Five Future Forces Impacting Banks
Is the banking industry in the midst of a major shift in the way we are structured and do business? No one knows for certain. But what is clear is there are several significant trends underway which, if they persist, will have critical implications for banks.
One such trend is that banking has been less profitable over the past 15 to 20 years. Return on assets (ROA) for most banks peaked around 1997 and has been in decline since. Currently, about 60% of banks’ earnings are not exceeding their cost of capital. The reasons are numerous: increasing competition, added regulation and savvy customers with more readily available information and choices.
A second trend has been the steady decrease in the number of financial institutions. In fact, there are 2,000 fewer banks since 2000, with an average decline of 3% to 4% annually. When combined with the effects of the Great Recession, the resulting New Normal conditions (i.e., sluggish growth) and demographic shifts of aging baby boomers borrowing less, these conditions have persisted and grown in significance. Indeed, we are working harder and making less money in banking today than in years’ past.
Will these trends continue or will conditions reverse themselves like a pendulum swinging back and forth? No one knows for certain, but let’s envision future trends and perhaps unforeseen consequences in five key future forces over the next 5 to 10 years: regulation, the economy, competition, shifting needs of customers and technology. And, based on these expected future conditions, what responses may be required for banks, in order to compete more effectively and thrive in 2020 and beyond?
Regulation. One thing is certain in the future for financial institutions: regulation will be omnipresent. Perhaps what is less clear is whether regulation will moderate from the current levels generated in the wake of the 2008-2009 financing crisis and the implementation of Dodd-Frank reform. In any case, regulation will continue to be costly and time consuming for institutions for the foreseeable future.
One possible future extension of current trends could be the intrusion of a Consumer Financial Protection Bureau (CFPB)-like agency into business lending, to “protect” small businesses from predatory lending practices and ensure access to capital. Also consider the possibility of privatizing the FDIC insurance fund, given government’s occasional push to deregulate. No matter what the changes, banks in the future will need to respond to the increasing regulatory burden with a strong focus on efficiency and cost/time savings in addressing regulation, instead of just adding compliance staff. This includes acquiring technology or partnering with others to more effectively manage the regulatory challenge.
Economy. All one can say for certain is that the economy over the next five to 10 years will continue to experience up and down cycles. Banks will need to be better prepared for the highs, lows and transitions than in the past.
Most notable is how lackluster the current recovery from the Great Recession has been and its long term implications on the future economy. Gross domestic product (GDP) growth has averaged 2.2% since the recovery began while normal during a recovery is 3.5%. For many, it still feels like a recession: in fact, 49% of Americans believe the U.S. remains in recession. Worldwide among businesses and consumers, there continues to be more savings, less spending and thus low interest rates. The long term consequences for banks may include a decade or longer of margin compression, with many cautious businesses and consumers still hesitant to borrow.
For the economy of the future, the next recession appears a ways off. Corporate profits are still rising; typically, they decline prior to a recession. In the interim, we need to be watchful of shocks that could send us suddenly into the next recession, including geopolitical events, a major slowdown in China, shifting energy prices or a large scale cyber attack disrupting commerce. We must also factor in the future economic drag of aging baby boomers, many with little savings and increasing health care needs and costs. It is likely that a vibrant economy (GDP growth of 4+% annually) over the next 10 years will be a rare event. And when future recessions do occur, jobless recoveries will be the new rule (as has been true with the past two recessions), with globalization and technology substituting for the need to rehire U.S. workers. Banks should begin now to proactively prepare their loan and investment portfolios for these future shocks, focusing on smoothing out both up and down cycles.
Competition. It is clear from preceding trends that there is less business to go around. Over 1,100 banks now have a loan to deposit ratio under 50%; and 82% of institutions rate loan competition as either high or extreme. Combined with irrational pricing, many institutions are wishful for their competitors to “go away” so they can get back to the “good old days.”
