Talk to dinner guests of Hall & Wilcox, lawyers, in association with the Wheeler Centre, Melbourne - Wednesday, July 29, 2015 in Sydney & Tuesday, August 4, 2015 in Melbourne
I’ve been invited to talk to you about the future of banking and finance which, being a journalist, I’m more than happy to do. As a great newspaper owner from the Victorian era, Lord Northcliffe, once said, journalism is a profession whose business is to explain to others what it personally doesn’t understand. I know a fair bit about the economy, a fair bit about budgets and monetary policy and a fair bit about the news media, but I’m no expert on banking and finance, and I’m certainly no techhead.
In preparing for tonight I faced two choices: I could give you a gee-whiz job about all the radical, amazing, frighten changes that are about to engulf us, or I could give you the benefit of the views of grumpy, somewhat cynical old man who’s been watching banking and finance from the sidelines for 40 years and, in particular, watching the process of economic and social change over that time. You can’t be a commentator without being a student of change. I’ve decided to give you a bit of both, but less of the gee-whiz and more of the sceptical old fart.
But before I get into it, let me say this: it never ceases to amaze me that people never tire of asking economists - or, in my case, economic journalists - to tell them what will happen in the future. They keep doing this even though they know full well that economists are hopeless at forecasting. Why? Because as humans we’re addicted to the desire to know what the future holds so we can do something about it: stop it, sidestep it or exploit it. Psychologists call this humans’ “illusion of control”. We have an ingrained belief that if we can find out what’s coming up we can control what happens to us. It’s an illusion, of course. No one knows what the future holds and our ability to change it is usually a lot more limited than we imagine.
It’s because our desire to know and influence the future is a product of our evolution as a species that no amount of bum forecasts in the past deters us from asking for another forecast. So let me oblige. But rather than getting down to a few sexy, gee-whiz examples, I’m going to give you a more top-down, analytical view.
Around the world, and in Australia, banking and financial markets have been changing continuously since the early 1980s - that is, for about 40 years, because of the interrelated forces of globalisation (including the increased integration of the world’s financial markets), changing attitudes to regulation (first deregulation and now a degree of reregulation), and technological advance (particularly greatly reduced costs of telecommunication and of the collection, analysis, transfer and storage of information).
The practice of banking involves “intermediation” - taking deposits from savers and lending the money to investors - and “maturity transformation”: borrowing money for short periods or at call, but lending money for long periods of up to 25 years. Australia’s banking system, like most countries’, has long been dominated by a small number of very large banks, engaged in providing the full range of financial services: facilitating payments, taking deposits and making loans, providing investment advice and the management of assets, and actively participating in most financial markets, for short-term money, securities, foreign exchange, shares, derivatives and so forth. Why is banking so oligopolistic? Because of high barriers to entry arising from economies of scale and the high cost of information.
At this point the main sources of change in banking and finance are, first, continuing changes in the regulation of banks and other major financial players as governments and financial regulators seek to prevent another global financial crisis and, second, continuing innovation as entrepreneurs seek to exploit the opportunities and greatly reduced information costs created by the digital revolution.
The main question we’re considering - the main imponderable - is the extent to which changes in regulatory requirements and in information costs will reduce the barriers to entry, break down the banks’ dominance in the provision of financial services and lead to a flowering alternative suppliers of those services.
The international regulators’ efforts to raise the capital and liquidity requirements imposed on the world’s banks will reduce their gearing and thus, as they frequently complain, increase their costs of intermediation. Whether these greater costs will be borne by the banks’ shareholders or passed on to their customers will be determined by the strength of competition in the relevant markets. But, either way, the higher cost of intermediation will make the banks vulnerable to unregulated suppliers of financial services. As witnessed by the growth of Australia’s corporate bond market, our big corporates are already borrowing directly from the market rather than from banks, and this practice is likely to move down to medium-sized corporates.
Of course, to the extent that the costs of tighter capital requirements shift transactions from the regulated to the unregulated sector, it will frustrate the regulators’ efforts to reduce the risk of another financial crisis. But don’t underestimate the regulators’ ability to fight back by using the digital revolution’s huge reduction in the cost of gathering and analysing financial information to impose much greater disclosure of transactions of non-banks as well as banks (see the speech by Andrew Haldane and others at the Bank of England, in March 2012).
At last we’re up to the sexy bit: all the amazing new products, and opportunities and new players that are likely to emerge as digital disruption reaches banking and financial services. As a journo I do know something about the way the digital revolution is hugely disrupting one industry after another, changing their face for ever. Whatever scepticism you may hear from me, be clear on this: I don’t for a moment doubt that major digital innovation is coming to banking and financial services.
For a full list of every presently conceivable innovation that may possibly disrupt banking as we know it, I refer you to the report on The Future of Financial Services, prepared by Deloitte and others for the World Economic Forum in June this year. But picking out the highlights, in payments system category we have mobile money and digital wallets, such as Apple Pay and Google wallet. This will continue the reduction in the use of cheques and cash, increasing the efficiency of the payments system to the benefit of all, but without much disruption to the banks. We can perhaps reduce the involvement of banks in the making of payments, but I don’t see how we can get away from holding our money in banks. If so, there’ll be a bank somewhere at either end of the payment, even if the transfer isn’t actually conducted by a bank.
Of course, we could keep our money in “crypto currencies” such as bitcoin, but so far the only people doing so seem to be crooks and a few geeks who love trying anything new. If you go back far enough you find we have a history of non-government money - of banks issuing their own banknotes - and it wasn’t a happy one, hence the ultimate outlawing of private money. Apart from any risk benefits from a government monopoly over the issue of fiat money, remember that governments and their central banks benefit greatly from seigniorage.
