In financial theory, as eloquently explained by Fama (1980), banking provides an accounting system for transactions and a portfolio system for the storage of assets. That will not change for the banks of the future. Fama (1980) explains that their activities, in an unregulated state, fulfil the Modigliani–Miller (1959) theorem of the irrelevance of the financing decision. In practice, traditional banks compete for deposits through the interest rate they offer. This makes the transactional element dependent on the resulting debits and credits that they process, essentially making banks into bookkeeping entities fulfilling the intermediation function. Since this is done in response to competitive forces, the general equilibrium is a passive one. As such, the banking business model is vulnerable to disruption, particularly by innovation in financial technology.
A bank is an idiosyncratic corporate entity due to its ability to generate credit by leveraging its balance sheet. That balance sheet has assets on one side and liabilities on the other, like any corporate entity. The assets consist of cash, lending, financial and fixed assets. On the other side of the balance sheet are its liabilities, deposits, and debt. In this respect, a bank’s equity and its liabilities are its source of funds, and its assets are its use of funds. This is explained by Klein (1971), who notes that a bank’s equity W, borrowed funds and its deposits B is equal to its total funds F. This is the same for incumbents and challengers. This can be depicted algebraically if we let incumbents be represented by Φ and challengers represented by Γ:
$$F_{\Phi } = W + \mathop \sum \limits_{i} B_{i}$$
(1)
$$F_{\Gamma } = W + \mathop \sum \limits_{i} B_{i}$$
(2)
Klein (1971) further explains that a bank’s equity is therefore made up of its share capital and unimpaired reserves. The latter are held by a bank to protect the bank’s deposit clients. This part is also mandated by regulation, so as to protect customers and indeed the entire banking system from systemic failure. These protective measures include other prudential requirements to hold cash reserves or other liquid assets. As shall be shown, banking services can be performed over the Internet without these protections. Banking as a service, as this phenomenon known, is expected to increase in the future. This will change the nature of the protection available to clients. It will change the way banks transform assets, explained next.
A bank’s deposits are said to be a function of the proportion of total funds obtained through the issuance of the ith deposit type and its total funds F, represented by αi. Where deposits, represented by Bs, are made in the form of Bs (i = 1 *s n), they generate a rate of interest. It follows that Si Bs = B. As such,
$$B_{i} = f\left( {\alpha _{i} } \right)F$$
(3)
Therefor it can be said that,
$$F = W + F\sum \alpha _{i}$$
(4)
or,
$$W = F\left[ {1 - \mathop \sum \limits_{i} \alpha _{i} } \right]$$
(5)
The importance of Eq. 3 is that the balance sheet can be leveraged by the issuance of loans. It should be noted, however, that not all loans are returned to the bank in whole or part. Non-performing loans reduce the asset side of a bank’s balance sheet and act as a constraint on capital, and therefore new lending. Clearly, this is not the case with banking as a service. In that model, loans are brokered. That said, with the traditional model, an advantage of financial technology is that it facilitates the data mining of clients’ accounts. Lending can therefore be more targeted to borrowers that are more likely to repay, thereby reducing non-performing loans. Pari passu, the incumbent bank of the future will therefore have a higher risk-adjusted return on capital. In practice, however, banking as a service will bring greater competition from challengers and possible further erosion of margins. Alternatively, some banks will proactively engage in partnerships and acquisitions to maintain their customer base and address the competition.
A bank must have reserves to meet the demand of customers demanding their deposits back. The amount of these reserves is a key function of banking regulation. The Basel Committee on Banking Supervision mandates a requirement to hold various tiers of capital, so that banks have sufficient reserves to protect depositors. The Committee also imposes a framework for mitigating excessive liquidity risk and maturity transformation, through a set Liquidity Coverage Ratio and Net Stable Funding Ratio.
Recent revisions of theory, because of financial technology advances, have altered our understanding of banking intermediation. This will impact the competitive landscape and therefor shape the nature of the bank of the future. In this respect, the threat to incumbent banks comes from peer-to-peer Internet lending platforms. These perform the brokerage function of financial intermediation without the use of the aforementioned banking balance sheet. Unlike regulated deposit takers, such lending platforms do not create assets and do not perform risk and asset transformation. That said, they are reliant on investors who do not always behave in a counter cyclical way.
Financial technology in banking is not new. It has been used to facilitate electronic markets since the 1980’s. Thakor (2020) refers to three waves of application of financial innovation in banking. The advent of institutional futures markets and the changing nature of financial contracts fundamentally changed the role of banks. In response to this, academics extended the concept of a bank into an entity that either fulfills the aforementioned functions of a broker or a qualitative asset transformer. In this respect, they connect the providers and users of capital without changing the nature of the transformation of the various claims to that capital. This transformation can be in the form risk transfer or the application of leverage. The nature of trading of financial assets, however, is changing. Price discovery can now be done over the Internet and that is moving liquidity from central marketplaces (like the stock exchange) to decentralized ones.
