Rules Force Banks to Innovate for Survival

Bankers complain that the government’s overhaul of the banking system has saddled the industry with a heap of new rules, stricter regulators and higher costs of doing business.

But there is something they might not be so quick to mention in their complaints: The overhaul may also be pushing banks to innovate in important ways.

The overhaul is reducing government subsidies for banks. The banks have for decades raised returns for shareholders with high levels of borrowing. The overhaul restricts that borrowing, so banks will now have to work much harder to post the sort of returns their shareholders expect.

Banks may decide to toss out old practices and adopt new ways of serving clients. Wall Street firms are devising new ways of making securities available to customers. Retail bank executives are rethinking how they can reduce branches while still serving customers. They also cannot ignore the start-up firms that are using technology to make loans far more quickly than banks do.

“Banks have a huge cost infrastructure,” said Samir Desai, the chief executive and a co-founder of Funding Circle, a British company that uses technology to connect small businesses that want to borrow with investors who may want to lend to them. “Banks are not based around getting businesses funding as quickly as possible.”

In some ways, the need for traditional banks to innovate may not seem obvious. The banking sector, after all, reported record earnings in the second quarter of this year. But such figures can be deceptive. The underlying profitability of banking is astonishingly weak compared with other industries.

In simple dollar terms, the banks’ latest profits may look large. But they were equivalent to only 1.1 percent of their assets in the 12 months through June, according to an analysis of data from the Federal Deposit Insurance Corporation. Wells Fargo, one of the nation’s top-performing banks, managed to achieve 1.53 percent in its latest quarter. Walmart’s return on assets, by contrast, has been close to 9 percent in recent years.

Banks have long relied on borrowing, or levering up, to amplify the profits for their shareholders. But the overhaul is restricting the use of leverage. Banks, therefore, have to think hard about how to squeeze more out of their assets â€" and have little choice but to innovate. A look at a simplified bank balance sheet shows just how the numbers are stacked against them.

A bank with $100 of assets and $1 of profits has only a 1 percent return on those assets. But this bank borrows $95, which it uses to make loans and buy securities worth $100. The remaining $5 comes in the form of equity capital, provided by the bank’s shareholders. Since profits theoretically go to shareholders, investors also measure earnings as a percentage of outstanding capital, to get a “return on equity.” In this case, that $1 of profits would translate into a 20 percent return on the $5 of equity, a solid return.

But banks can become unstable when they skimp on equity capital and borrow too much. Equity is the part of a bank’s balance sheet that is supposed to absorb any losses from the bank’s assets. The crisis showed that banks’ equity was too thin for the losses they experienced. As a result, the postcrisis regulations forced banks to substantially build up their capital.

But that depresses returns for shareholders. If the bank with $5 of capital had to raise it to $10, the $1 in profits would translate into a 10 percent return on capital, half of what it was before. For this bank, the only way to get back to a 20 percent return would be to double profits from $1 to $2.

Bankers don’t expect to get back to the sort of high returns on equity that they achieved before the crisis. But they recognize that they need to improve their returns, or capital may gravitate to other sectors of the economy.

“If you take a look at the return on equity that most financial institutions are producing these days,” John Gerspach, chief financial officer of Citigroup, said in a public conference call in July, “there’s reason to think that the profitability is really not enough to sustain continued investor involvement.”

This is why banks have to look for new ways to bolster profits.

The overhaul has already forced Wall Street to change how it performs one of its core activities. As investment banks adapt to new rules on capital and trading, for instance, they are holding much smaller inventories of securities for clients. That leaves them less vulnerable to losses that result from shocks in the markets. They are also devising new electronic trading platforms to connect buyers and sellers.

Yet a leaner Wall Street was able to underwrite one of biggest booms ever in bond issuance over the last four years.

Nor has the streamlining in market making led to hard times on Wall Street. JPMorgan Chase’s revenue from trading bonds and other “fixed income” instruments, for example, was $45 billion from 2010 to 2012. By comparison, total revenue produced by all the divisions within JPMorgan’s investment bank from 2004 to 2006 was $46 billion.

Financial firms, in their efforts to be more efficient, are also doing business with fewer employees. The number of people employed in financial activities has fallen 6 percent since the end of 2006, according to the Bureau of Labor Statistics. The decline has occurred even as bank credit has risen considerably over that period, despite the crisis.

Still, banks’ costs make up a higher proportion of their revenue than before the crisis, according to a regular F.D.I.C. survey. To cut back further, banks will be forced to stop money-losing activities, like offering low-priced checking accounts and maintaining lavish branches. Banking specialists say restrictions on leverage will play a big role in persuading banks to cut back. “Leverage allowed banks not to care about the cost of their products, and they gave them away for free,” said Richard Ramsden, a banking analyst at Goldman Sachs. “That’s all gone.”

The biggest challenge for banks is finding innovative ways to increase revenue. On this front, banks have a patchy record. While banks have introduced products that have had a lasting and positive impact, like A.T.M.’s and most credit cards, they have also acted destructively. Before the crisis, innovation meant finding new ways of lending aggressively to people with shakier credit histories, which resulted in large losses when the loans went bad. Since then, banks have focused almost exclusively on individuals with strong credit.

To bolster returns, however, banks may have to start thinking hard once again about lending to borrowers with less certain prospects, but in a way that does not lead to lending abuses and high losses. That is not an easy goal to achieve. Traditional banks say that the new rules, as well as the legal risks, make it too expensive for banks to find new ways of lending to riskier borrowers. In addition, the government itself dominates the mortgage market. And in doing so, it has brought down interest rates on home loans to a level that makes them unattractive for banks to hold.

But banks may lose out to innovative new entrants if they don’t start becoming more adventurous in their lending. Executives from start-up firms say that fear is also one of the factors apparently holding banks back from lending to borrowers who do not have pristine creditworthiness.

“Banks will only play in the most certain spaces in underwriting, leaving a massive hole for other players to fill,” said David Klein, chief executive and a co-founder of Common Bond, a young company that matches student borrowers with investors, often alumni, who may want to lend to them.

“Banks are fearful,” he said, “New companies are fearless.”