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Sep 3, 2019

The Future of Banking

How open banking will transform the financial industry.

The future of banking

As the saying goes, “What goes up must come down.” In this case, the ‘what’ are the stock prices of Swiss full-service banks like UBS and Credit Suisse, which are down 50 to 80 percent since the 2008 financial crisis.

The plight of these banks illustrates the coming crisis of the global banking industry. To use Switzerland as an example, the financial industry is losing ground as its contribution to GDP has decreased from 12.8 to 9.1 percent since the financial crisis. In other countries around the globe, things don’t look much better. Deutsche Bank – probably the most important bank in all of Europe – reported on July 7th that it would lay off 18,000 employees, sending its stock price into freefall. As Deutsche Bank has 49 trillion dollars in exposure to derivatives, a full collapse would have significant ramifications for banks around the world.

It’s Systemic Problems, Stupid

From a systemic perspective, banks have been suffering from a flattening yield curve as well as a zero, or even negative, interest rate environment. While that means banks have to pay less on their interest expenses, margins within their core business have also shrunk. In Switzerland, banks have paid CHF 6.3 billion to the central bank since the institutionalization of negative interest rates in the beginning of 2015.

Banks do still enjoy unabated demand for high-profitability mortgage loans. On average, mortgage receivables on the assets side of banks have risen by 46 percent, while other receivables from customers, such as SME loans, have declined by 14 percent. Banks would rather offer mortgage loans because they are regarded a more tangible security in comparison to loans like SMEs. This results in credit being steered away from financing productive businesses to inflating real estate prices. On paper, everything looks fine, but that trend may result in significant downsides for future economic growth.

Yields in the bond market have also dropped significantly. In Switzerland, the entire yield curve for government bonds is now below zero. Collapsing yields means rising asset prices in return, which is how the zero-interest rate environment has boosted stock markets. As financial market intermediaries, banks have benefited from this asset price inflation as they have experienced a considerable growth in volume.

Nevertheless, their profitability has been declining along with their commissions business. Firms like Robinhood or Etoro have ushered in zero-commission trading. Banks have an increasingly hard time collecting commissions on the issue of new loans and securities. The fact that banks are confronted with dwindling profitability despite rising volumes is the result of outdated legacy systems.

Many banking processes are still manually-controlled, bloated, and inefficient. The scaling of internal processes is bumping against a natural limit. As Citibank has found, 70 to 80 percent of all IT expenditure is spent on IT maintenance instead of on acquiring new investments. And on a personal note, try getting the account number for your credit card from Credit Suisse after they have failed to set up your online banking interface. It’ll takes you several weeks, a gazillion phone calls, and even require you to sign paper documents for an online service!

Although bankers might disagree, the traditional banking sector has stagnated and innovation has slowed. It’s not for nothing that we call our bankers “asset managers,” someone who manages or maintains, not a position known for radical insight and innovation.

The Unholy, Financial Triumvirate

Banks emerged out of society’s need to allocate capital by mediating between borrowers and savers. But contrary to what you might think, banking has never been purely about intermediation between the two.

Banks operate from an inherently fragile business model. They bundle many small and short-term savings deposits into large loans with long maturities, which makes the risk of a mismatch in duration a constant reality. @fernandoulrich has a great thread going into the details of the mismatch dilemma.

As long as they have existed, banks—including investment banks, credit banks, and joint-stock banks – have been involved in credit expansion, which isn’t necessarily a bad thing. Extending credit is actually a vital practice for a well-functioning economy and is evidence of a high trust society. However, there are severe potential downsides once credit expansion becomes institutionalized; in effect, credit expansion incrementally erodes trust, potentially sending an economy into a downward spiral of declining marginal productivity and ballooning credit and debt.

Because credit and capital are inseparably linked, modern capitalism has always suffered from these birth defects. This is not an argument against free market capitalism per se, but a reminder that credit expansion is an inherently risky business. Given that credit expansion is a tight-rope act, a lender of last resort was established that would bail out banks once they inevitably over-expanded. Thus in 1913 the Federal Reserve System was introduced. But this exacerbated the moral hazard and may even have been counterproductive in the long run. Banks, knowing that they can be bailed out by the Federal Reserve, felt free to take on even greater risk.

This isn’t, of course, merely an American story. In the 18th and 19th centuries, banks emerged around the developed world as part of the triumvirate of modern “capitalist” history: the state, the central bank, and commercial banks.

Here’s how the system functions. Corporations, private individuals, and the State ask for credit in the form of various loan instruments; those requests are fulfilled by commercial banks, thus expanding the money supply. Not only does the central bank issue cash and electronic central bank money, it is also responsible for keeping credit relations running smoothly. As the lender of last resort within this triumvirate, and endowed with the sole power over the base money supply, the world’s central banks have an obligation to support the monetary system whenever the economy founders.

