Mid-decade is a convenient point to assess the interplay between secular and cyclical changes in U.S. society and how they will affect the way banks operate in the future.

The forces familiar to banks include consolidation, competition, and technology. Combined with "macro" factors like moderate economic growth, an aging population, and globalization, they suggest the need for an entirely new outlook on the business. Minor tinkering won't do.

In this article we intend to describe the framework of these changes. Later, we will examine the implications on bank decision-making, and what will separate winners from losers.

First, what we call industry factors:

*Consolidation. This activity declined precipitously in the fourth quarter of 1994, but we expect this to be a temporary, six- to 12-month phenomenon. During this period, sellers will rationalize their high expectations while buyers improve their ability to purchase, and then the trend should continue for a long time.

*Market share. Banking organizations have consistently lost share to nondepository institutions. This trend can be reversed. We believe there has been sufficient deregulation and enough experience with it for banks to capitalize on, and increase their markets as a result of, the dramatic changes.

*Technology has become critical for the production, processing, and delivery of financial services. It can no longer be viewed as a frill.

*Breaking with tradition. Banks have typically followed fads en masse. The industry jumped into credit businesses and other lines after major institutions led the way, and has experienced repeated credit crises with the introduction of questionable products.

*Deregulation. A combination of legislative and de facto deregulation has enabled banks to compete effectively with nondepository financial institutions across a broad array of financial services. Though incomplete, deregulation has given banks an opportunity to expand share of wallet and convert unprofitable to profitable customers.

Add to these macro factors that include a moderate-growth, low-inflation economy. Productivity will increase while labor costs will remain contained, resulting in 3.5% annual real growth in gross domestic product with low inflation. Consumers will be more restrained, reflecting continued job and income uncertainty, higher taxes, and debt levels.

Now that the beneficial impact of lower interest rates has ended, we expect the growth of consumer debt to slow. The rate should be closer to that of nominal GDP growth, and the banking industry will at best hold its current market share.

This economic scenario will not result in robust revenue growth. It will be a tough operating environment.

We are also witnessing more than just the aging of the Baby Boom generation (defined as the 80 million people born between 1946 and 1964). There is a big increase in the 40- to 60-year-olds and an absolute decline in 20- to 40-year-olds, both unprecedented. Baby boomers are also the first generation in which more than a quarter have graduated from college and half have had a substantial amount of college education, as opposed to those born in the 1920s and 1930s, where only one in four went to college and one in eight actually graduated.

Any listing of macro factors affecting industries today must include globalization. While it will enhance opportunities for trade finance and foreign exchange trading, it will also result in the cost of funds of banking companies being increasingly determined by global financial markets.

The rapid growth of emerging-market countries, and the development there of a middle class, presents great opportunities for major international banks.

One of the most dramatic revolutions in recent years has been the penetration into the home and business market of direct sales, which bypass traditional delivery systems and meet customers at times and places they choose. Banking is no exception to the rule facing all types of retailing organizations: they must plan to serve a new breed of customer in very different market conditions.

This change will create tremendous growth opportunities for banking companies, but will lead to disappointing growth performance for some companies that adopt failed strategies. The successful retail banks of the future will be outstanding retailers that successfully integrate sales, service, quality, and cost.

Historically, the largest banking organizations were driven by commercial activities. While these remain important for most large banks, we expect banks' on-balance-sheet financing in general to continue to decline. Retail banking (credit and noncredit services to consumers and to businesses with less than $5 million in annual sales) is the true engine of future growth.

Most banking companies today are undifferentiated the way department stores used to be. Just as Sears went through a reengineering to become competitive, so must most banks. Cost structures must come down.

In the new environment, markets will not be as important to earnings growth as marketing. The size or even strength of the balance sheet will be less critical than what banks do with their capital. Differentiation will become more important to performance.

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