Evolving Financial Institutions

Posted by John Slater on November 20, 2012

So much of the world is in transition, why do people want the commercial banking industry to be what it was many years ago? This is just not going to happen.

As I have written many, many times, finance is information! We have seen, over the past fifty years or so how the advancements in information technology have contributed, for better or worse, to the innovations that have taken place in financial institutions and financial instruments.

Given the continuing advancements in the information technology field how can we not expect the financial field to continue to evolve? Check out all that is being done in mobile banking these days. At least in my area of the world I am seeing more and more advertisements about mobile banking and what it does for the customer.

And, this is just the ground level. More and more people you talk with and read about claim that they have only gone into a bank office once or twice in the past two or three years. And, the only reason they went into the bank was to complain about not receiving notifications from the bank that their interest rates were being dropped. If this is not enough, read David Wolman’s book, “The End of Money” (Da Capo Press, 2012).

But, who is going to even keep their money in a typical commercial bank? I don’t. I work with an institution that satisfies my banking needs and ties all my financial relationships together so that I can move seamlessly from one asset class to another almost instantaneously.

How about my mortgage? (Yes, I have one!) The commercial bank I know set me up with their affiliated mortgage that immediately sold the mortgage to Wells Fargo (WFC), which now just services the loan because it is owned by Fannie Mae. No banking is really involved here: just electronic transfers.

And, who are the biggest players in this arena? Wells Fargo and JPMorgan (JPM) create the vast majority of mortgage loans given in the United State. Furthermore, this area is evolving rapidly as these mega-banks and Fannie Mae and Freddie Mac (FMCC.OB) transition into the twenty-first century … along with the help of the Federal Reserve.

However, small- and medium-sized banks are not going to be able to keep up with this … at least independently. They just don’t have the expertise nor can they afford it. And, they can’t reach the scale necessary to be competitive.

What do we have? Mega-financial institutions and non-profit credit unions for people who do not have a lot of assets.

And, what about bank lending to businesses? After all, the banks are called “commercial” banks.

Well, other arrangements are being made for commercial loans. Note that private placements to medium-sized business in the United States have already exceeded $50 billion for the first time in history.

“The market has become both deeper and larger in recent years as companies look for alternative sources to bank finance, and investors put more money to work in this space.”

This shift is taking place as banks around the world shrink their loan books amid market pressures and regulatory changes.

“Groups, many of which are smaller than those borrowing in the full public markets and often unrated, have turned to the U.S. regulation D private placement market to borrow money direct from big asset managers with few regulatory requirements.”

Evolving Financial Insitutions

And, while we are talking about this move … what about the “shadow banking” community. Shadow banking grew tremendously in the 2000s and is not going to go away. I see these institutions playing more and more of a role in the banking sector in the future. And, information technology is going to allow this to happen and will let these shadow banks take away more business from the small- and medium-sized commercial banks than we can imagine.

Information technology has already played a massive role in finance. See for example my review of the book called “The Quants” by Scott Patterson. In this book we see, for example, of how Jim Simon has used the mathematical approach called “information theory” to build the very successful “Quant” fund, Renaissance Technologies. The application of electronic approaches to the world is changing the way things are done.

Furthermore, the technology is spreading. Note the opinion piece in the Financial Times, “In Politics Too, the Quants Are Taking Over.” Specifically, the article refers to the “machine” set up by the Obama team to get re-elected.

“This trend won’t come as a surprise for anyone familiar with finance. Algorithm-based trading has created a high demand for quants and difficult times for the old-school financier. UBS (UBS) last week announced it was letting go of 10,000 employees. At least one of these, David Gallers, the bank’s former head of credit-default swaps index trading, is to be replaced with an algorithm, according to Bloomberg. It is a familiar and not unwelcome story: creative destruction at work.”

And, this is only going to spread. For an example, take a look at Robert Shiller’s book “The New Financial Order: Risk in the 21st Century” (Princeton University Press, 2004). If Shiller is correct, and I believe that he is, “we ain’t seen nothin’ yet!” Finance is going to be ubiquitous! This is going to be a large part of what I am going to be looking at going forward. The structure of the world, the structure of finance, is changing. This is going to provide us with tremendous opportunities for investment. But, the companies we want to be involved in are not those companies that are going to return us to the past. And, a lot of the opportunities are going to be created by the government and the regulators. We are going to have a more active government in the future and along with this, more invasive regulators.

This is going to create tremendous opportunities as people and organizations are incented to move into other spaces and other tools and techniques to get around new governmental economic policies, new rules and regulations and new enforcement. One thing we have learned when reviewing the history of information technology is that information spreads. The spread of information and information technology can be postponed for a while in certain areas of the world but eventually information spreads. If you want to get even a brief view of what the future is going to look like, look at what the kids and young people are doing. Given the electronics they are working and playing with today, can really believe that financial institutions are going to be like they were in the past?

About the Author

John M. Mason writes on current monetary and financial events. He is an entrepreneur and a writer. Current projects include a new banking institution, an Internet company, a private equity fund, two depository institutions and a community redevelopment fund. He formerly was on the faculty of the Finance Department, Wharton School, the University of Pennsylvania. Dr. Mason has been President and CEO of two publicly traded financial institutions and the executive vice president and CFO of a third. He has also served as a special assistant to the secretary of the Department of Housing and Urban Development in Washington, D. C. and as a senior economist within the Federal Reserve System. Dr. Mason has served on the boards of venture capital funds and other private equity funds. He has worked with young entrepreneurs, especially within the urban environment, starting or running companies primarily connected with Information Technology.

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