Alongside these trends, in considering what the bank of the future will look like, it is necessary to understand the unregulated lending market that competes with traditional banks. In this part of the lending market, there has been a rise in shadow banks. The literature on these entities is covered by Adrian and Ashcraft (2016). Shadow banks have taken substantial market share from the traditional banks. They fulfil the brokerage function of banks, but regulators have only partial oversight of their risk transformation or leverage. The rise of shadow banks has been facilitated by financial technology and the originate to distribute model documented by Bord and Santos (2012). They use alternative trading systems that function as electronic communication networks. These facilitate dark pools of liquidity whereby buyers and sellers of bonds and securities trade off-exchange. Since the credit crisis of 2008, total broker dealer assets have diverged from banking assets. This illustrates the changed lending environment.
In the disintermediated market, banking as a service providers must rely on their equity and what access to funding they can attract from their online network. Without this they are unable to drive lending growth. To explain this, let I represent the online network. Extending Klein (1971), further let Ψ represent banking as a service and their total funds by F. This state is depicted as,
$$F_{\Phi } = W + \mathop \sum \limits_{i} I_{i}$$
(6)
Theoretically, it can be shown that,
$$W + \mathop \sum \limits_{i} B_{i} > W + \mathop \sum \limits_{i} I_{i}$$
(7)
Shadow banks, and those disintermediators who bypass the banking system, have an advantage in a world where technology is ubiquitous. This becomes more apparent when costs are considered. Buchak et al. (2018) point out that shadow banks finance their originations almost entirely through securitization and what they term the originate to distribute business model. Diversifying risk in this way is good for individual banks, as banking risks can be transferred away from traditional banking balance sheets to institutional balance sheets. That said, the rise of securitization has introduced systemic risk into the banking sector.
Thus, we can see that the nature of banking capital is changing and at the same time technology is replacing labor. Let A denote the number of transactions per account at a period in time, and C denote the total cost per account per time period of providing the services of the payment mechanism. Klein (1971) points out that, if capital and labor are assumed to be part of the traditional banking model, it can be observed that,
$$C~ = ~eA,~e~ > ~O$$
(8)
It can therefore be observed that the total service charge per account at a period in time, represented by S, has a linear and proportional relationship to bank account activity. This is another variable that financial technology can impact. According to Klein (1971) this can be summed up in the following way,
where d is the basic bank decision variable, the service charge per transaction. Once again, in an automated and digital environment, financial technology greatly reduces d for the challenger banks. Swankie and Broby (2019) examine the impact of Artificial Intelligence on the evaluation of banking risk and conclude that it improves such variables.
Meanwhile, the traditional banking model can be expressed as a product of the number of accounts, M, and the average size of an account, N. This suggests a banks implicit yield is it rate of interest on deposits adjusted by its operating loss in each time period. This yield is generated by payment and loan services. Let R1 depict this. These can be expressed as a fraction of total demand deposits. This is depicted by Klein (1971), if one assumes activity per account is constant, as,
$$R_{1} = \frac{{\left( {e - d} \right)AM}}{{MN}} = \frac{{\left( {e - d} \right)A}}{N}$$
(10)
As a result, whether a bank is structured with traditional labor overheads or built digitally, is extremely relevant to its profitability. The capital and labor of tradition banks, depicted as Φi, is greater than online networks, depicted as Ii. As such, the later have an advantage. This can be shown as,
$$\Phi i \Leftrightarrow ~eA,~e~ > ~IieA,~e$$
(11)
What Klein (1972) failed to highlight is that the banking inherently involves leverage. Diamond and Dybving (1983) show that leverage makes bank susceptible to run on their liquidity. The literature divides these between adverse shock events, as explained by Bernanke et al (1996) or moral hazard events as explained by Demirgu¨¸c-Kunt and Detragiache (2002). This leverage builds on the balance sheet mismatch of short-term assets with long term liabilities. As such, capital and liquidity are intrinsically linked to viability and solvency.
The way capital and liquidity are managed is through credit and default management. This is done at a bank level and a supervisory level. The Basel Committee on Banking Supervision applies capital and leverage ratios, and central banks manage interest rates and other counter-cyclical measures. The various iterations of the prudential regulation of banks have moved the microeconomic theory of banking from the modeling of risk to the modeling of imperfect information. As mentioned, shadow and disintermediated services do not fall under this form or prudential regulation.
The relationship between leverage and insolvency risk crucially depends on the degree of banks total funds F and their liability structure L. In this respect, the liability structure of traditional banks is also greater than online networks which do not have the same level of available funds, depicted as,
Diamond and Dybvig (1983) observe that this liability structure is intimately tied to a traditional bank’s assets. In this respect, a bank’s ability to finance its lending at low cost and its ability to achieve repayment are key to its avoidance of insolvency. Online networks and/or brokers do not have to finance their lending, simply source it. Similarly, as brokers they do not face capital loss in the event of a default. This disintermediates the bank through the use of a peer-to-peer environment. These lenders and borrowers are introduced in digital way over the internet. Regulators have taken notice and the digital broker advantage might not last forever. As a result, the future may well see greater cooperation between these competing parties. This also because banks have valuable operational experience compared to new entrants.
It should also be observed that bank lending is either secured or unsecured. Interest on an unsecured loan is typically higher than the interest on a secured loan. In this respect, incumbent banks have an advantage as their closeness to the customer allows them to better understand the security of the assets. Berger et al (2005) further differentiate lending into transaction lending, relationship lending and credit scoring.