Future Banking Business Model

What will the future of the banking business model look like?

The Big Banks have had a tough 1st half of 2022 – their share prices are down significantly and the prospects of a recession are on the short-term horizon. At this point a couple of years ago, many were predicting the end of the banks. That’s because between rising Fintech stars and the inception of Blockchain Banking, many were projecting the end of the banking behemoths that have dominated the landscape for the last century. But despite everything, the banks are not dead!

Bitcoin + Cryptocurrency – slated to take over the banks – have not only seen a bloodbath in terms of performance in their token prices, but have also seen adoption rates plummet across the majority of major protocols and networks, worldwide. There are always exceptions and anomalies, but very few people – in either emerging or Western economies – are transacting using either Bitcoin or an equivalent ‘Blockchain Bank.’

Challenger (or Neo) Banks and credit disruptors in the BNPL space had a big year in 2021; but 2022 has not been kind to them, with many seeing valuations and stock prices slashed by 80+%. Their main Value Proposition was about lower fees, a better technology stack, and a friendlier interface to attract a new generation of customers. The problem with most Fintechs has been their business model – or lack thereof – whereby they take the Silicon Valley model of offering a lot of value to new customers for very little money in order to drive adoption rates and network effects. Few Challengers and/or BNPL providers have been able to turn on the profitability taps, a problem that has been further compounded by the inflationary environment amid record debt levels.

The major problem right now is that consumers are awash in debt and inflation has caused the majority of Central Banks to start hiking interest rates. In the Western world, that problem has a different feel than in emerging economies; the focus of this piece is on the banking business model as it pertains to Western economies. Future actions for banks in continents like South America and Africa will be dramatically different than future actions for banks in the US, Canada, and Europe.

So where does the future of the banking business model lie?

Blockchain Structure

We know that ‘The Blockchain‘ – a very controversial word at this point in history – will form some part of the future of banking. While many banks have come out against Bitcoin, it is still the reference point for a successful digital currency and decentralized network. Big Banks tried to create their own private ‘enterprise blockchains’ and other experiments related to ‘The Blockchain’ and virtually all have failed. Certain protocols like Ripple (XRP token) are more geared towards banks. And there is a growing chorus of Western Central Banks who have proposed CBDC (Central Bank Digital Currencies) for which the banks would certainly be the backbone. Nevertheless, trust is at the foundation of banking, and there is so much distrust/disdain towards Big Banks that edge cases on ‘The Blockchain’ will form and potentially compete against Big Banks in the future. We don’t know what form that will take, but we do know a Blockchain Structure is part of the future banking business model in some way shape or form.

Relationship Banking

Local Credit Unions have seen a boom in terms of deposit (14.8% YoY in 2021 in the U.S.) and membership growth since the onset of the pandemic. The problem with most Credit Unions is that they have a) outdated technology stacks and b) high fees. Problem a) is linked to problem b) because without significant improvements in technology on both the front and back-end, it is hard to create a low(er)-fee model in the way that most Fintechs endeavor to do. Nevertheless, the local Credit Unions have maintained trust and depositors in these times want to be able to walk into their local bank and speak with real people. The Big Banks also operate a high-fee model, but they also have cut the majority of their front-office functions in favour of cost savings. This has shifted the core of the banking business model to being transactional, rather than relationship-based. The uptick in Credit Union deposits and growth show that the demand for Relationship Banking is there and it needs to be channeled into a localized model. Even with lower fees and better technology, people will not simply abandon their need for local relationships when it comes to money.

CUInsight

Budgeting Tools

Whether or not a bank offers their structure on the blockchain, or has great customer service at the local level, people are soaked in debt. Personal savings rates are at their lowest since 2008 and the lack of savings is being exacerbated by high debt levels in a rising interest rate environment. That means an even greater percentage of consumers’ already thin savings will be used to service debt. The complexity of problems pertaining to personal debt and savings means that next-gen Budgeting Tools need to arrive to help consumers save money in a sustainable, personalized way – by helping them change habits, manage emotions, and make the best decisions around money in their current context. Mint came along in 2006 to much acclaim as the 1st real ‘futuristic’ budgeting tool. Now, breakthroughs in Data Science are leading to new methodologies to take the Mint model to the next level. Blanket, generalized advice won’t work in the future. It needs to be personalized and contextualized to the current macro environment, which will no doubt change dramatically in the years ahead.

