Financial institutions in general, and banks in particular, have faced an increasingly competitive environment. These forces, in some cases reinforced by episodes of widespread financial distress, have been instrumental in a major restructuring and consolidation of the banking industry,
Against the backdrop of generally favourable cyclical conditions, bank profitability has been stable or improving in most industrial countries in the second half of the 1990s. The main exception has been Japan, reflecting serious financial difficulties in the banking sector. These recent benign developments, however, should not be allowed to mask the structural challenges facing the industry. Seen from a longer-run perspective, profit margins have tended to decline somewhat in several countries, at least since the mid-1980s. Similarly, outside the English-speaking countries, bank share prices have lagged behind the general equity market indices. More tellingly, the widespread narrowing of net interest margins underscores the long-term loss of profitability on traditional intermediation activities, while the fairly widespread decline in ‘individual’ credit ratings since the late 1980s highlights the deterioration in institutions’ risk profile.
Profitability
In terms of rate of return on assets and net interest margins, the United States is somewhat of an outlier, with clear improvements in these variables having been recorded over the longer term. These statistics are symptomatic of the powerful forces operating at both the firm and the macro level that are inducing a restructuring and consolidation in the banking industry. At the micro level, deregulation in the functional, geographical, price and balance sheet dimensions of the operation of institutions, together with technological advances in the production and delivery of financial services, have vastly increased potential output and reduced marginal production costs. At the same time, in a structural sense, financial capital has tended to grow more expensive at the margin as the cost of retail and wholesale funding has increased, and shareholders have become more demanding and assertive in requiring a focus on appropriate returns on their investments. To a similar effect, regulators have become more alert to the need for banks to operate with adequate capital levels.
At the macro level, relaxation of credit constraints and heightened competitive pressures have arguably contributed to episodes of widespread financial distress, both nationally and internationally, not least by supporting vicious circles in credit expansion and asset price misalignments.
Deregulation and competition
Looking ahead, there is little reason to believe that the forces for change will abate. Deregulation has not fully run its course. While the prospect for the elimination of the remaining functional barriers in the United States is still somewhat uncertain, in Japan the effects of the ‘Big Bang’ are only beginning to be felt. In the European Union, it is probably only a matter of time before the mortgage lending sector is exposed more fully to the rigours of competition and before the conduct of business restrictions that still hamper the direct provision of cross-border services in the retail sector come under closer scrutiny. In addition, the creation of EMU has been widely heralded as a major catalyst for further restructuring.
Technology
More generally, while deregulation in the insurance industry has so far lagged that in banking, it is expected to have a significant impact on the other segments of the financial industry in the foreseeable future. Meanwhile, the pace of technological change is unlikely to slow down. In particular, the longer-term impact of the development of new delivery and payment channels should not be underestimated, especially in the retail sector; the various forms of electronic banking are one such example. These developments have increased the contestability of the market for distribution of financial services as a new set of potential competitors, such as software houses and computer network providers, are bound to put increasing pressure on networks of bricks-and-mortar branches. Overall, booming demand for financial services may well continue to fuel above average growth rates for the financial sector in the long term; the bright prospects for asset management services in the wake of the increasing demand for private pensions are the most obvious example. A precondition for banks to take advantage of the new opportunities is to achieve cost-effectiveness and to redeploy resources towards the more profitable activities while avoiding the temptation to take excessive risks in the restructuring process. The number of institutions is expected to decline and their average size to increase, leading to a rise in concentration. This should facilitate the necessary reduction in excess capacity in both retail and wholesale segments. Costs will need to be cut further. Branch networks should shrink and be converted to higher value added services; at least in the medium term, employment should fall and skills would have to be upgraded. Less clear, however, are the speed and limits of these trends. |
