What does the future hold for traditional banks?
The rise of new technologies has allowed for improved mobile connectivity, cloud computing and the ‘Bitcoin’ phenomenon. This has led to an increasingly negative narrative with regard to the future of existing traditional banks. Newer entrants into the financial services realm such as Paypal and Square are seen as potentially successful ‘disruptors’ of an industry facing increased scrutiny and regulatory zeal. Venture capital companies are clamoring to invest in new peer-to-peer lending schemes, with many seeing this as the future for lending into the next decade and beyond.
In our view, the current market narrative which sees new ‘disruptor’ companies replacing the older or traditional banks may, at least partially, be incorrect. It is true that the evolution of cloud technology and mobile connectivity, more importantly, will likely render physical bank branches obsolete in the future and thus bring the current ‘physical’ banking model into question.
On the surface, this may provide an advantage to newer entrants into the banking sector, who now do not need to build an entire branch network from scratch. However, building a large-scale banking organization with the ability to extend loans of hundreds of millions if not billions of US Dollars or any other currency, requires an enormous amount of capital. Quite simply, supporting a loan book of say USD 1 trillion, requires approximately USD 100bn in capital. Even if all the VC companies in Silicon Valley were to combine their capital into a single investment, they may likely struggle to pool as much as USD 100bn in capital.
US Alternative Loan Market Size : CrowdFundInsider
Lending is Capital Intensive
This then is the first advantage that existing and specifically larger traditional banks have over newer entrants. An existing pool of capital can support large-scale lending activities, which is ultimately required to generate substantial interest income. This same customer base of lenders is then also more likely to use the same bank to deposit their money and for other financial services. For any new entrant, despite their technological proficiency, to reach the scale that large established banks have achieved would take many years or require regular and massively dilutive rights issues.
Some may say that peer-to-peer lending platforms would render obsolete the need to have a large pool of capital to support large-scale lending. A major weakness associated with peer-to-peer lending, however, is the risk exposure associated with such lending. Lending that is facilitated through a large bank, effectively allows risk to be ‘pooled’ or spread between the shareholders of the bank, the depositors, and debt holders. This means that as a deposit holder you are very unlikely to suffer a loss on your money deposited with a large bank and effectively lent out to another customer of the same bank. How does one manage risk in a peer-to-peer lending platform where, as someone seeking a return on your money, you may face a total capital loss if the specific lender on the other side of the platform defaults?
A type of insurance model could perhaps evolve, where you could ‘take out’ insurance on your loan on such a platform. But would this be cheaper or generate better returns? The ‘safety’ or security offered by larger banks, both in terms of avoiding fraud and losses on your savings, is a major advantage over smaller or newer entrants. Whilst they may have better technology from the start, the larger banks can ultimately adopt this technology as well or simply buy these new startups.
With the advantage of existing scale and capital, the larger banks can eventually embrace newer technologies to improve their efficiencies, while radically reducing costs. A large bank with 10,000 branches and USD 1 trillion in loans, could theoretically close down all its physical branches and reduce the associated costs while generating the same net interest income from its asset base. The scope for a meaningful upward shift in the return on equity being derived by the banking sector from technological innovation and cost-cutting could, in fact, be quite meaningful over the next decade.
What about Bitcoin?
Some say Bitcoin or virtual currencies could replace the need for traditional banking. Bitcoin is not a currency and can never be a currency as it has no intrinsic value, or if it does it is something which is not consistent or can be reliably estimated over time. The intrinsic value of Bitcoin is either tied to the cost of ‘mining’ a new Bitcoin, namely computer equipment and electricity costs, or it’s regulatory ‘arbitrage value’ for users trying to circumvent the law, exchange controls or launder money.
Some would say that present day money does not have any intrinsic value either. This again underlines a vital misunderstanding of the nature of money and the present day financial system. Money that we use today is ‘credit money’ or in essence IOUs. Very simply the loans created and extended by banks to their customers become IOUs which we then use as money in the economy. These IOU’s are theoretically, albeit indirectly, backed by the cash flows and assets that borrowers from the banking system have used as collateral to obtain these loans in the first place.
Is it a perfect system? Probably not. Winston Churchill once said that democracy is not perfect either, but it is the best political system we have available. Similarly, the modern-day FIAT monetary system is the best system available to us at this time. Credit is inherently contractionary in nature as it has to be paid back and with interest. This means the system can never be stable and can be at rest for only for fleeting moments. The total amount of credit and therefore money in an economy will therefore either be growing or contracting which are inflationary and deflationary trends respectively, a dynamic which creates inherent economic volatility. It does, however, offer an elastic money supply, which then allows for the given demand for money at any point to be met at all times without wildly fluctuating interest rates.
Under a gold standard, the supply of money would essentially be fixed in quantity and therefore inelastic, ultimately resulting in deflation under such a system. The demand for money fluctuates exogenously of interest rates as it is also dependent on many factors such as investment cycles and demographic trends etc. Interest rates fluctuate accordingly, thus creating, even more, economic volatility than under a FIAT monetary system with a Central Bank acting as lender of last resort.
For a similar reason, apart from its intrinsic value being hard to quantify, Bitcoin can also not act as an efficient economy-wide monetary unit of exchange. Its supply is largely fixed or grows very slowly dependent on how many ‘new’ Bitcoins are being mined. There is no doubt however that the ‘Blockchain’ technology that underlies Bitcoin is powerful and potentially revolutionary. This technology could, in theory, make traditional payment systems and payment intermediaries obsolete outside of banks.
Blockchain Payments
This will impact substantially on the whole existing payments eco-system and value chain and in theory would allow for transaction costs to be significantly reduced. While this is very negative for companies that rely exclusively on payment processing or transaction processing for their revenues, it could potentially further substantially reduce transactional costs for traditional banks. The technology will not replace banks since people will still require credit, financial services, and a place to perhaps park you excess savings and earn a return on it. Larger banks with scale for all the reasons already cited, have an advantage in this regard.
A view of the future
Existing larger banks that can move quickly over the next decade to embrace new technologies and effectively shift to a ‘virtual’ banking model, will have the opportunity to earn roughly similar levels of interest income. They would additionally be in a position to substantially reduce their operating costs by eliminating physical branches and possibly also transactional costs by adopting the Blockchain payments or transactional technology, likely in a co-operative platform with other banks. Banks certainly need to undergo a technology transformation, but their place in the financial ecosystem would appear assured.