58% of Americans now feel uncomfortable with the amount of emergency savings they have, which is up from just 46% two years ago. Discomfort is higher for millennials than it is other age groups. Fully 62% of Americans ages 26-41 are uncomfortable with how much savings they have, compared to 59% of Gen Xers and 51% of baby boomers.

Marketwatch

Banking Business Model

The banking business model relies heavily on NIM (Net Interest Margin), which is the differential between what banks loan money out to customers at and what they pay out in interest to depositors. Average NIM in the U.S. is generally somewhere between 3 – 4%, meaning that a Big Bank will generate $3,000 – $4,000 in income for every million dollars loaned out annually. Fractional reserve banking enables banks to lend out money that is leveraged against deposits, so they earn much more than simple loans. Mortgages, auto loans, home-equity lines of credit (HELOC) and credit cards enable banks to leverage up their deposit base across multiple products, to multiple different types on the Consumer side of the business. On the Business banking side, a separate suite of products are offered.

Generally speaking, as interest rates go up – as they have been – banks will generate more revenue/profits from their NIM, referred to as NII (Net Interest Income). As Big Banks see an uptick in NII due to rising interest rates, they have to measure that against the other levers of their business model.

If we look at US Big Bank JP Morgan and their latest set of results from Q2 2022, we can see how they structure their earnings.

There are three major revenue streams across ‘Consumer and Community Banking’ or CCB:

  • Consumer and Business Banking
  • Home Lending
  • Card and Auto

We can see that Net Revenue for CCB was $12.6B in Q2 ’22,. This is against Noninterest Expenses (ie. NIM is used to calculated Net Revenue) of $7.7B and Provisions for Credit Losses (PCL) of $0.76B ($761 Million) for a Net Income in the quarter of $3.1 Billion USD. The key to understanding the CCB business model is that it is driven by a balance between deposit growth and loan growth across the 3 different categories. The profitability of the model depends on both growing both sides – deposits and loans – without taking on a large amount of problematic loans, which is why they allocate money towards credit losses (ie. PCL).

Further down their Earnings release, they have Corporate and Investment Bank (CIB) that had $11.9B in Net Revenue and $3.7B in Net Income. The CIB business model is an investment banking business model that relies more on services offered to companies and the listing/marketing of securities.

Commercial Banking (CB) generated $2.7B in Net Revenue and $994M in Net Profit for the quarter; Asset & Wealth Management (AWM) generated $4.3B in Net Revenue and $1.0B in Net Profit for the quarter; finally, Corporate generated $80M in Net Revenue and posted a Net Income Loss of $174 Million for the quarter.

Each Big Bank will have a different strategy beyond Consumer and Business Banking. In JPM’s case, they are notorious for being one of the top Investment Banks, and that is reflected in the CIB section of their earnings. But the core of the banking business model remains around three key areas:

  • the spread between the interest rate money is lent out at, versus what is paid to depositors (NIM)
  • growth in underlying customer deposits creates a bigger balance sheet to lend money out
  • loan growth relative to either PCL or Bad Debts – any loan where the consumer/business stops paying either interest or principal becomes a bad debt that results in big losses for the banks

Debt and Defaults

While a bank will make a lot of money when their customers carry a lot of debt – especially with interest rates rising – there is an inflection point when a significant % of customers start to become unable to pay back their debts and banks are forced to right off large swaths of loans.

Where is that inflection point?

It generally happens when we enter a recession. As you will see on the news these days, talk of ‘recession’ worldwide has ramped up and that’s why the high personal debt levels and low savings rates can become so problematic.

The vicious cycle that we are currently caught in revolves around the role of Central Banks, who have a dual mandate to control inflation and maintain high employment rates. To control inflation requires them to raise interest rates. The U.S. has increased the interest rate from the net zero range to the 2.25 – 2.5% range, the 4th rate hike in the last five months. That means that virtually all business and consumer debt that is not fixed rate has become significantly more expensive to service. That means that even though employment remains high in the U.S. and across most Western economies, the money earned not only becomes worth less each month due to inflation, but they are required to spend more on interest payments. The problem is that taming inflation requires further interest-rate hikes, which in turn means that consumers and businesses will need to spend more money to service their debt. This vicious cycle inevitably leads to a recession.

