Forces Driving Change in the Banking Industry

Introduction

The banking sector is one of the most resilient industries in the world and has long been considered largely insulated from the worst effects of economic recessions. This is not to say that the industry is unaffected; rather, the effects tend to be less widespread than those felt by other industries such as the airline or oil industries. Members of the banking industry are the financial institutions and financial intermediaries that accept deposits and use those deposits to finance their lending activities, either directly to customers or through the capital markets. Typically, the industry connects customers who have capital deficits with those who have capital surpluses.

The banking sector is therefore critical to the financial system and the economy as a whole. This is the primary reason the industry is heavily regulated in many countries. Member institutions are required to maintain reserves of deposited funds with the relevant regulatory authority, usually as a fraction of total customer deposits.

This literature review analyzes different pieces of academic literature to examine the forces that lead to changes in the banking industry. To do this, it is important first to trace the history of the banking industry, which provides crucial information on the sector's evolution. It is also important to explore the size of the banking industry and to examine banking regulations and laws, since these govern how banks relate to their customers and are therefore a key consideration in any analysis of industry change.

The banking industry has its roots in medieval and early Renaissance Italy, though banking practices existed as far back as 2000 BC in Babylonia and Assyria. In Renaissance Italy, banking extended to the prosperous cities of northern Italy such as Genoa, Florence, and Venice. Two families — the Peruzzi and the Bardi — dominated the sector in 14th-century Florence and expanded by establishing branches in several other parts of Europe (Hoggson 14).

The banking sector saw enormous growth over the following centuries as the lucrative business of lending expanded. Banks diversified their services to include money changing, the transfer of funds, and the issuance of bank debt. However, the industry suffered a major shock in 1907 when panic over bank insolvencies in the United States prompted customers to make bank runs, withdrawing their deposits en masse. This panic spurred increased financial regulation of banks (Stiroh and Strahan 802).

History of the Banking Industry

In 1929, the margin requirement for financial institutions in the United States was just 10%, meaning that brokerage firms were able to lend $9 for every $1 that investors had deposited with them. When the market began to fall, brokers called in these loans, resulting in high default rates as most of the loans could not be repaid. Banks, as debtors, began to default on their own obligations, and when depositors realized this, they began to withdraw their funds en masse. Government guarantees and Federal Reserve regulations were either absent or ineffective at the time. As a result, banks lost billions in assets, and outstanding debts became increasingly burdensome. Some 744 banks failed during the first ten months of 1930, and by April 1933, approximately $7 billion was frozen in failed banks (Schweikart 608).

With future profits looking bleak and debtors unable to repay their loans, the banks that survived the Great Depression became extremely conservative in their lending. They accelerated the buildup of their capital reserves and issued fewer loans, which intensified deflationary pressure and deepened the economic downturn in a vicious cycle (Braunschweiger, Geyer, and Kelly 118).

Approximately 9,000 banks failed worldwide during the 1930s Great Depression. This catastrophe prompted governments to significantly increase financial regulation. The US Securities and Exchange Commission (SEC) was established in 1933 in response to the crisis. The Glass-Steagall Act was also enacted, separating investment banking activities from commercial banking activities in order to prevent riskier investment banking from causing the failure of commercial banks, which had been a key driver of the Depression (Braunschweiger, Geyer, and Kelly 120).

The World Bank and the International Monetary Fund (IMF) were created in 1944 through the Bretton Woods Agreement during the post-World War II period. This framework encouraged financial institutions to lend money to third-world governments. However, several banks subsequently became insolvent when developing countries defaulted on their debts following the abolition of the Gold Standard in 1971. The Gold Standard had been a monetary system that used gold of a fixed weight as the standard unit of economic account, and its abandonment left a number of banks exposed and unable to meet their obligations (Schweikart 612).

Technology used in the banking industry has evolved over many decades. In 1959, the first standard for MICR (machine-readable characters) was developed and patented in the United States, leading to the first automated check-reading and sorting machines. The following year, the first ATMs (automatic teller machines) and cash machines were developed, growing in popularity throughout the decade (Schweikart 616).

