The forces reshaping banking
Business Standard, 25 December 2023
In advanced economies, banking is changing. At first, there was `the fintech revolution', the idea of doing things that were traditionally done by banks through new kinds of firms. Now we have seen the loss of stability of bank liabilities through electronic payments. The third problem is the possibilities for important trusted technology-intensive consumer-facing firms to replace banks. The centrally planned Indian financial system has largely held these elements at bay.
A great thinker, Arnoud W. A. Boot from the University of Amsterdam, did a talk at the recent 14th Emerging Markets Conference, on the place of banks in modern society. These ideas are summarised here. They raise questions about how the Indian story might unfold.
The problem
The economist Merton Miller famously described banking as a `disaster-prone nineteenth century industry'. There is much outrage when taxpayer resources are used to recapitalise banks. There has been a long-standing process of trying to solve these problems. The thinkers fall into two camps: Those who believe that banking regulation and resolution can (finally!) be made to work correctly, and those who believe that the only safe path lies in having a smaller role for banks in society. Into this debate, there have been three disruptions.
I. The fintech revolution
The first big idea was the `fintech revolution'. Firms that are not banks can increasingly do things that were traditionally done by banks. As an example, it is feasible, through modern technology, to build firms that do payments, or home loans, or vehicle financing, etc. These firms can go directly into the bond market, either through direct bond issuance or through securitisation. Fintech firms were traditionally cutoff from the information that banks had about their customers, and from the payments system, but were better at building IT systems and processing some new kinds of information.
The fintech revolution began in about 2005 and gained momentum when advanced economy regulators created greater space for non-banks. The big idea in this field is to remove the informational advantage of banks through `open banking'. This involves state coercion of banks, in favour of considering information about a customer to be the property of the customer and not the bank. This has started getting traction in the UK and the US. The Indian work on the `account aggregator' framework similarly offers API-based access to information about a customer to non-banks. While these developments involve open protocols (which are true `digital public goods'), it is important to avoid the toolkit of government monopolies, protectionism or coerced use, that Indian state intervention often slips into.
II. Unstable demand deposits
The second big idea unfolded with the demise of Silicon Valley Bank. Once consumers have electronic payment systems, banks runs can proceed faster and are unabated on the weekend. This disrupted the old ideas, where runs unfolded at the pace of a queue, and the weekend was a pause on which the bank could organise liquidity to defuse the run on Monday morning. The economists running risk management in every bank worldwide understood that demand deposits were more unstable, and modified their assumptions about core vs. volatile, which are used in risk management models. This development improves the viability of non-banks as opposed to banks, as a competitive advantage of banks (stable cheap demand deposits) is diminished.
III. Owning the consumer
While fintechs have taken away pieces of the activities of banks, banks have remained the owner of the customer for a checking account and a flow of related activities. The brand names of banks are writ large on the minds of consumers.
That could now start changing. Firms like Google, Amazon and Apple now command the connection to every consumer, and a corpus of trust through long years of good behaviour. The big technology firms have better knowledge of IT. So, we now get developments such as Apple launching savings accounts in the US, with a 4.15% interest rate.
Google long had a slogan "don't be evil", and Apple refused one FBI demand for data. Most consumers have a greater trust in, and awareness of, a firm like Google as compared with their banks.
Further, these firms command a remarkable depth of information about the consumers. While the fintech revolution involved new firms trying to access information inside banks (e.g. through open banking), these new rivals possess superior information about the customer when compared with banks.
Conclusion
This is the contemporary strategic sense about the future of finance. There are those who believe that repeated failures in banking regulation can be overcome by building a better banking regulator. There are those who would like to derisk society by reducing the reliance on banks. The `fintech revolution' was about doing bank-like things in non-bank firms, through IT innovation and ideally access to data inside banks, and then connecting this up to the bond market e.g. through securitisation. The moat of stable demand deposits of banks has diminished through the greater flightiness of customers. And now, there are firms with superior trust in the eyes of consumers, who can own the customer.
The business model of banking involves fragility. Corporate culture, shaped by regulation and entry barriers, has made banks weak in understanding customers, in innovation, and harnessing the wonders of computation and statistics. This has created important opportunities in the hands of the new players (fintechs and IT giants) who can do technology better than banks, who are steeped in modern statistics knowledge, and can amass informtion sets about borrowers that are superior to those controlled by banks.
In India, we watch these developments with wonder, much like the way in which we watch drone warfare in Ukraine. The Indian banking industry is roughly where the advanced economies were in the late 1960s. After decades of difficulties in financial reform, Indian banking is doing well on consumer finance and failing on funding firms. The fintech revolution was marred by state coercion that blocked non-banks from the payments system and from many bank-like activities, and by the difficulties of the bond-currency-derivatives nexus and securitisation. Many kinds of protectionism inhibit foreign companies from operating in India. The prevalent policy strategy in finance inhibits the capabilities of Indian finance, i.e. the translation of the investment/GDP ratio into the GDP growth rate.
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