The Impending Disruption in Banking and How Pro-Competitive Policy Can Help
By Henry Greene
Alan Greenspan, in a Wall Street Journal op-ed, recently warned that the US has seen a steep drop in competition in major economic sectors. According to the Census Bureau, in 1980 one in eight companies had been founded within the past year. In 2015, however, this figure had dropped to fewer than one in 12.1
This reduction in competition has been especially present the banking sector over the long term. What used to be a sector populated by mostly local players, has evolved into an oligopoly of a few dozen national and international banks. However, as I will argue, the relative security that the handful of major American banks have found in their positions in the market is due to expire if they do not fundamentally change their business models. Banks have been artificially shielded from the upheavals of the data revolution and continue to profit off of a dearth of information that they artificially maintain.
The most egregious example illustrating how traditional banks and financial institutions continue to leverage a nonexistent informational edge over their customers has played out recently in response to the federal reserve’s decision to raise interest rates for the first time since the 2008 financial crisis. It has come to be seen as a mere platitude that bank profits rise with interest rates. But, why is there such a direct connection here? The reason is mainly that in the event of a hike in interest rates on the part of the federal reserve, banks will wait to raise the interest that customers receive on deposits, while quickly raising the rate at which they lend customers’ money.
Although this does not do irreparable harm to the consumer, as most find the interest they earn on basic checking accounts to be negligible, it is symptomatic of a more widespread issue and reveals a point of weakness for mainstream banks. The fact is that banks are too addicted to profits that arise out of their informational edge and lack of transparency, profits that are thereby unsustainable in the information age.
The fintech frenzy of late illustrates that the most basic banking services can be easily replicated by simple applications of information technology. In China, ecommerce giant Ali Baba, which had no previous experience in financial services, now manages the world’s largest money market fund.2 Thus, although the artificial disparity between the interest earned on checking accounts and changes in the risk-free rate do not have consumers complaining, it would be easy for someone to come around and offer higher average interest rates on checking accounts simply by foregoing the profits that arise from the disparity in favor of a “freemium” model. I think the same logic applies to other sources of bank profits.
When Valla Vakili of Citi Ventures came to speak at Georgetown, he admitted that, in order to maintain their positions in the market, traditional banks must fundamentally change their business models. They need to realize the new paradigm set by the likes of Google and Facebook, the “freemium” model, involves offering some services without profiting off of them, while either profiting by selling their customer reach to other businesses or using their non-profitable reach to market other profitable services.
While it seems the Trump administration recognizes the need to reinvigorate competition in the financial services sector, they might be going about doing so the wrong way. Leveling the playing field for regional banks is a good start, but we need policies that will promote the ability of nonbank players to offer innovative services that benefit the consumer. With this in mind, here are two policy suggestions:
1. Reduce the minimum market capitalization required for a regulated IPO.
For there to be real competition and a place for innovators in the banking space, companies need nonbank ways to find funding. However, stringent requirements for a fundraising exercise to be labelled as an IPO, and granted the necessary investor protections by the SEC, all but demand the need for an underwriter for a small venture. A company that poses a direct threat to the mainstream banks should not be forced to employ their services of one in their fundraising efforts. Moreover, the fraudulent nature of ICOs (Initial Coin Offerings) might be mitigated if it were easier for innovators in blockchain or fintech more generally to pursue conventional means of fundraising.
2. Reconsider minimum reserve requirements.
While there are many cases where reserve requirements should probably be raised, as in the case of any real estate lender, static reserve requirements might be anti-competitive as banking paradigms change. It might be the case that better assessments of risk, due to either better data or smart contracts, will mean that one size does not fit all when it comes to reserve requirements. Thus, smaller players should be evaluated on a case by case basis to determine the reserve requirements that should be applied to them.
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