Banks heavily invested in computer technology, which automated many manual processes and led to a shift away from large clerical workforces toward automated systems. These technological advancements produced the first payment networks, culminating in the creation of SWIFT in 1973 — the first international payment network — developed by the Society for Worldwide Interbank Financial Telecommunication (Schweikart 618).

During the 1980s, the banking sector in a number of countries underwent significant deregulation, resulting in substantial growth and proliferation across the industry. The "Big Bang" of 1986 in London allowed banks to access capital markets in new ways, leading to significant changes in how banks operated and obtained capital. A broader trend also emerged in which retail banks began acquiring investment banks, and stockbrokers began creating universal banks offering a wide range of financial services. This trend reached the United States when the Glass-Steagall Act was effectively repealed in 1980, enabling US retail banks to engage in mergers and acquisitions as well as other investment banking activities (Ng 878).

Financial services continued to experience rapid growth through the 1990s, driven by strong demand from companies, financial institutions, and governments, as well as generally buoyant and bullish market conditions. During the twenty-year period from 1980 to 2000, interest rates in the United States declined from 15% to approximately 5% for two-year US Treasury notes. Financial assets grew at roughly twice the rate of the global economy. The period also witnessed the significant internationalization of the banking industry, as banks began identifying and investing in opportunities in overseas markets (Ng 880).

By the end of 2000, the top ten banks in the world commanded a combined market share of greater than 80%, while the top five banks held 55%. Of the top seven banks, three were American and four were European. The remaining large banks were major US investment banks, which collectively held a market share of approximately 33%.

These impressive figures attracted new non-bank financial institutions — including insurance companies, mutual funds, pension funds, hedge funds, and money market funds — into the broader financial sector. This growth was so significant that by the end of 2001, four of the fifteen largest financial institutions in the world by market capitalization were non-bank entities (Morris 437).

Banks continued to invest heavily in technology, and by the end of the first decade of the 21st century, many had introduced internet banking services to further automate and simplify account management for customers (Morris 436).

That same period also brought considerable stress to the global banking system. Several large US banks required substantial government bailouts, beginning with the global credit crunch and banking crisis of 2008. Governments around the world were forced to bail out, nationalize, or arrange emergency sales of major banks. On September 29, 2008, beginning with the Government of Ireland, several governments began providing wholesale guarantees underwriting their banking systems in order to prevent panic and bank runs. This led to widespread characterization of the sector as "too big to fail" and prompted extensive debate about the ethical dimensions of such government interventions (Gorton et al. 300).

The global banking industry is extremely large. In the United States alone, there are over 7,000 institutions operating in the banking sector with more than 82,000 branches nationwide. A report on China's banking industry noted that the top four banks had over 67,000 branches as of November 2009, in addition to approximately 140 smaller financial institutions whose branch counts were not specified. Japan has 129 banks with close to 12,000 branches. In Europe, banks in Germany, Italy, and France together account for more than 30,000 branches — more than double the number of branches in the United Kingdom alone.

In terms of revenue, the European Union held the largest share of total asset growth at 56% for the fiscal year 2008/2009, down from 61% the previous year. The share of Asian banks rose from 12% to 14% during this same period, while that of US banks increased from 11% to 13%. During this period, the assets of the world's 1,000 largest financial institutions grew by more than 6.5% to a record $96.4 trillion, even as profits declined to $115 billion — an 85% drop.

The banking industry is heavily regulated, and despite the waves of deregulation documented in its history, numerous regulations continue to govern the sector. Banks generally require a special license to operate, as is the case for most institutions around the world. The legal definition of a bank does not necessarily include lending, but does include the acceptance of customer deposits, which may not be repayable at the order of the customer (Bertrand, Schoar, and Thesmar 600).

Unlike most other industries, the banking sector is regulated by an authority that also participates substantially in the market itself — either a privately or publicly owned and governed central bank. Central banks generally hold a monopoly on the issuance of banknotes to other banks. This is not universally the case, however; in the United Kingdom, for example, the Financial Services Authority (FSA) licenses and regulates banks, while certain institutions such as the Bank of Scotland have legal authority to issue their own banknotes in addition to those issued by the Bank of England, the UK's central bank (Gorton et al. 263).