industry over the past half century are nowhere more evident
than in banking. Given that banks are typically the first
financial institution growing businesses turn to for capital, we
now consider the structural changes that have occurred in the
banking sector, and what all this means for entrepreneurs who
seek debt finance. Any business owner seeking to access the
capital available from the global banking system should have
at least a basic understanding of these changes and how they
have shaped today’s financial services industry.
The most important reality for traditional banking over
the last generation has been its decline in both size and profitability.
At the core of traditional banking’s problems have
been declines in its cost advantages in acquiring funds (the liability
side of the business), while at the same time losing
some of its income advantages (the asset side). The result has
been an effort by banks to leave, or at least curtail, the traditional
business of deposit taking and conventional lending,
while engaging in a range of new and potentially more profitable
activities. One problem with these activities, however,
is that they are often riskier than more traditional banking
functions, as evidenced by the large number of banks that
have failed in recent years or that had to be taken over by
more profitable rivals.
One important contributing factor to the declining profits
of traditional banking in the United States was the effect of
rules that prohibited banks from paying interest on checking
accounts. These rules worked to the advantage of banks, at
least until the 1960s, because their major source of funds was
checkable deposits. Given that the cost of these funds was
zero, banks had a very low cost of capital. Although savings
accounts did pay interest, the rate was capped at little more
than 5 percent. But the good times for bankers didn’t last.
Rising inflation in the late 1960s and early 1970s led savvy
investors to seek more attractive alternatives. By the late 1970s,
money market mutual funds began to appear. These funds offered
checking accounts but were structured in a way that allowed
them to circumvent the restrictions on paying interest. As
a result, millions of people took their money out of banks and
put it into these higher-yielding investments. Today, checkable
deposits account for less than 20 percent of bank liabilities; as
recently as the 1960s, such deposits accounted for more than 60
percent of the total. The regulatory structure of the banking industry
gradually caught up with these realities with a series of
rules changes, starting in 1980, overturning the interest-rate
ceilings. But by then the damage to the competitiveness of banks
had already been done.
Just as banks were suffering on the cost side, they lost
their advantages on the income side, too. Traditionally, businesses
relied mainly on bank loans for new debt capital, offering
bankers an effective monopoly on the provision of debt
finance, apart from the largest, most creditworthy firms that
could access the bond markets. But within the past 25 years,
the banking industry has been badly hit by a seemingly
nonending stream of financial innovations, including junk
bonds, securitization, and the market for commercial paper.
Perhaps the most important effect of this development is that
traditional commercial banking lost the advantage it once enjoyed
in the commercial lending business (and the higher returns
that came with that advantage), while businesses of all
sizes now have more avenues available to them for raising
debt capital.
These changes have not been limited to the United States.
Similar effects have been observed in Canada, in Europe, and
in some Asian countries. The impact of these changes on the
banking industry is much as one would expect: A growing
number of bank failures and extensive consolidation of the
sector through mergers and acquisitions. But bankers have responded
in other ways, too. For example, some have tried to
maintain their commercial lending businesses by expanding
into new and riskier areas of lending such as commercial real
estate and leveraged buyouts. Another response has been to fo-
cus on off-balance-sheet services and various forms of financial
innovation, including those mentioned earlier, that offer
the prospect of higher margins than are found in traditional
banking. As a result of these changes, banks today bear only a
superficial resemblance to banks of the 1960s.
Off-balance-sheet activities involve the trading of financial
instruments and the generation of income from fees and loan
sales, activities that affect profits but do not appear on bank
balance sheets. As the term loan sale implies, the bank sells all
or part of the cash stream from a specific loan, thereby removing
the loan from the balance sheet. The profit comes from
selling the loans for amounts slightly greater than those of the
original loans. But the interest rates on these loans are still
high enough to be attractive for investors, mainly large institutions
such as pension and mutual funds. Fee income is generated
by providing banker’s acceptances (in which the bank
promises to make debt payments if the party issuing the security
cannot), making foreign exchange trades on behalf of customers,
and a range of other activities.
Financial innovation has been the catalyst behind many of
the changes observed since the 1970s in the financial services
industry. Some of these innovations have become so integral
to the industry, it is hard to imagine a modern financial sector
without them. Innovations take on many forms, but they have
always been driven by the never-ending desire of banks and
other major players in the capital markets to improve their
competitive positions. Changes in the economic environment,
combined with regulatory changes and advances in information
technology, have helped to create these opportunities.
Automatic teller machines and home banking via the Internet
are just two examples among many. So, too, are the futures,
swaps, and options contracts that allow corporate clients
to better manage currency, price, and interest-rate risks.
To banks, one of the key attractions is that these riskmanagement
tools have become important sources of fee income
and commissions, as well as allowing banks to manage
their own business risks.
Another important innovation has been the development
of “securitization,” in which a wide range of assets—such as
mortgages, credit card loans, accounts receivable, automobile
loans, and computer leases—are converted into marketable securities.
The process works like this: A bank combines loans in
pools with similar features, and sells certificates that are secured
by the interest and principal payments on the original
assets. This arrangement offers several advantages to bankers.
First, the activity is profitable, with banks collecting fees from
the securitization process. In addition, as long as the bank sells
the certificates without recourse (which means that they have
no liability on loans in the pool that go bad), they are not required
to allocate loan-loss reserves.
A further advantage of securitization is that it frees up
funds for further loans (and more profits). Just about any type
of loan can be securitized as long as the candidates for the loan
pool are similar regarding size, collateral, pricing, and maturity.
Also, they must show reasonably predictable losses over
time. Commercial loans are one type of loan that normally do
not fit these criteria, because they tend to be negotiated on a
contract-by-contract basis and exhibit substantially different
characteristics. For this reason, commercial loans are not good
candidates for securitization. More specialized lending, such as
car loans and credit card receivables, are more standardized
than commercial loans and have been successfully securitized.
Nevertheless, growing businesses do benefit from securitization
because of its effect on capital requirements.
Capital requirements exist to protect deposit insurance
funds in case a bank fails. If a bank should fail, regulators,
such as the Federal Deposit Insurance Corporation (FDIC) in
the United States, can either pay off depositors or arrange for
another financial institution to buy the failed bank. Minimum
capital requirements provide a cushion that can lower the cost
of either alternative. But these requirements constrain growth
and thus limit the ability of banks to take on risks that might
lead to failure. One effect of off-balance-sheet lending is that
because the loans disappear from the balance sheet, the capital
that would otherwise be required for regulatory purposes is
freed for other uses, including additional loans. This is the major
benefit of securitization to growing businesses that seek
debt capital from banks.
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