Over the last two centuries, this triumvirate has laid the foundation for a steadily expanding money supply and an impressive financialization of global assets. It is to this triumvirate that we owe our current credit system, including the modern equity and derivatives markets. Together with technological progress, the monetary system has led to unbelievable, unprecedented material prosperity.

Banks have played an important role in this. However, they may have reached peak centralization. They have turned from being a great enabler of economic scalability to becoming an ever-greater disabler of the same, as has been highlighted by SMEs’ struggle to get credit – a clear sign of declining social scalability, which is so important for economic and societal well-being. As a result, many business sectors remain un- or under- banked.

Past the Inflection Point

Big banks function like bureaucracies in that both are tightly regulated. Because they act on an international scale in a global economy, both regulatory burdens as well as compliance costs keep increasing. From 2010 to 2016, annual compliance costs with Swiss financial regulations have more than doubled for Switzerland’s financial industry.

As a result, more bankers are openly criticizing the growing stack of rules, since a lot of their time is consumed by dealing with ensuring regulatory compliance. But many banks have adopted an ambiguous stance on the issue since the higher compliance costs gives a competitive advantage to incumbent firms, which are much better equipped to shoulder the regulatory burden then small, upstart newcomers that cannot afford to have a large staff focused solely on compliance and regulatory matters.

There are other hurdles and disincentives also keeping banks from being innovative. Once a bank is listed on a stock exchange, it has little scope for undertaking significant reforms. There are no incentives for its high earning managers to cannibalize their own business in the short-term, even if doing so repositioned them for the long-term.

Because financial analysts tend to be focused on quarterly numbers, launching an innovative low-fee product for example would crash revenues with dire short-term results. The stock price would plummet, something neither the shareholders nor the managers want because their performance bonuses would be slashed. Managers look for other ways to cut costs instead, including sacking employees.

In 2017, Swiss banks employed 93,555 people, which makes it the first time in recent history that the number of people working in the financial sector in Switzerland dropped below the mark of 100,000. Losing one’s job is always inconvenient, but even the remaining employees are suffering for it as their teams become chronically undermanned and the work load increases. As work / life balance deteriorates, the number of burnouts increases.

Adding fuel to the fire is the fact that banks live off of their artificially high nominal productivity. Although the marginal utility from profiteering off credit expansion has been shrinking, banks are still the greatest net beneficiary (besides, perhaps, the state). But that nominal productivity lets banks ignore the customer to a greater extent than if its productivity was closer to reality. A widening gap between the company and its customers is not only bad for the latter, it’s also unfavorable for a company’s employees.

The greater the distance between a bank and its customers, the less it is clear to the employee what his work in the company is good for. Anthropologist David Graeber defined this kind of job as a bullshit job in his book of the same name, an occupation that is so meaningless, unnecessary, or harmful that even the worker cannot justify its existence.

Those working in such terrible jobs may find that their conscience, named by neurologist and psychiatrist Viktor Frankl the “meaning-organ,” has come knocking at the door, complaining about the day-in, day-out lack of meaning. Thankfully, there are innovative startups and fledgling crypto networks that can offer both workers meaningful employment and customers a superior banking experience.

The great unbundling of banks is happening. Amazon is leading the way and other tech companies are following along. Upstart banks likes Revolut, TransferWise, N26, and Monzo are entering the field. In Switzerland, innovative financial technology firms like Viac, Descartes Finance, Yapeal, and Neon have taken up the chase.

Another great challenger to traditional banks are central banks themselves, which have been experimenting with Central Bank Digital Currency or, for short, CBDC. Similarly, to the sovereign money movement, CBDC can be viewed as a tool to cut commercial banks out of the equation by offering citizens a direct account with the central bank. Simon Dixon neatly expands on this idea here, while this article explains why central banks should consider offering accounts to everyone. Obviously, a CBDC would be a huge disruption to commercial banking, both because it would siphon off a stream of customers and revenue and because it decreases the likelihood that the central bank would bail out bypassed commercial banks in any future financial crisis.

In response, the banking industry is attempting to redefine itself by embracing what is called Open Banking. Opening up and standardizing APIs is supposed to turn the banking industry into an open data economy and by doing so foster a cooperative instead of competitive ecosystem. In practice this means that a new banking app, operated by a start-up, can automatically connect to the bank’s relevant client data, feeding that data to its own app thus bootstrapping the services it offers to users.

