After the Crash: The Future of Finance

2. The Uncertain Future of U.S. Commercial Banking

11 2 alan mcintyre michael zeltkevic The Uncertain Future of U.S. Commercial Banking Commercial banking in the United States since about 1930 has for the most part been a simple business, with adequate but not particularly attractive returns to shareholders. Then for a golden decade, between the early 1990s and the first half of the 2000s, it outperformed, offering high and stable returns to shareholders and accounting for an increasing share of corporate profits. At the time, few sought to identify the confluence of factors that led to such a positive environment for banking or to ask whether that environment was sustainable . With a decline that began somewhat slowly in the middle of the 2000s and then accelerated with the giddy fall of 2008 and 2009, commercial banking underwent a reverse alchemy, turning gold into lead. With eleven straight quarters of declining profitability, enormous industry dislocation, and unprecedented financial support from the government, some may now be tempted to declare commercial banking a bad business, and there are certainly reasons to do so.1 A combination of investor fear, increased market discipline, more intrusive supervision, and stricter regulations is likely to raise both regulatory and de facto capital levels, reduce balance-sheet leverage, and generally limit risk taking and its returns. The financial crisis also sensitized consumers and regulators to certain bank fees, considered excessive and opaque, resulting in quick action on credit 1. FDIC (various years b). 02-0404-1 chap2.indd 11 7/12/10 6:00 PM 12 alan mcintyre and michael zeltkevic card fees and legislation focused on deposit fees, debit interchange, and consumer financial protection. In addition to the threat from both prudent and more politically motivated regulation, the industry faces an uncertain macroeconomic environment. The next few years could see either the spectre of inflation reemerge—and with it higher interest rates and corresponding challenges for profits—or a tepid recovery with persistently high unemployment and low interest rates, which would also challenge the banking industry (as the Japanese discovered in the 1990s). Given these developments, commercial banking could face an extended period of low returns, even after the current credit losses have worked their way through the system. Yet despite these not immaterial challenges, it is too early to declare commercial banking to be a poor, or even a mediocre, business. Banking services remain a basic need for the vast majority of the population, and only 10 percent of U.S. households lack a checking account.2 Financial services are an essential lubricant in the gears of the broader economy, offering not only transaction services but also the stores of value through which the results of all other economic activities are ultimately measured. Nor will increased government involvement in the industry necessarily erode profits. On the contrary, increased regulation may create barriers to entry that prevent profits from being competed away and may permanently eradicate the shadow banking sector that thrived during the 1990s and the first half of the 2000s. The government’s implicit promise to bail out any large failing commercial bank also amounts to an economic subsidy, as it massively reduces banks’ cost of debt capital and strengthens their competitive position vis-à-vis institutions without that government backing. As we show in our historical analysis of the profitability of the industry, the fortunes of commercial banks depend primarily on such structural factors as the rate of economic growth, the shape of the yield curve, and the regulatory regime under which they operate. How the commercial banking industry emerges from its currently fragile state, and which are the best business strategies to maximize returns, depend on the direction taken by these structural factors. Nobody can anticipate such developments with certainty, but some possible and quite plausible scenarios—and their likely effects on the industry—can be considered. The three scenarios we envision are benign, malign, and a base that lies between these two. In our three scenarios we attempt to look beyond 2010 and 2011 to a point at which current credit losses have worked their way through the system and new domestic and international regulation is in place. We also look at current 2. Federal Reserve (2007). 02-0404-1 chap2.indd 12 7/12/10 6:00 PM the uncertain future of u.s. commercial banking 13 markets (and in particular bond markets) to tell us what macroeconomic environment we might expect two years out and...