Turning from payments to intermediation, we come to peer-to-peer lending. The main point here, I think, is that you don’t need to be a bank to match a person or company wanting to lend a certain sum for six months or five years with a person or company wanting to borrow that sum for the same period. Nor do you have to be a bank to assess borrowers’ credit worthiness using advanced software. But matching is not intermediation; it’s not standing between the depositor and the borrower so that the depositor’s claim is against a big, regulated, virtually government-guaranteed bank, not against some puny borrower. Similarly, matching is not maturity transformation; it’s not using a thousand at-call deposits to issue one 20-year loan. Both intermediation and maturity transformation involve taking risks. If a digital upstart doesn’t take on those risks there wouldn’t be many people wanting to lend through them rather than a bank. Certainly, not after the first time the economy had turned down and caused many borrowers to be unable to repay their debts. Were the digital upstart to take on those risks it would either have to lay them off to a bank, or with help from a bank, or it would itself become a virtual bank - in which case it wouldn’t be long before the bank regulators began regulating it.
Turning from intermediation to investment management, much of which is done today by bank subsidiaries, it’s not hard to see that digital upstarts could have success in offering automated, and hence cheaper, advisory functions and actual asset management. But one question is how many punters - or even businesses - would be happy to hand their savings over to a financial robot rather than a human with a good bedside manner.
Summing up, it’s clear that digitisation gives new entrants to the financial services industry the potential to greatly reduce the costs of gathering, processing and transferring financial information. They also have the potential to create valuable new information from the analysis of that financial information. And they have the advantage of having no legacy assets or attitudes.
By the same token, incumbency also carries some advantages. The banks have deep pockets to match the upstarts on the digitisation of financial information or to buy out or copy innovators that succeed with new tricks. And they have a record of being early adopters of improved technology.
But banking is very different from news or books or records or shopping for sneakers. Banking is much more about managing of various forms of risk. And to me the key question is whether digital innovation offers any great advance in the management of risk in addition to its advantages in the management of information. If it doesn’t, I doubt if it will get far. If it does, the banks really will be given a run for their money. But remember that the regulators’ primary concern is systemic risk - the ability of failures in the banking system to inflict great damage on the rest of the economy. So if the digital upstarts do become bank-like - the banks you have when you’re not having banks - I don’t imagine the authorities would waste too much time in starting to regulate them as banks. Bill Gate’s famous saying that “we need banking but we don’t need banks” is a non-sequitur. Any rival outfit that steals the banks’ core business itself becomes a bank.
Now, at last, we come to the part where the grumpy old man comes out of his cave. People have been predicting the demise of the big banks since the advent of financial deregulation in the 1980s - so far to no avail. Can you remember when the entry of the foreign banks was going to do in our local banks? Can you remember when deregulation and the emergence of superior specialised rivals in the provision of particular financial services was going to dismember our big universal-provider banks? So far, whatever the challenge, our big four have gone from strength to strength. Moral: don’t write them off too cheaply.
Next, if you want advice on what the future holds for banking and finance, my advice is that you’ll do better talking to economic historians and the students of earlier waves of major technological innovation - from the railways to electricity to the internal combustion engine to radio - than listening to futurologists and tech-heads. One thing the students of economic history will tell you is that it can take decades for the full commercial potential of major advances to be uncovered and implemented. Another is that the hundred or more start-ups determined to make a killing out of producing automobiles (or whatever) will eventually pack down to just a handful of big, successful, long-lasting corporations - GM, Ford and Chrysler - but until the end it’s impossible to predict who the victors will be.
Even in terms of which gee-whiz new ideas will survive and prosper, and which won’t, the futurologists have a list of failed predictions as long as your arm. They impress us because they seem to know so much about the new technological wonders just over the horizon, but this is their downfall: they love the technological and they love novelty. What they don’t know much about is human nature. Consequently they fail to make the key distinction between what new technology could do for us and what we’ll want it to do for us. Only the stuff we want - the stuff that fits in with human nature - will survive and prosper. Consider the lack of interest in telecommuting. Or the continuing concentration of the financial markets despite the move to electronic trading. Predictors must never forget that humans are intensely social animals. We like to be with others. Urban economists studying the increasing concentration of GDP - value-adding - in CBDs are realising that we learn from being in contact with others. It seems conference calls, even Skype, are a poor substitute for face-to-face contact. MOOC - massive open online courses.
Next, what drives technological change is competition and the desire for profits; business outsiders trying to steal a march on the incumbents, or insiders on their fellow incumbents. I remember Bob Gottliebsen before the Tech Wreck banging on about the huge profits to be made from B2B. But if you study the major technological advances of the past you soon realise that what starts as business people out to make a killing ends up delivering its greatest benefit to customers. The way it works is that any player who comes up with a really successful innovation will soon be copied - by other outsiders and, eventually, by the incumbents- which forces down prices and profits, and shifts the benefit to customers. Apart from any history, I know this from the digital disruption of classified advertising in newspapers. The users of classified ads for houses, jobs and cars have ended up with an infinitely better product for a fraction of the price of an old newspaper classified.
This process by which well-functioning market economies deliver the benefits of digital disruption and other technological change to customers rather than capitalists is one of the great attractions of capitalism. Which is why, though I’m uncertain how much digital disruption will do knock the banks off their perch, I am confident the new or improved products we end up with will be of great benefit to the users of financial services.
