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Make No Mistake, Your Bank Can Be Disrupted (Just Ask Coca-Cola)

Disruption is all the rage these days, with companies like Uber and Airbnb demonstrating just how fast new entrants can reshape entire sectors. But the winds of change are also leading industry behemoths to alter the way they do business. Just a year or two ago, who could have predicted that Coca-Cola would be compelled to develop a high-protein milk drink or that McDonald's would contemplate table service and celebrity chefs?

Banking is even more vulnerable to disruption than these once impregnable purveyors. The industry is being pummeled by the same forces of technological change and shifting consumer preferences, as well as by regulations that redefine banking in often-uneconomical ways and limit the sector's ability to quickly adapt to shifting environments.

That's paved the way for the rise of shadow banking, a term that conjures up the image of sinister figures eager to prey on weak banks overwhelmed by regulation. Such terminology is now outdated. Although I used it just last year to warn the Federal Reserve about the rapidly realigning financial playing field, nonbanks have become a powerful force operating in the plain light of day. They now pose a clear danger to the business models of banks large and small.

Objective analysis of the factors that give nonbanks an edge is thus a vital priority for traditional financial institutions' strategic planning.

Sizing Up the Competition

Lest one doubt the magnitude of the challenge, it’s useful to consider the many firms entering into financial services fields long dominated by banking institutions. On the retail and small business side, these include an array of potent technology companies such as Apple, Google and Square, all of which are crafting new mobile products that increasingly gather as well as disburse funds. PayPal and Amazon are also venturing into small-business lending as well as payment processing and, increasingly, deposit-taking. Peer-to-peer lending across the retail and small-business spectrum is also showing considerable potency, with institutional investors getting in on the action. Asset managers, insurance companies and nonbank advisors are making headway in wealth management with deposit-like products, and powerful nonbanks are increasingly elbowing into mortgage lending.

Wholesale and capital-markets activities may be under even greater competitive assault. Large corporate loans have increasingly morphed from a credit-intermediation product into an asset class that is originated, structured, and sold by mutual funds, private-equity firms and investment banks. Municipal finance is now shared with hedge funds and securities finance and divvied up with insurance companies, hedge funds, and investment banks. Proprietary trading is heading out of banking even where it’s still allowed under the Volcker Rule, and market-making activity is either moving to hedge funds and investment banks or simply shrinking, exposing markets to liquidity risk even as profits from this once-core activity shrivel for large U.S. banks.

Regulators hope that collateral transformation, by which risky assets are converted into safer ones, will cure some of these ills in the derivatives market. But big banks must horde their high-quality assets and thus cannot transmute them for others. Banks' brokerage businesses are also facing tough new rules that will surely shrink their ability to provide this critical service.

And what of derivatives clearing and settlement, a core function traditionally housed largely in banks because no one trusted any other party to do it? This critical function is fleeing from regulated banks to entities largely exempt from prudential regulation as a result of new capital and resolution rules as well as rules requiring central counterparties. Nonbanks' exemption from these rules makes business a darn sight cheaper and easier, if not exactly safer. 

The Cost of Complacency

Many bankers see these trends clearly but discount the need for action because few competitors have made major dents in market share, especially in the retail arena. But this view offers false comfort.

Careful analysis by line of business shows that banks are losing significant market share in critical customer segments like younger retail customers, higher-return borrowers and prime wealth-management clients. On the wholesale side of the shop, one is likely to be trampled standing between key businesses and the front door as core activities head for the exit.

Even bankers who recognize the challenge are at a disadvantage in the race against nonbank competition. That's because regulators have tied a large sack of potatoes around their legs. Many bankers cite the direct cost of new capital, liquidity, resolution, and prudential rules as a major hobbler of bank innovation, and the effect is significant to be sure. But the indirect cost of these rules is also a formidable barrier to change. With sluggish economic growth crimping profits that are already strained by direct regulatory costs, many banks have scant operational resources with which to support innovation. This is especially true given the huge cost of building out all the systems necessary to meet the prudential rules.

An even more important and hidden impediment to innovation stems from fear. Management contemplating entering a new activity and thereby taking a chance often encounters stiff internal opposition from recently-empowered risk managers and skittish boards. Nonbanks, meanwhile, tend to reward new ventures instead of shunning them.

Risk management is of course critical. But balancing it with innovation is also vital to ensuring future success.

Charting a New Course

Banks that hunker down and try to ignore the storm will fade away. Chief executives and board members must thus quickly reckon with the new reality, rules and all, and define their comparative advantages in the face of formidable challenges. Then, without wasting a minute, they must rebuild their franchises to capitalize on what they do best — and what customers still want.

Karen Shaw Petrou is managing partner at Federal Financial Analytics. Follow her on Twitter 
@KarenPetrou

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