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There's a revolution — in banking

Like music and publishing, finance is cutting out the middleman 

2 November 2013

9:00 AM

2 November 2013

9:00 AM

In 1925 Winston Churchill, then Chancellor of the Exchequer, famously declared that he wished to see ‘finance less proud and industry more content’. In the light of the financial crisis, much the same refrain has been heard from policymakers and politicians over the past five years. How are we to avoid repeating the mistakes of the past? And how might the financial sector reinvent itself for the future?

I wish to argue there are grounds for optimism. Out of the ashes of the financial crisis a new type of banking is emerging. Old business models are being rewritten and new entrants are driving change. Indeed, it’s possible that the financial sector is in the early throes of a miniature revolution, the like of which has swept through a number of other industries recently.

For the past 200 years or so, the business of banking has been essentially unchanged — let’s call it Banking Version 1.0. This model has fared reasonably well in its core task of providing payment and credit services to the general public. For example, the assets of the banking system, including loans to households and companies, have grown much more rapidly than the economy as a whole. Driven by liberalisation, this ‘financial deepening’ has taken place in two waves.

In the first, century-long wave, between 1880 and 1980, bank balance sheets relative to national income (or GDP) rose on average by around 1 per cent a year. In the second, single-generation-long wave between 1980 and 2007, financial deepening rapidly picked up pace, with bank assets relative to GDP growing five times faster than in the previous century.

Until the financial crisis, this deepening was seen as positive from a growth perspective — companies and households, freed from credit constraints, would be able to finance increased spending and investment, stimulating growth.

As bank credit grew, the contribution of the financial sector to GDP rose in lockstep — in the UK, from 5 per cent in 1970 to 8 per cent by 2007. At the peak, financial markets valued global banks at more than twice the book value of their equity. This was a boom the like of which banking had never previously witnessed.

Financial innovation helped fuel this boom. It was also perceived to have contributed to a near-unprecedented period of macroeconomic stability. Through sophisticated repackaging and exporting of financial assets, risk was thought to have been scattered to the four winds. This was the period of the so-called ‘Great Moderation’ and it lasted for the better part of a generation, from the mid-1980s to 2007. A proud (and richly rewarded) financial sector was contributing to a contented (and richly valued) industrial sector.

That was then. The crisis has fundamentally changed the narrative. Banking pride came before a fall of epic proportions. Peak to trough, the market value of global banks fell by a factor of five, to less than half of book value, plumbing depths last seen after the Great Depression of the 1930s. The Great Moderation gave way to a Great Recession, with output in the UK contracting as sharply and recovering as slowly as after the Great Depression.

And company contentment turned quickly to disillusionment as the credit tap was abruptly turned off, especially for small businesses. Credit growth to small firms in the UK has been contracting for the past five years and counting.

Financial innovation, much vaunted pre-crisis, became a dirty word. Risk distribution was shown to have been a mirage. Repackaged assets, once unwrapped, were found to contain toxic waste. Not for nothing did Paul Volcker, former chairman of the US Federal Reserve, comment in 2009 that the most important piece of financial innovation in the past 20 years had been the ATM.

Yet out of the furnace of the financial crisis a new banking model appears to be being forged. This is part reformation of the old, part revolution of the new.

For the old, massive losses and myriad scandals have laid waste to pre-crisis management and business models among the world’s largest banks. Bruised and beadier-eyed investors have forced up the cost of financing for banks, causing balance sheets to slim and simplify. In 2009 Adair Turner, then chairman of the Financial Services Authority, was widely mocked for discussing the social utility of banking. Today, social usefulness is never far from the lips of any self-respecting bank chief executive.

Both the physiology and psychology of global banking appears to be changing: smaller and simpler balance sheets; higher buffers of capital and liquidity; a more risk-averse and customer- or client-oriented mission statement; and a lower risk-return trade-off for both shareholders and staff. This is back to the future for banking. And financial markets are pricing banks accordingly. Although the market value of global banks is nowhere near its Himalayan pre-crisis peaks, it is back to parity with its equity book value.

Yet more important in some ways, and certainly more dramatic, has been the mini-revolution among new banking entrants. At root, banking is a market in information. Banks are an informational middleman between savers and borrowers. In other industries, including music, advertising, publishing and sales, information technology has had a dramatic effect on the middleman. Think of the impact of Amazon, Google and eBay. They are peer-to-peer models, directly connecting customers, producers and investors through the web. Their business models and profitability have been built on cutting out the middleman.

And how they have built. In 2007, the collective market capitalisation of these three technology firms was around $80 billion, or 8 per cent of the value of global banks. Today it is $310 billion, or 36 per cent of that of global banks. The nerds have struck back. As business revolutions go, this is a big one.

This revolution is now sweeping through banking. Take something as basic as the making of a payment. Web and mobile technology ought to transform this simple task. In a beautiful irony, mobile payments technology was first introduced in Kenya back in 2007. It was born out of necessity, given the paucity of bank branches and dangers of carrying cash in that country. The crisis has since created the wider necessity, and IT the opportunity, to enable advanced economies to catch up with Kenya. Paypal, Google and Square, among others, have arrived on the scene, scenting opportunity. Electronic money and wallets, after many years of being all mouth, are now finding their way into people’s trousers.

Credit to households and companies may be witnessing even more significant change. As eBay directly matches buyers to sellers, so web-based finance companies can directly match savers to borrowers. Over recent years, that has heralded the rapid emergence of new peer-to-peer entrants into most aspects of banking services — consumer financing, foreign exchange, IPO underwriting, invoice financing, small business lending and equity venture capital financing (so-called crowdfunding).

At present, these barbarians at the gate are small and few. But they are growing rapidly in size and multiplying in number. And the cost advantages of the peer-to-peer model means they are wielding superior weapons to those defending the castle. As in music, sales and publishing, customers should welcome this innovation. For them, a squeezed middle-man means a lower cost of finance — lower bank charges for retail customers, cheaper and more plentiful credit for companies.

This revolution could be transformational for many small and medium-sized businesses seeking seed-corn financing. Eighty-five years ago, just after the 1929 stock market crash and four years after Churchill’s missive, the UK government commissioned a report into industry financing chaired by Hugh Macmillan, a Scottish judge. The committee included such luminaries as John Maynard Keynes and Ernest Bevin, and it identified important structural gaps in the financing of small and medium-sized British companies.

Today’s crisis re-exposed those ‘Macmillan gaps’ with a vengeance, not just in the UK but in many advanced economies. The new world of peer-to-peer credit and crowd-funding offers hope that they might, at long last, be durably closed. By improving the diversity of the financial ecosystem, these developments would meet the needs both of regulators such as the Bank of England and of wider society. Diversity, in finance and in nature, improves richness and resilience.

It is not just new entrants adding to diversity. Existing institutional investors, such as insurance companies and pension funds, may also be getting in on the act. One way of doing so would be by creating a robust market in securitisation: the bundling of loans for onward sale. This market is yet to emerge in size in Europe. Financial innovation in the area of securitisation — simpler structures, free from toxic waste — would mean another new financing channel opening up for everything from company loans to student loans. The Bank of England will be helping in this re-laying of the financial landscape.

This is Banking Version 2.0. Two hundred years on, we are probably overdue a technology upgrade in banking. As with all upgrades, there will be teething problems and some customers and competitors will remain wedded to the old model. But if other industries are any guide, change is a when, not an if. The prize is simply too big. Finance may yet do Churchill, and industry, proud.

Andrew Haldane is Executive Director for Financial Stability at the Bank of England.

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