The Changing World Of Financial Intermediation

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Three weeks ago I wrote two posts about the changing structure of the banking world, focusing on how the smaller banks were going to be facing a difficult time over the next five years or so, primarily due to changing technology.

These posts can be found here and here.

The conclusion I came to was that the number of “smaller” banks was going to decline substantially in the near future. The economics of the new technology primarily rewards “scale” and the “smaller” banks were not going to be able to keep up with larger institutions because they just could not afford to compete on the basis of the intellectual property and other intangibles that were behind the scale economies.

I also pointed to the fact that commercial banks were going to be facing, more and more, the technological pressures that were changing the “new” Modern Corporation.

Now, McKinsey & Company has produced a report covering the “changing world of financial intermediation” that reinforces the conclusions that I have presented earlier.

McKinsey & Company argues that the financial-intermediation system is changing, and changing dramatically, and these changes particularly threaten the position of the commercial banks within this system.

“The dual forces of technological (and data) innovation and shifts in the regulatory and broader sociopolitical environment are opening great swaths of this financial-intermediation system to new entrants, including other large financial institutions, specialist-finance providers, and technology firms.”

In the view of McKinsey & Company, “the current complex and interlocking system of financial-intermediation will be streamlined by forces of technology and regulation….”

Well, one of the things that will be assisting these forces is the profitability of the banking system as a whole.

The data that McKinsey & Company present show that banking return on equity (Exhibit 2) tanked in 2008, in the middle of the Great Recession in the United States, at around 5.0 percent. This is for the approximately 1,000 largest banks globally in terms of assets.

In the first full year after the end of the recession, 2010, the return on equity moved up to somewhere around 9.5 percent and remained within an 8.4 percent to 9.6 percent range up through 2017.

Note two things. First, for 2007, the year the Great Recession began (in December), banking return on equity was in excess of 15.0 percent. It was even higher in previous years. That is, 15.0 percent, on average, for all the banks in this classification.

Second, a rule of thumb for the cost of capital for these banks is that the marginal cost of capital is around 10.0 percent.

Thus, up until 2008, this group of banks earned a return on capital, on average, that was significantly above the assumed marginal cost of capital of the banks. Economists look at a situation like this and talk about these institutions having a sustained competitive advantage in their markets. This contributes to a stable, sustainable banking system.

But, note what happens. During the period of economic recovery following the Great Recession, these banks did not earn a sustained return on equity that was above their marginal cost of capital.

In other words, the earnings performance of the industry was not sustainable, and many banks were earning a return that did not justify them remaining in the industry. As we therefore saw, the decline in the number of banks during this time period was at the fastest rate since the Great Depression in the 1930s.

The poor performance can be attributed to the low return on assets during this time period. The return on assets of these banks (after taxes) only reached 0.6 percent in 2017, from a level of 0.5 percent in 2012.

In terms of the impact of regulation, the Tier I capital ratio rose from 9.8 percent in 2007 to 13.2 percent in 2017. This certainly had an impact on the average return on equity of the banks.

McKinsey & Company notes that “growth for the banking industry continued to be muted—industry revenues grew at 2 percent per year over the last five years, significantly below banking’s historical annual growth of 5 to 6 percent.”

Valuations dropped in line with these performance figures. Whereas the global price-to-book ratios were in the 2.0 to 2.5 range in the seven years before the beginning of the Great Recession, by 2011 the price-to-book ration dropped to just over 1.0 and then remained in the 1.0 to 1.2 range through 2.17.

“In part, low valuation multiples for the banking industry stem from investor concerns about banks’ ability to break out of the fixes orbit of stable but unexciting performance. Lack of growth and an increase in nonperforming loans in some markets may also be dampening expectations. Our view, however, is that the lack of investor faith in the future of banking is tied in part to doubts about whether banks can maintain their historical leadership of the financial-intermediation system.”

That is, banks are going to have to do something to improve their performance and increase their valuations. McKinsey & Company sees this coming is a vast change to the banking industry and to the relationship between the banking industry and the financial-intermediation system. McKinsey & Company thinks that the “system of financial-intermediation will be streamlined by the forces of technology and regulation into a simpler system with three layers.”

Layer one consists of “everyday commerce and transactions (for example, deposits, payments, and consumer loans). Intermediation would be virtually invisible and ultimately embedded into the routine digital lives of customers.”

Layer two consists of “products and services in which relationships and insights are predominant differentiators (for example, M&A, derivatives structuring, wealth management corporate lending). Leaders here will use artificial intelligence to radically enhance but not entirely replace humans.”

Layer three will be business-to-business, such as scale-driven sales and trading standardized parts of wealth and asset management, and part of origination. Institutional intermediation would be heavily automated and provided by efficient technology infrastructures with low costs.

And, where is Main Street in all this?

The times they are a’changin.’

As with the “new” Modern Corporation that I have been writing about, financial intermediation will also be dominated by intangibles and intellectual property. The economic incentives are already in place to drive the structural changes into the reality of the “new” Financial Corporation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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