The problem with banks: causes

TL;DR: With the low rates environment depriving them of interest income, banks have increased fees while they try to find a new model for their expensive branches as parts of their customer base migrate to online banking.

Part one of this series took a hack at banks. I pointed out that while banks are central to our lives (in ways we don’t often consider), with rising fees, confusing terms, and exclusionary pricing and practices, banks aren’t providing the greatest service. Perhaps more importantly, they’re also innovating at a much slower rate than they did pre-2001. Remember: banks invented ATMs and popularized credit and debit cards, arguably two of the more important innovations in the history of retail finance. Today, innovation is largely left to tech companies and the card networks themselves while banks fight the deployment of chip & pin card protection or a quicker fund transfer system.

Contrary to some popular depictions, bankers aren’t sitting around, rubbing their hands gleefully while they offer less satisfactory services at ever-higher prices: this situation has causes beyond the banks themselves. The most readily identifiable cause of many of these issues is that the banks’ business model has been hurt by two trends: falling interest rates and the internet.

Let’s start with falling interest rates

Banks basically earn two kinds of income: interest income, and non-interest (i.e., fee) income. As a depositor, you give the bank money which the bank lends out in exchange for interest. They pass a portion of that interest on to you, and keep the rest as “interest income”. This is one of the reasons banks were able to offer seemingly free services like checking accounts — the interest they earn by investing your deposits covers their costs. Or, it does as long as the amount they earn in interest is substantially greater than what they pay you. This difference is called the “net interest margin”, and with the Federal Reserve putting pressure on interest rates in order to reinvigorate the US economy, the net interest margin for banks has fallen. A lot.

10 year NIM for all U.S. Banks, courtesy of FFIEC

As the chart above shows, the NIM fell from >3.8% to ~3.1% between 2010 and 2014. Why? Because the Federal Reserve was busy stimulating the economy by buying up all the mortgages they could get their hands on in order to make it cheaper for US homeowners to hold on to their homes. Here’s the same chart, but with the Fed’s balance sheet holdings of mortgage-backed securities mapped on the right-hand axis.

10 year NIM for all U.S. Banks (LH) and MBS held by Fed (RH), courtesy of FFIEC

As you can see, as the Fed starts buying, NIM drops substantially, which means that the banks aren’t able to earn as much by lending your deposits. This leaves them with non-interest, or fee, income. For most banks, that means charging more for ATM use, overdrafts, and account maintenance, which is precisely what’s happened over the same period. The only reason these fees haven’t surged more drastically is that the government has done as much as possible to stop this kind of behavior (with mixed success). So, that’s one of the major reasons why account fees have gone up: because banks need to make up for lost interest income.

Second? Structural changes

The second reason is longer-term and structural. The banks’ business model has for centuries been tied to branches, both as places to deposit your money and to take out loans. The majority of banks have been built on that model (US banks tend to be decades-old, with less then 1,000 de novo bank charters approved in the last decade vs. 8,000 existing banks over that period). Branches are interesting because most of the services provided by branches are “free”: their costs must be made up for through the deposits they gather and loans they originate. The problem is that consumer behavior has started to shift towards online / phone banking, facilitated by the rise of online-only direct lenders like USAA, ING Direct, Ally, and CapitalOne 360. Branches are returning less, but banks are caught in an awkward place: while some of their consumers are happy to make the switch to mobile, a substantial number still place a high importance on branch availability. Banks are therefore trying everything possible to find a new, cheaper branch model, while paying to extend into online banking. So it’s fairer to say that while banks aren’t innovating on the ATM/card scale of the late 20th century, they’re innovating tactically to find a new model for branches and better ways to make up for lost time in the online banking space.

Banks are working to build online services for one set of customers, find a new branch model for another set of customers, all while earning less interest income. Perhaps unsurprisingly, bank profitability has fallen as a result. Where once banks would earn ~15% on their equity, they now earn just ~10%, and the number of banks in business has fallen from around 10,000 at the turn of the century to just under 7,000 today. The industry is also more concentrated, with the top 5 largest banks holding over 50% of the industry’s assets, compared to just 17% of assets in the 1970s. As the market becomes more concentrated, the diversity of customer experiences will likely fall, exacerbating the industry’s falling customer satisfaction rates.

1994–2014 U.S. Bank ROAE, courtesy of FFIEC

Last post I went over some of the problems with the services banks offer, and this post I’ve identified two of the major causes of those problems: an unhelpful rates environment and longer term structural trends around how bank products are distributed. Banks are, for better or worse, still looking for a workable model as they move into the 21st century. This often gets people asking questions like: what will the bank of the future look like? What is the future of banking?

In part three, I address both of these questions and show how many bank activities can be conducted outside of banks.