as we know it

I make forecasts of the future of banking with caution. One need only recall the many eulogies that experts had written for banks during the early 1990s to justify this humility. Of course, skepticism about the future of banks did not appear unjustified. Bank failures had increased to levels not seen since the Great Depression, and oft-cited data revealed a long-term decline in banks' share of assets held by financial institutions. But economists with the Federal Reserve Bank of Minneapolis, among others, found that the death of banking was greatly exaggerated. They concluded that after correcting for both the mismeasurement of foreign bank loans and the exclusion of off-balance sheet activities, any evidence of a substantial decline in commercial banks' share of intermediate assets vanishes.

The record profitability of banks in the Ninth Federal Reserve District and the nation as a whole over the last several years has made claims of demise appear even more off base. The valuations put on banks across the country by the stock market, and as revealed through acquisition prices, suggest that banks have significant worth.

Nonetheless, I think a reasonable case can be made that the long-term future of banking is not particularly bright, if we think of banks as we have traditionally known them. As we observe them today, traditional institutions are in for a struggle.

There are essentially two reasons for my view of the future of banking. First, the unique franchise of banking has eroded and will continue to do so. Changes in technology, together with advances in the theory of finance, are partially responsible for this. Second, two important characteristics that set banks apart—direct participation in the payments system and safety net coverage—may not persist in their current form.

Changes in technology

Technological progress in the fields of information processing and asset valuation/risk measurement have brought down the cost of credit quality evaluation such that capital markets can now finance an increasing variety of previously illiquid loans. Securitization of assets, beginning with consumer loans, moving to commercial real estate, and now creeping to small business loans, has increased liquidity. New technologies, such as credit scoring, may be an important factor behind the further spread of securitization. In any event, it is clear that commercial loans are taking on securitylike attributes. As a result, demands for credit are being met by a wide, and expanding, range of institutions engaged in origination and/or portfolio investment. Similar technological initiatives also allow nonbanks to provide increasingly close substitutes for bank liabilities. Among other things, this implies that banks, relying on traditional funding sources, will have to pay up for such deposits or watch a core funding channel decline.

Payment systems and the safety net

Most of the new payment instruments and systems one can envision will still settle with bank balances, but this fact may become less important over time in terms of what it says about customer services, relationships and revenue. A software firm, for example, may provide more of the value-added and take a greater share of the revenue from new forms of electronic payment than the bank that settles the transaction.

As for the safety net, as a matter of public policy Congress should rein in federal insurance of bank deposits and encourage more market discipline of banks. There are a number of respectable proposals to reform deposit insurance, including the Federal Reserve Bank of Minneapolis' proposal that would make banks subject to increased market forces by requiring uninsured depositors at the nation's largest banks to bear losses upon failure.

My contacts with community bankers suggest a great reluctance to support any change to deposit insurance, including our limited plan, in the belief that modifications will reduce the competitive position of community banks. While this is not the forum to debate deposit insurance reform, it is important to understand that our plan actually levels the playing field for small banks. Banking law that we want to reform effectively allows 100 percent coverage of uninsured depositors at the largest banks. In contrast, the FDIC has increasingly imposed losses on the uninsured at community banks since 1992.

Wide Range of Options

This perhaps sobering view of the future of banking is positive, nevertheless, for bank customers. This is because the changing nature of the financial services industry allows it to meet the demands of customers, large and small, at competitive terms and conditions. Moreover, this assessment need not augur poorly for bank employees. These employees provide valuable services—evaluation and management of risk, clearance and settlement of payments, administration of loans, investment of funds, and so forth. Demand for these skills and services will persist.

The harder question to answer concerns the organizational form in which these skills and services will be deployed over the long run. Certainly, community banks meet a significant demand, and banks that look very much like the community bank of today will remain. But it is easy to imagine new breeds of banking institutions. Some banks may become similar to their nonbank competitors and focus on the origination and sale of loans. Others may concentrate on business and financial consulting with specific types of borrowers, such as farmers, with which they already have credibility. Even the bank which keeps its traditional form may have to serve a niche clientele, such as those with lower credit quality or in unusual and specialized businesses, due to increased competition in and commoditization of standard banking products.

Conclusion

My view, in short, is that banks as we know them are facing a rough competitive ride. Technological progress, and the ability of all sorts of institutions to capitalize on such progress, contributes to this. Moreover, I question the extent to which the special role of banks in payments will continue to translate into a special relationship with customers. The safety net, unquestionably of considerable value to banking, is in a sense a double-edged sword and, in any event, is in need of judicious reform. Interesting, perhaps exciting, times lie ahead.

This article originally appeared in the Northwestern Financial Review.