Unfortunately, that may not occur. Even with future industry consolidation, most areas will remain overbanked for the foreseeable future. Furthermore, technology enabled non-traditional entrants will continue to gain a foothold and market share. Perceived as a threat by 71% of bank executives today, PayPal, Walmart, Quicken, Amazon, Google, Lending Club, et al. put community based institutions at risk of suffering the same fate of the corner hardware and book stores. However, in our estimation, we believe these non-traditional entrants will remain as niche players, for the very reasons that hobble banks today: there are less profits and increasing burdens with having a bank charter. Still, these players can be disruptive to banks in picking off your most profitable niches, now and in the coming 10 years. If that occurs in a meaningful way, financial institutions risk becoming irrelevant among consumers and then serve largely as a quasi-utilities offering monetary safekeeping via FDIC insurance.
To achieve top performance in 2020, banks must find and excel in one or more profitable niche(s). In order to shift away from a commodity perception and price only competition, it will be critically important to differentiate your lines of business and distinguish how you deliver your services, much like the finest hotels or restaurants.
Shifting Needs of Consumers/Businesses. The Great Recession has left deep scars on the spending behavior of consumers and businesses, which may persist into the future. They have been unable or unwilling to spend like it is 2006, as demonstrated by credit outstanding in comparison with other recent economic recoveries. Also consider that these recent events can have a long lasting impact on behaviors; the Great Depression changed that generation’s fiscal behavior for their lifetime. When combined with aging baby boomers’ less need for credit, it is likely that demand will fall short of pre-2008 vigor, although it will pick up from current levels.
Consumer and business needs are shifting in other ways as well. They will have less need for branches, with branch traffic already down by double digits at many banks. Younger generations will have less need for traditional institutions, opting instead for person-to-person (P2P) lenders and niche players. When combined with declining loan revenue from changed behaviors, we need to question if institutions can afford costly branch networks in the future. The reality may be that we can no longer subsidize money-losing customers (typically 85% of your customer base!) or branches and must transition them to lower cost tech-based delivery channels over the next decade. The key to a successful transition will be to educate and incentivize your customers, making the benefits of doing so readily apparent.
It is important to recognize that future opportunities do exist in serving consumers and businesses. With 60% of households having less than $25,000 in liquid savings, there is a tremendous need for retirement and health care savings in the U.S. Moreover, 93 million U.S. adults are un- and under-banked and can be profitably served in the future with mobile delivery. By focusing on the customers’ needs and priorities, borrowing lessons from top retailers, leveraging the need for trust/safekeeping, and utilizing existing relationships, banks have the opportunity to create and realize real value for their customers in the future and give those customers a compelling reason for wanting to do business with their institution.
Technology. The impact of technology on the bank of the future can be delineated into negative and positive influences. On the negative side, the security risks of technology will be further amplified in the future. Currently seen as a major risk by 70% of institution executives, the Federal Reserve Bank has identified seven broad categories of risk. The threat even today is slowing the adoption of new technology: 49% of mobile banking non-users cite security concerns. The key for banks and their Information Technology (IT) partners in the future will be keeping ahead of these ever-changing risks and maintaining safety and trust. If we fail, we run the real threat of backlash and being branded as “untrustworthy” by our own customers. The need for basic and secure interactions and transactions will be great. Customer verification will shift focus from what you know (passwords) to who you are (biometric). And while branches are often seen as sales and service facilities, they could evolve into a new primary role in 2020 and beyond as a safe haven in which to conduct secure transactions.
Technology will also play a positive role in the bank of the future. It will be a must to enable further efficiencies and lower the cost of delivery. Big data can be deployed to better identify and address customer needs. Through mass customization, individual products, services, risk management and pricing will be tailored to each customer’s exact needs. But the benefit must be carefully designed and the “good” readily apparent to the customer; otherwise it could be used and viewed as another “evil” way to sell unwanted products or further invade one’s privacy.
The importance of privacy offers another opportunity to financial institutions: known for our safekeeping of monies, this trust could also be expanded to include the safeguarding of customers’ personal data. Mobility will also be a greater focus in the future, where transactions will be exclusively at the customers’ convenience, not ours. Mobile payments, already growing 68% per year, will become a battlefield for revenue and market share. The challenge for institutions will be maintaining our role and relevance in this competitive space.