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 / Winter 2009 / Issue 57(originally published by Booz & Company)


What Banking Needs to Become

The industry is most affected in three broad areas:

  • The role of government is growing around the world, as evidenced by increased regulation and even outright ownership of the financial-services sector.
  • Banks urgently need to regain their traditional closeness to customers. Even before the crisis began, the banking value chain had been fractured. In the pursuit of returns, banks enmeshed themselves in a complex web of intermediaries and new financial instruments. But the returns proved unsustainable, and now the old focus on customer relationships is returning.
  • As growth slackens, it will affect the ways that banks compete and capture value. This has important implications for the nature and availability of banking services, such as loans, in the future.

Utility-style Regulation

The magnitude of the government response to the financial crisis will have fundamental and long-lasting effects on banks everywhere. In the short term, governments have been forced to bail out insolvent institutions, supplying liquidity and guaranteeing obligations so these banks can survive. Many Western governments have taken ownership stakes in banks, and they will seek to exit these investments in an orderly manner, with a reasonable return. So far, at least, there is reason to think they will succeed.

However, a much broader debate with more enduring consequences is occurring as governing officials rethink the long-term regulatory framework for this sector. It is highly likely that, by 2011 or so, the regulatory landscape in banking will more closely resemble that of public utilities. Like a water or electric power company, a bank will be seen as an entity that provides society with a product or service so essential that its delivery cannot be left to market forces alone. Utilities tend to face a high regulatory burden, which dictates many elements of their pricing and operations, and often inhibits their levels of innovation and experimentation.

In many countries, the regulatory pendulum in banking had swung away from this model and toward free markets during the 30 years prior to the crisis. Many banks had been partially or completely deregulated during this time. They gained greater efficiency, enhanced their ability to attract and retain management talent, and enjoyed greater access to global capital for funding innovation and growth. But now, five driving forces are causing the pendulum to swing back.

1. The growing perception of banking as a public good. The crisis reinforced the idea that a steady flow of credit and a stable banking sector are as important to a productive economy as abundant resources, physical infrastructure, and human capital.

2. The recognition that markets are not always efficient. For decades, the prevailing logic of economics has maintained that market forces can best connect the sources and users of capital — with the resulting price accurately reflecting all available information. Now the realization is growing that people, and markets, can and do behave irrationally, and that these “animal spirits,” as John Maynard Keynes famously called them, can dramatically skew market behavior.

3. The rising levels of systemic risk. The increasing interconnectedness of the global financial economy has introduced new points of failure. Portfolio choices or product offerings that make sense at the level of a single business unit or small institution may trigger problems at the level of a large bank, a national economy, or a global financial system.

4. The realization that “too big to fail” is simply too big. The consequences of failure among key banking players are causing policymakers to reappraise the need for government control over the size and scope of the largest banks.

5. The broader consequences of misaligned compensation and risk management structures. Existing pay and bonus models, in both the size and the design of their incentives, encouraged outsized risks by bank employees. Employees enjoyed the reward, but left shareholders, and ultimately governments, responsible for the downside.

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  1. Shumeet Banerji, Paul Leinwand, and Cesare R. Mainardi, Cut Costs, Grow Stronger (Harvard Business Press, electronic book, 2009): Step-by-step insights for reducing expenses dramatically by focusing on a coherent system of capabilities.
  2. Alan Gemes, Peter Golder, and Thorsten Liebert, “Global Financial Governance: Improving Stability and Mitigating Future Threats,” Booz & Company white paper, September 2009: Basic principles for the next generation of financial-services regulation.
  3. Henry Kaufman, The Road to Financial Reformation: Warnings, Consequences, Reforms (Wiley, 2009): A banker’s perspective on thehistorical precedents for the current crisis, its likely aftermath, and the impact on regulation and the industry.
  4. Yoshiyuki Kishimoto, Hiroyuki Sawada, and Chieko Matsuda, “Follow the Customer, Follow the Car,” s+b Leading Ideas Online, 12/17/08: Lessons from Japan’s “lost decade” reinforce the imperative of being close to the customer and the dangers of excess capital.
  5. Andrew Turnbull, “Is State Control Making a Comeback?s+b Leading Ideas Online, 04/28/09: Why permanent government control of banks is unlikely — but a new regulatory environment is assured.
  6. For more thought leadership on this topic, see the s+b website at:
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