A recession will cause a large amount of debt to be defaulted on across both the consumer and business banking division. We saw this in 2008 in the mortgage market, and it eventually became so problematic that Big Banks were bailed out to keep the financial system afloat. That doesn’t mean the same thing will happen during ‘the next recession’ but as we saw in the JPM Q2 ’22 Earnings above, the profitability is driven by low PCL. If PCL start to increase due to an uptick in defaulting loans, the stress moves from the Income Statement on the P&L towards the Balance Sheet, which is where the real problems can begin.

Since 2008, has the core business model for banking really changed at all? No.

Some of the regulations around risk + risk management have changed through Basel II and III for example, making a 2008-type event very unlikely. But the leverage in the system is at extreme levels while inflation runs rampant. Rising interest rates is a natural part of the business cycle, and keeping them artificially low to spur demand has created a mountain of personal and consumer debt that is now becoming more expensive to service on a near monthly basis.

The question is, will the future banking business model be a fractional reserve model built on a mountain of debt? Or will the current macro environment force a shift to the underlying model due to the pressures from inflation?

Bitcoin, Blockchain Banking, and CBDCs

Bitcoin – the rebel, decentralized digital currency – was launched by the still-unknown Satoshi Nakamoto in response (to a certain extent) to the 2008 financial crisis. The Genesis Block – launched on Jan. 3, 2009 referenced the headline (pictured below) ‘Chancellor on brink of second bailout for banks’ from The Times in the UK.

Many people detest Bitcoin. And certainly the wild swings in price make it difficult to compare to a ‘currency.’ Nevertheless, the structure of it was designed in such a way that the 21 Million fixed supply could not be tampered with in any way. This meant it was designed to be an anti-inflationary digital asset that would become, effectively, the antithesis of Central Banking. We have seen how this underlying ideology became much more popular outside of the original ‘cypherpunk’ community that Satoshi was a part of.

There is a very small group of Bitcoin evangelists who went all-in on Bitcoin and effectively can now transact outside of the mainstream financial system. This forced the type of open-source innovation that has spurred so many successful technological innovations in the form or digital wallets, local bill payment rails, collateralized loan schemes, and other such innovations that would allow a Bitcoiner to transact in local currency without actually holding said currency in a bank.

There are also pseudo ‘Blockchain Banks’ whereby a customer could take their digital asset(s) and convert it into ‘Stable Coins,’ which are designed to be stable relative to the USD. This means that at least some percentage of the customers’ assets don’t gyrate with the prices of the underlying digital assets; therefore customers can hold USD-based assets outside of the mainstream financial system. Many of these ‘Blockchain Banks’ are regulated and offer some form of debit card that takes money from their digital asset base and allows them to withdraw in the local fiat currency.

As we start to think about all of the innovation as it pertains to Bitcoin + Blockchain Banking, it becomes clear that the ‘edge cases’ have become relevant, even in Western societies. Necessity is the mother of invention, and these inventions become ‘compelling’ for those who want to be part of a new financial system.

But Central Banks are well aware of this trend and have created their own CBDC (Central Bank Digital Currency) schemes. In a sustained downturn of the economy (ie. a recession), they can also test their own plans by offering those who are unemployed or in poverty the ability to receive CBDC in local currency via their bank account. This may – and likely will – be linked to UBI (Universal Basic Income) schemes. Automatic deposits of a ‘living wage’ will be deposited in the accounts of those who are part of UBI each month and they can spend it as they currently do.

This has led to a movement against the ‘cashless society’ due to the overwhelming view that the CBDCs are closet mechanisms to control society. This creates a demand for physical cash and a view that large amounts of debt should not be taken on – ie. avoid a mortgage and rent instead.

