Tuesday, April 24, 2012

Banks Continue to Move Into the Future

Financial institutions continue to move ahead of those trying to keep up with them, the regulators, rating agencies, and investors. 

I have written quite a bit about this phenomenon in recent years.  Tracy Alloway, in the Financial Times the other day, gives us some more insight into what is going on…behind the scenes. Her article is titled “How Rewired Investment Banks Opt to Go With the Flow,” (http://www.ft.com/intl/cms/s/0/c7da229a-8b00-11e1-bc84-00144feab49a.html#axzz1st6Gh6Zx)

Banks are innovating and using technology to advance their cause.  The results are being seen in more and more areas within the banks and the consequences are now showing up in their reported financial results. 

Morgan Stanley, for example, posted an adjusted increase in fixed income, currencies and commodities (FICC) revenues.  “Other banks were also buoyed by their FICC business.” 

“The secret sauce of Morgan Stanley’s success, chief financial officer Ruth Porat says, was investment in new technology and fresh concentration on so-called ‘flow.’”

The definition of ‘flow’ is vague.  However, it has to do with ‘low margin business’ that ‘flows’ through the bank from customers’ orders and trading.  One aspect of this is that funding can seemingly come from almost any area of the bank.  Having these ‘vast amounts of flow’ at the banks’ disposal “gives you a lot of leniency to match order books, thereby saving on hefty financing costs.”

Banks with “the biggest balance sheets and heaviest customer flow” can dominate. 

This means that smaller players must be more imaginative in managing their ‘flows’.

But, this all requires the technology and the “know how” to make this happen…another benefit to scale.

The effort is aimed at ”matching inner streams and synergies.”

In other words, as I have discussed many times before, finance and financial flows are just information.   They are just 0s and 1s.  With sophisticated technology, these 0s and 1s can be carved up in almost any way you want to meet a need; they can be redirected to almost any place you would like them to go; and you can do this almost instantenously.

But, it is not just the cash flow side that can be impacted.  “One of the biggest levers that can be pulled within banks is expenses.”

“Technology has been invaluable here, with banks automating more and more of their traditional market-making activities.” 

Alloway argues that “if we learned anything from the swath of US investment banking results published this week, it should be that (the) client-facing, ‘front office’ model is not as important as it once was.  When deal volume is down, it’s what’s happening inside the big banks that counts.” 

“The difficulty” Alloway concludes, “is that much of the clever rewiring is taking place within banks—largely beyond the gaze of rating agencies and investors.”  And, one might add, beyond the gaze of the regulators.  

This technology is also impacting the customer side.  As I discussed last week in my post “Why Do I Need A Commercial Bank” (http://seekingalpha.com/article/488341-why-do-i-need-a-commercial-bank), financial institutions are evolving in a way that is rapidly changing the way individuals, let alone businesses, do their “banking.”  These developments mean that there is less need for the “classical” model of what a commercial bank does. 

Congress and bank regulators have worked very hard over the past three years of so in an attempt to make sure that 2008 doesn’t happen again.  By early 2009, as I was writing at that very time, financial institutions had moved ahead and, in my mind, were moving far in advance of where Congress and the bank regulators were.  I believe that the banks are even further ahead of Congress and the bank regulators now than they were then and the gap continues to grow.

This gap may be narrowed at some future time but it will never be closed.  Allan Meltzer proposed two laws of regulation in his book “Why Capitalism?” (Oxford University Press, 2012).  His first law of regulation: "Lawyers and bureaucrats regulate. Markets circumvent regulation." His second law of regulation: "Regulations are static. Markets are dynamic. If circumvention does not occur at first it will occur later."  

I have seen nothing in my professional career that would lead me to argue against these laws.   

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