The Future of Banks: Dinosaurs or Adapt

Blain’s Morning Porridge – 29th March 2023 – The Future of Banks: Dinosaurs or Adapt

“Dinosaurs are extinct today because they lacked opposable thumbs and the brainpower to build a space program.”

This morning: The current crisis (?) is another step in banking’s progress towards an evolutionary dead end. The future doesn’t need banks. It will need smart risk takers, and new ways to originate and distribute risk.. an opportunity for banks clever enough to evolve!

There are massive changes underway to how capital markets function – yet vast swathes of the current financial ecosystem seem to have little awareness of what is coming their way. One thing I can confidently predict is banks will become less and less important in driving financial markets.

Harsh? Not really. Everything evolves. The role of banks as risk takers and financial provides has utterly changed in the 4 decades I’ve worked in markets – change accelerated in the deluge of regulations that followed the collapse of Lehman in 2008.

Banks are no longer the sole risk takers, risk facilitators, or risk distributors – but, as the current ructions have highlighted, they represent a bottleneck within the financial system. They have a critical role in the processing of financial transactions – the flow of money, but do they need to be the venue for transactions anymore? Not really.

There are three processes underway that will end the evolutionary niche of the current conventional bank:

• Decentralisation of financial markets – making them less risky to systemic events
• De-risking banks through regulation – a process likely to be given further impetus by the current banking wobbles
• AI – new ways of processing and administering risk, payments and title.

Some banks will evolve into something new. Others will be… well think Royal Mail or the Brontosaurus.

The current “wobbles” across the banking sector provide hints on what’s next. Three weeks ago it was a liquidity event that crashed Silicon Valley Bank as depositors fled the bank, followed days later by the collapse of confidence in Credit Suisse leading to a “rescue/raid” by UBS, and deeply subordinated debt investors being bailed in to the tune of $17.3 bln. Then it seems a single $5mm Credit Default Swap (CDS) trade on Deutsche Bank’s junior debt unleased an avalanche of selling in the name as fears grew it would be next against the wall.

Across the financial commentariat, the thinkers, analysts and strategists have been trying to figure the costs, the next victims, what it means in terms of cheap and expensive bank stocks and bonds, and how it happened.

I am not so many are thinking about what it means for the future of markets and the roll of banks within the system.

The speed at which modern media enabled rumours about the soundness of banks to establish themselves as irrefutable fact has been extraordinary. It took literally moments for banks to be overwhelmed by withdrawals. The speed at which modern banking systems allow depositors to electronically empty the tills has caught the authorities by surprise.

Nothing in finance is so certain as the inevitability of regulators reacting to events – usually over-reacting. How will they seek to ring-fence banks from the potential of a virtual run on deposits, or a confidence collapse trigged by social media? The reality is large banks are large targets.

One answer may be the inevitable shift to digital currency – where money is not held or created by banks, but simply processed by banks. Frankly I find that ironic – the tenants of libertarian cryptocurrencies being used to give government effective regulated oversight and “control” of digital money. How it works will be fascinating, with a reworking of how lending creates money through fractional reserve banking – but that’s a problem for another day.

Meanwhile, the current banking instability will inevitably trigger a new round of regulation to make sure whatever caused it this time does not happen again. Make banks safer by allowing them to do less! is a core regulator mantra.

There are rumours circling of possible solvency events across banking – how derivatives could sink them (rumour and sigh: massive bank derivatives books mean nothing – it’s how their derivatives exposure is laid off among all counterparties (another risk) that actually matters). Again derivatives and counterparty risk could probably be handled digitally or on distributed ledgers…

There is strum-et-drang about commercial property exposures sinking banks over exposed to New York, San Francisco, London or Asia…. Or maybe it will be auto-loans, or corporate debt… or who knows.. In times of financial stress, nervous investors will find no shortage of reasons to be fearful.  Regulators will find no shortage of measures to regulate.

The result will not be the end of lending, the collapse of markets as finance dries up.. Risk taking has already largely transferred from the new obsolete banking sector to the asset management sector.

If you want to talk to a financier who really understands the risks-in-depth in a particular sector you will find that expertise now resides in the hedge funds, credit funds, private equity and debt funds that now price risk. Banks used to have massive risk management departments, legions of branches and lending officers on the ground reporting financial risk conditions, and the smartest financiers on the planet. No longer. Most bank risk departments are box ticking exercises.

All of which leads me to yesterday’s superb Ishka Aviation Finance conference in London, where I was drafted in to the Alternative Investment Panel.

Before we came on there was a banking panel. All respect to the bankers, but I struggled with my eyelids. They talked about what they are prepared to lend on – formulaic, and what they wont – most stuff. They talked about regulation, capital rules, risk appetite. I concluded two things:

• Bank lending is a formula – not a decision
• Banks don’t actually making lending decisions – regulators set the rules.

In contrast, I was on a vibrant panel of asset managers who knew their markets backwards… and had very clear views on the risk/reward returns they seek to generate for their clients/investors. Their sole goal is to make the returns they have promised investors by taking risk based on their knowledge – and where I trust a manager, I will follow their expertise.

The area I work in is partly origination, but also risk in determining the deals we share with our investors. That’s a critical role in Alternatives – hooking up investors (the risk takers) with the risks (the issuers, the borrowers, the firms seeking capital). I guess that’s what banker’s once did – and could do again… outside conventional bank processing.

The big risk the market faces now is not so much another raft of over-regulation making banking look even more Jurassic, but real losses from market events triggering failures across the asset management sector – giving regulators the excuse they have no doubt been looking for to over-regulate the investment sector also. (And its already happening to a degree!)

Five Things to Read Today:

If there is one story you must read today – might I suggest this great tale of the Football club I support: Heart of Midlothian. Its fantastical….. it should be a film…

The Athletic   – Inside Vladmir Romanov’s Hearts – Mowgli, tartan shorts, and a nuclear submarine

FT              – Martin Wolf: Monetary Policy is not solely to blame for this banking crisis

FT              – Bank of England Governor dismisses chances of financial crisis

BBerg         – After Slamming ESG Plan, Fund Managers Are Told to Sit Tight

WSJ            – Jamie Dimon to Face Questioning in Lawsuit Over JP Morgan’s Epstein Ties

Out of time and back to the day job

Bill Blain

Shard Capital