Between Bitcoin, Blockchain Banking, CBDCs, and the anti-cashless-society view, lies some kind of middle ground that will likely lead to the future banking business model. Despite what governments, banks, and corporations intend, for the economy to function and grow requires business loan growth and consumer spending. Even under the view that more modest spending and better budgeting would help individuals to improve their ‘financial fitness,’ the collective economy can only function if businesses take risks and individuals spend money.

As we have seen in previous cycles, inflation can quickly turn into stagflation (persistent inflation and low economic growth) if interest rates rise quickly enough. A rate-hiking cycle inevitably lasts more than a few months, and businesses position themselves based on future expectations. Right now we are clearly in a ‘belt-tightening’ phase where many major businesses are laying off a percentage of their workforce, meaning that productivity and the labour-force participation rates will take a hit. Individuals will be forced to take on more debt as a result and government schemes like UBI will come to the forefront.

But innovation will persist. Some who are unemployed will start their own companies. They will either need to dip into saving, raise equity, or take on debt to do so. Others will clamp down on expenses and sell-off assets to increase savings rates. Banking is at the core of society and will never grind to a halt no matter what is happening in the world or the economy. The banking business model will be forced to shift dramatically, probably more so than it has in the last century.

Blockchain Structure, Relationship Banking, Budgeting Tools

Credit Unions have established the trust and are seeing huge growth in both membership and deposits – but loan demand lags the growth in deposits. And the front-end technology experience of most Credit Unions is awful. The upshot is that Credit Unions seem to be seen as the ‘best place to put money’ from a trust perspective,. But if loan growth lags deposit growth than what will that do to the banking business model? Gen X and older seem poised to stick with Credit Unions in the years ahead because of Relationship Banking.

Meanwhile, despite the massive drawdown in the cryptocurrency market in 2022, the younger generations remain much more interested in digital assets and currencies than anything the mainstream has to offer. Furthermore, those with a higher risk tolerance will continue to ‘gamble’ on certain cryptocurrencies if they believe it can get them out of debt. The fact that Bitcoin and other leading digital assets are ‘rebels’ in the current financial environment pretty much guarantees that the Blockchain Structure will be part of the future banking business model. Will Big Banks start offering custodian services on Bitcoin and other Cryptocurrencies? Some already are. BNP Paribas – the largest bank in the Eurozone – will be launching some form of Crypto custody service. Meanwhile articles such as this one suggest that many Big Bank executives are leaving the industry to get into the Crypto space, even during this downturn.

Finally, the mathematicians and data scientists continue to pursue ambitious roadmaps for all of the major Fintech companies. Budgeting Tools are necessary to help empower consumers in their day-to-day financial lives. Saving a few dollars here and few dollars there can lead to big changes in consumer spending, which can help turn a significant % of the population into better customers for banks. If the leading Fintechs start to get even more serious about taking on the Big Banks – and get their banking licenses – then this type of data on customers will be essential to help with Compliance and Risk Management going forward. We need a more sustainable balance between lending and savings going forward.

Bringing the pieces together, we can see that not only is a Multi-Trillion dollar industry dominated by Big Banks seemingly in the crosshairs for new competition – from Credit Unions, Blockchain Banks, and Fintechs alike – but the banking business model itself is teetering on the edge of sustainability. In this type of situation, it would be expected that crossover emerges between one entity and another. Blockchain Banks working with Credit Unions, Fintechs partnering with Credit Unions, etc.

The Credit Unions have the trust and experience at managing the risks associated with finance, yet lack in the ability to build technology and excite younger generations. Fintechs have an increasingly diverse set of strategies they can deploy because they have huge Software Development teams and a lot of funding that they can use to execute a given strategy. Blockchain Banks will still, generally, fall in the regulatory crosshairs, especially with the chain of events that happened this year. They will need help to drive adoption and create legitimacy, but can be a darkhorse if we move deeper into recession territory.

Overall, the future banking business model likely looks much different than the current banking business model. There is too much debt in the system and with interest rates rising to quell inflation, it spells disaster for many. During this period, innovation will be happening and certain ‘edge cases’ will open the door to new business models. Time will tell how this process plays out, but it doesn’t mean the banks themselves will be gone; they will just need to move outside their traditional comfort zones and adapt rapidly in order to survive.