Market structure, Regulation and Low interest rates
Banks always used to be the primary source of debt for companies. The advent of bond markets has changed that scenario and today large corporates never approach a bank for loan. A firm like Apple issues bonds and raises the required capital. So the market structure is something that has changed forever and there is nothing that can be done about it.
The aftermath of 2008 financial crisis saw banks suffering a huge backlash from the public and they were viewed as the villains. This resulted in new regulations like the Dodd-Frank Wall Street Reform and Consumer Protection Act being enacted, which lowered the ability of banks to take risk.
The updated Basel norms resulted in higher capital requirements and it raised the cost of operations permanently, while reducing profitability. Another major event which impacted banks was QE (Quantitative Easing) as economies were flooded with money from major Central Banks and this diminished the role of banks as an intermediary.
In Silicon Valley, the start ups that attract most attention these days are those related to financial technology. Many of those start ups aim to transform banking through innovations like block chain, marketplace lending, crypto currencies etc.
The kind of threats that banking faces from multiple points is mind boggling. Case in point is blockchain based innovations and digital currencies which can disintermediate the world of payments. Even otherwise, mobile as well as real time payments are posing a threat to the role of banks.
Venmo, Now owned by Paypal, in recent years has emerged as one of the most popular apps for electronically transferring funds from one person to another person. Venmo eliminates the need for ATM/credit cards. The reason why it is popular with millennials is because of features like payment splitting. For example, tenants who share a room can send their part of rent to the landlord through the Venmo app. Currently this app has 52 million users in United States.
Technology has reduced the entry barrier for new innovative players and the regulation for them is also relatively lax. For example, Robo advisors and AI (Artificial Intelligence) based wealth management products are today available which nullify the need for mutual funds or an investment advisor from bank.
The Covid-19 pandemic and social distancing norms have resulted in a surge of digital transactions. Millennials already prefer the digital channels to traditional branches and many have never ever visited
a physical branch. Currently, people belonging to older generation also have experienced digital banking for the first time and they are unlikely to return to traditional banking.
This reiterates the need for banks to invest more into technology.
Will banks survive?
Banking as an industry does face a real threat from new trends. In general, banks are complex organizations due to the multiple roles that they perform in the economy.
This needs to change and they need to reduce their organizational complexity by changing their business as well as operating models. Banks need to change their current structure and should have a sharper focus on customer experience. This is important as research suggests that customers will change the change banks just for the sake of a better mobile banking experience.
This means banks will have to reduce manpower and number of physical branches. But the human element in banks will be important when it comes to complex investing, mortgages, insurance or other products.
This offers traditional banks an advantage over other institutions that offer only a digital only service. Nonetheless, it is important for banks to offer the most advanced technological products through their platform.
From a macro perspective, banks are still needed as trusted custodian of public funds and the excessive regulation means new players will find it tough to enter the segment.
General public will always prefer to park their funds with a regulated institution rather than an unregulated one. And just being a custodian of funds will provide banks with a lot of data that are not available to others which should in turn enable them to take better decisions regarding whom money should be lend to.
Or in other words, Banks will still be the most efficient capital allocator and they will not only survive but thrive.
How long will it take for banks to reclaim their previous glory?
Analysts forecast that losses from bad debts in major US as well as European banks are likely to rise to $880 billion by the end of 2022. In stock markets also, banking shares have underperformed.
Investors don’t see banks returning to Pre-covid profit levels in the next few years with negative interest rates in Europe and near zero interest rates in United States. Net Interest Margins (NIM) of banks are likely to stay compressed.
A study of Diversified Banks category in United States offers some interesting lessons. The RoA (Return on Assets) of these banks had rose from 0.3% in 2008 to 1.2% by the end of 2019. In 2000s, the peak RoA was 1.4% in 2004 or it never reclaimed the peak after the crisis in 2008.
By that yardstick, we might quite far away from banking sector returning to Pre-covid era profits. Capital buffers which are at almost five times the 2008 level will help banks survive this crisis and they will continue to play an important role, but it will be some time before they reclaim their past glory.
* Any opinions expressed in this article are the author’s own
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© Opinion 2020