US Banks Face an Uncertain Future

October 23, 2015 | By Neil Howe

In July, the Federal Reserve introduced new standards that raise the amount of capital the nation’s largest banks must hold to safeguard against failure—the latest in a series of post-crisis reforms that the Fed has made to pressure Wall Street firms to get smaller and cut their appetite for risk. Seven years after the financial crisis, big banks are still struggling to raise revenue in a volatile trading environment marked by tougher regulations, ultra-low interest rates, and a new crop of non-bank lenders that is gaining favor among young borrowers. The challenges are even greater for their small and mid-sized counterparts, whose best chance of survival may be tapping into the community ethic that sets them apart.

The new Fed rule applies to eight financial giants—among them JPMorgan Chase, Citigroup, and Bank of America. Together, they hold more than $10 trillion in loans and securities. As described in a statement from chairwoman Janet Yellen, the rule leaves these firms with a choice: maintain more capital to reduce the likelihood they will fail, or shrink to reduce the harm their failure would have on the economy. These concerns reflect the key mandates of 2010’s Dodd-Frank Act, which spurred the most significant changes to financial regulation since the reforms following the Great Depression.

No corner of the banking world has gone untouched by these reforms. While the Wall Street firms closest to the crisis have been subject to the toughest restraints, nearly all types of banks—whether investment, retail, community, commercial, or private—have been affected. Though these banks serve different customers and offer a widely divergent range of services, the core of their business boils down to the same basic principle: borrow­ing short-term and lending long-term.

The far-reaching scope of the banking system reflects a dramatic trans­formation that unfolded in the dec­ades leading up to the financial crisis. As a recent Brookings report con­cludes: “[The] traditional banking model of taking deposits and extending loans to regionally-based customers evolved into one characterized by global reach, new technology, and a diverse range of com­plex services.” In the 1980s and ‘90s, deregulation—most notably, the repeal of 1933’s Glass-Steagall Act—fueled massive consolidation and banks’ expan­sion into securities activities. The push for deregulation was largely spurred by the growing success of “shadow banks,” which offer services that compete with those of commercial banks (for example, hedge funds) but are not regulated.

Today, big banks are operating in a far more subdued environment. Under Dodd-Frank’s regulatory pressure, many are pulling away from risky investment activities that were once their profit engine. According to data from the Inter­national Monetary Fund, banks dedica­ted only 21 percent of their assets to trading in 2013—down from 41 percent in 2006. They also continue to be on the hook for tens of billions in settlements related to the crisis. Mean­while, the traditional lending-and-deposits side of the business isn’t any more promising: Rock-bottom interest rates have resulted in a historically low net interest margin (the difference between what banks charge on loans and pay for deposits) of 2.95 percent. Though most Wall Street firms have reported solid profits in recent quarters, they have largely achieved that growth through cutting expenses, such as slashing salaries and staffing. Many have gut entire business lines altogether.

Industry observers are divided on whether this downsized version of Wall Street is here to stay. Investors appear gloomy: The price-to-earnings and price-to-book ratios of the big banks generally trail those of the S&P 500. But more sanguine analysts insist that as the economy continues to improve, long-term interest rates will inevitably rise and lift Main Street’s fortunes. Others point out that despite banking’s overall struggles, some players have managed to carve out successful models that are prospering, namely Morgan Stanley in wealth management and Wells Fargo in mortgage lending.

Generational forces, however, favor the pessimists. The Great Recession left Millen­nials with a famously low opinion of banks; they’re also less likely to carry debt and invest in stocks than other generations were at the same age. The past few years have seen an uptick in the “unbanked” and “underbanked”—a population dominated by under-40 households, a plurality of which cite “not having enough money” as the main reason they don’t use banks. The next most-frequently cited reasons are distrust of banks and high service fees.

Once this generation’s financial situation improves, it’s unlikely that they’ll be em­bracing retail banks wholesale. Instead, they may turn to the thriving system of non-bank services—which also offer more choices to people with no or poor credit. Between 2013 and 2014, the number of loans to subprime borrowers arranged by online loan start­up LendingTree soared 761 percent. And Millennials would welcome even more disrupt­ion: One recent survey found that 49 percent of 18- to 29-year-olds would consi­der alter­native banking services from digital providers like Google, compared to only 16 per­cent of those age 55 and over.

For smaller banks, the road ahead looks even rockier. Many don’t have the resources to cover rising regulatory compliance costs, and they haven’t had alternate revenue streams to lean on as their bread-and-butter business has flattened. The rise of mobile banking technologies has also created a fiercer competitive environment where nimble upstarts can readily absorb rivals across local and state lines. In 2013, following decades of decline, the number of banks nationwide fell to a record low (6,981, down from a peak of more than 18,000 in the mid-1980s).

At the same time, small lenders do hold one key advantage over their Wall Street counterparts. These banks make the lion’s share of loans to small businesses and have fierce defenders who see them as a pillar of their communities—a major selling point to young consumers already committed to buying close to home. In the past five years, only two new U.S. banks have opened—with the founders of both emphasizing the importance of personal relationships and the desire to reach under­served markets. One, Bank of Bird-in-Hand, has found success catering to the Amish community in Pennsylvania. The other, New Hampshire’s Primary Bank, focuses on lending to small and midsized businesses. “People here like going to see the bank president at his house on Saturday morning,” president Bill Greiner told The Wall Street Journal. “They like to know things are going to be locally owned.”

Most of the questions on Wall Street and Main Street can only be answered with time. Perhaps more than in any other industry, its future performance is also closely linked to external factors—namely, the state of the economy at home and around the world. All banks can do is continue making adjustments to suit the new regulatory regime—and try their best to rehabilitate their image before upstarts steal the next generation away.