In the US this is already very much the case. A great example is Nummo, which is a personal financial management platform helping the customer to connect each and every bank account through APIs. In Europe the regulator is pushing for Open Banking with regulations like PSD2. As usual, Switzerland is taking a different route; regulation is not their preferred way of doing things, which is why the Swiss National Bank has been pursuing a more direct access model. Fintech startups can acquire what is called a fintech license, which gives them access to the Swiss Interbank Clearing system.

In this way, new actors are integrated into the Swiss payment system without needing to go through a commercial bank; they will be operating full-reserve banking at the central bank. Since start-ups with a fintech license are not allowed to do any type of maturity transformation, which means they are not allowed to directly manage a client’s money, their current account offering will truly be operated on full-reserve basis. In times of virtually liquid banks, this is a very interesting development.

Will Open Banking be a critical turning point in the ongoing decline of commercial banks? Yes and no. Banks will have to respond by turning into platform aggregators of data. The current state, marked by siloed banks, will transform into an open ecosystem. It seems improbable that incumbent banks will play a major role in shaping the new ecosystems. Tech giants like Amazon appear to be much better positioned to do so.

But not all hope is lost as Martin Stadler, the CEO of Altoo, a Swiss WealthTech company, argues: “Whatever bank offers the greatest API set will have a huge advantage. This implies that banks have the courage to let clients stray. If bank manages to let clients use a foreign service through its own platform, they can still keep their most valuable asset: the customer relationship.”

That direct relationship with customers radically changes most bank’s business model. They will make money by selling good advice and services that have an immediate benefit. Bankers will turn into financial amigos, caregivers, or even chaplains. Here’s an example of how Andy Waar, co-founder of Yapeal, envisions the future: Microservices of all types will be a gigantic business opportunity. Whether you go on a summer trip with our brand-new reflex camera or head to the mountains to ski, you will be able to insure your camera as well as your skis for just the relevant amount of time. You won’t be buying one-year insurance but an actual customized insurance policy for exactly the right amount of time.

When it comes to banking, the data driven business has a huge potential, especially if it is linked with deep, machine learning. However, working with data is a delicate business. As we know from the ongoing scandals involving AdTech companies like Facebook and Google, consumers are fed up with feeling like their privacy and data are being abused. Banks needs to reassure potential customers that they possess data sovereignty and can decide who can receive which data. Primacy in this new style of banking will be won by those organizations which win customers’ trust and as a result receive a critical mass of consumer data, gaining a lasting first mover advantage in the field.

Bitcoin, the Force to be Reckoned With

One additional force to reckon with is Bitcoin and the wider crypto ecosystem, which – in its correct form and interpretation – is open by design and definition.

Swiss banks should fear Bitcoin. For now, the banks are still in first place when it comes to international wealth management. People from all over the world have sought refuge in Swiss bank vaults to protect their wealth from confiscation and other dangers. But Switzerland was a popular destination for global wealth not only for the banking sector’s service and promise of privacy. It was also due to the fact that Switzerland had great political stability originating from its decentralized governance structure.

In addition, up until the turn of the millennial the Swiss franc was equipped with a legal requirement that a minimum of 40 percent of the value of the franc must be backed by gold reserves, which meant that Switzerland was the last major country to run on at least a partial gold standard. The Swiss National Bank has since been forced to take steps to weaken its currency, but at the cost of chipping away at the Swiss franc’s long-lived reputation for stability.

That has widened the opening for Bitcoin to function as a direct competitor to the Swiss franc as well as the Swiss banking system in general. Switzerland might be perceived as a decentralized, politically stable and non-inflationary network, but Bitcoin is growing up to be a neutral, non-centralized store of value with a fixed supply schedule that no human can mess with. Bitcoin might just out-Swiss Switzerland!

In broader terms, Bitcoin might foster the de-institutionalization of banking. Banking is evolving into a set of apps, software, and algorithms. If Bitcoin succeeds in depriving banks of their payment function, their function as deposit providers will also falter. Once you don’t use your bank for payments, you are also less likely to store your money there.

In the age of zero-interest rates, most people’s deposit accounts are also their savings account. If savings accounts are outsourced from banks, they lose their traditional reason for being, which is lending. That will relegate banks to their early historical function as warehouses for gold and other assets, though this time around that will include acting as third-party custodians of private keys for crypto wallets.

In a sense, banks face the fate of the fax machine. As Andreas Antonopoulos points out, fax machines, while dated, are still around, maintaining their niche in old hospitals, backward-looking bureaucracies, and inefficient tax administrations.


 

Thanks for valuable feedback coming from Nic Carter, Yassine Elmandjra, Rino Borini, Andy Waar, Martin Stadler and Urs Bolt.