Commercial Banking in 2011

Commercial banking in the United States is going to change substantially in the next five years.

Most of my comments on the banking industry over the past year have been spent on the “smaller” banks, the banks are not among the 25 largest commercial banks in the industry, the banks that control about 30% of the banking assets in America. At last count there were a little less than 7,800 of these banks. The average size of the banks in this category is about $480 million, pretty small.

My concern about these banks is their solvency. The FDIC placed 860 commercial banks on its list of problem banks at the end of the third quarter. The question that is still outstanding is how many more banks are seriously challenged to remain in business. That is, how many banks are not on the problem list but “near” to being on the problem list. Elizabeth Warren gave testimony in front of Congress in the spring and stated that 3,000 commercial banks were threatened by bad loans over the next 18 months.

Commercial banks have been closed at the rate of approximately 3.5 per week during 2010 and many other acquisitions have taken place. So, the industry is shrinking. I still believe that there will be fewer than 4,000 commercial banks in the United States by the end of the upcoming decade.

However, something new is going to happen at the other end of the banking spectrum. International banks are going to play a much bigger role in the United States in the future and this is going to substantially change the playing field and will help to accelerate the decline in the number of banks in the American banking system.

What’s going on? Just in the recent past we have had the news that the Bank of Montreal, the fourth largest bank in Canada, acquired the banking firm of Marshall and Ilsley Corp., which has $38 billion in deposits, 374 branches throughout the Midwest, and is the largest lender in Wisconsin. Then we learned that TD Bank, the second largest bank in Canada, is acquiring Chrysler Financial, the former lending wing of the Chrysler Corporation.

We also learn that Deutsche Bank AG and Barclays PLC have moved up the rankings of global business when compared to other Wall Street organizations. (See the Wall Street Journal article “New Banks Climb Wall Street Ranks,” http://professional.wsj.com/article/SB10001424052748703581204576033514054189044.html?mod=ITP_moneyandinvesting_2&mg=reno-wsj.) These organizations have grown substantially filling in some of the hole left by the collapse of Lehman Brothers, and the moving of Bear Stearns and Merrill Lynch into other banking firms.

The point is that the American banking scene is much more open to foreign competition on its own turf in the 2010s than it was previously. This has the potential for causing even more changes in the structure of banking in the United States and in the world than we have seen over the last fifty years.

If we go back to the start of the 1960s, the United States contained some 14,000 commercial banks and a large, prosperous thrift industry. But, things were changing. Let me point out just three of the major factors impacting the banking and thrift industries by the start of the 1970s. First, was the beginning of the credit inflation that was to spread throughout the economic system that would result in the rising interest rates which would eventually bankrupt the thrift industry and drive it out of business.

Second, the United States commercial banking system at the start of the 1960s was a mish-mash of banking rules. For one, the branching laws were such that banks could not branch across state lines, and in some states banks could only have one office, in others they faced severe limits on the number of branches they could have, while in other states there was unlimited state-wide branching.

What broke this structure down? Information technology. With the spread of information technology banks could not be constrained from branching across state lines. The death knell for state control and limited branching was sounded. National competition became the new norm and banks had to compete.

The third factor was the freeing up of the flow of funds internationally. By the end of the 1960s the capital flows were basically unrestricted between the United States and Europe. One of the major signs of this openness was the creation of the Eurodollar deposit which became an important tool in the move to “liability management” which freed up American commercial banks from limits on their ability to grow their balance sheets. This factor contributed to the demise of the “Bretton Woods” system of international finance.

All three of these factors played a big role in the changes in the financial system of the United States and the world and to the movement away from “relationship finance” and “arms-length finance”. For more on the changes in the banking system and the growing “impersonal” nature of the financial system see the book “Saving Capitalism from the Capitalists” by Raghuram Rajan (the winner of the Financial Times/Goldman Sachs award for the best business book of the year, “Fault Lines”: http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan) and Luigi Zingales, both of the University of Chicago.

All of these factors are still at work but we are now seeing another important factor coming into play, “competition from the outside.” Just as the forces inside the United States have been attempting to build up walls to constrain the finance industry, America is now coming to experience a breaking down of the barriers. Unless the Congress puts up restrictions on foreign financial interests acquiring domestic companies, it seems as if the door is opening for more and more banks from outside the United States to come knocking.

The result of this “opening up” according to Rajan and Zingales is that the new competition really “shakes things up.” I have contended throughout the events which began in late 2008 that by the middle of 2009 the largest 25 commercial banks in the United States had moved beyond most of the structural problems that contributed to the financial collapse. Furthermore, by the time that the Dodd-Frank Financial Reform bill got passed, these banks had moved beyond most of the onerous portions of the legislation.

Now with these foreign financial organizations moving into the competitive space of the United States banks, all banks will be using information technology and uncontrolled capital flows throughout most of the world to further outpace efforts of regulatory reform.

Another consequence of this will be the pressure on the larger banks to continue to merge and acquire and diversify their businesses in ways we have not yet imagined. And, when one brings into the picture the things that information technology can do and the progress the “Quants” have made in finance, one can only guess at how exciting the near-term evolution of the banking system is going to be.

Merry Christmas and Happy New Year to Everyone!