Ninth in a series

Predictions are supposed to be harder to make the longer your time frame. But in another paradox courtesy of a financial crisis that has been chock full of them, there appears to be more of a consensus on where the banking industry is heading than on where it is today.

In the near term, arguments abound over the actual value of distressed assets or the amount of progress that has been made in risk management efforts. But in thinking about the longer term, who would quibble with the conclusion that regulations will be stricter, that credit will be more expensive, that customers will want simpler fee structures along with new "apps" for depositing their checks via iPhone?

This crisis threw a curveball that many in the industry never saw coming. But because of the strong reactions it provoked, the future of regulation and consumer behavior has never seemed clearer. From there, piecing together a picture of what the industry will look like five years down the road is simply a matter of determining how banks will respond to the trends.

Conventional wisdom points to a shrinking number of banks in the system — from just below 8,200 today to somewhere between 6,700 and 7,200 in five years, depending on whom you ask. By that time the government will have long disposed of its ownership in banks that managed to ride out the crisis, and will have shut down the ones that could not. The survivors will keep more of their own capital on hand, both to fulfill tougher regulatory requirements and to support the recapturing of select slices of business that had been ceded to the shadow banking system and securitization markets in the years leading up to the crisis.

American ingenuity will continue to drive innovation. But Rick Spitler, managing director at the consulting firm Novantas LLC, said that, consciously or not, the industry may start taking its cues from somewhere else.

"We're going to move ever so slowly to look like the Canadian banking system, with a less developed capital markets environment and banks with bigger balance sheets and a tighter relationship with regulators," Spitler said.

He predicts a "massive" consolidation of banks with assets of less than $1 billion, with much of the momentum coming from private-equity investors who will be looking to cash out their investments in the industry.

Hundreds more small banks may simply disappear, a conclusion that becomes all the more plausible with every update of the Federal Deposit Insurance Corp.'s list of troubled institutions, which at last count had 416 names on it.

Mergers of the largest banks will be limited because of the 10% deposit cap, which appears to be sticking around for the long haul, but Spitler expects membership in the trillion-dollar-plus balance sheet club to rise.

"We think there's room for one or two more," he said. "You can imagine a U.S. Bank or PNC or possibly even SunTrust — or some combination of those guys — maybe being amongst those."

Citigroup Inc., meanwhile, will try to stick to a strict diet of plain banking and fortified client relationships.

"We're going to be 40% smaller in our balance sheet versus where we were when all this got started," Citi's chief executive, Vikram Pandit, promised last week in a talk at the 92nd Street Y in New York.

Pandit and his industry peers will no doubt continue to draw the ire of a public that finds executive pay packages distasteful at best, and banking regulators will be more watchful of pay practices that could encourage outsized risk taking. But with shareholder revolts still difficult to organize, and since Congress bungled the chance to extract meaningful concessions on pay when it started bailing out the industry last fall, bank executives five years from now should have little trouble financing the standard of living to which they have grown accustomed.

What is more likely to change is the dynamic within executive teams, with risk officers continuing to wield their newfound power, and more entrepreneurial types — the techies devising new ways for banks to reach customers — finding a seat nearer to the head of the table.

"Every institution is thinking about what the market is going to be in the future and what they want to be in the future. And you go very quickly from that to, 'Oh my gosh, do I even have the right people to do that?' " said Rob Sloan, head of the U.S. financial services practice at Egon Zehnder International Inc., an executive search firm.


The convergence of banking and technology will be a strong theme in business development and in talent recruitment, Sloan said. Regulation will spur a deconstruction of the financial supermarket concept and there will be an emphasis on people and institutions with highly specialized knowledge, he said.

"Everything today will become more channeled, and then the innovation will build out the breadth of the market again," Sloan said. "The thinking is shifting away from product production to client service, and backing into what the consumer needs."

And what the consumer needs, said Bob Hedges, managing partner at the retail banking consultancy Mercatus LLC, is clarity and disclosure on deposit pricing, overdraft charges and other fees that before the crisis might not have warranted much more than a cursory glance from customers. Banks also would be wise to apply the same principles of transparency to the development of simple saving and investment products for retirement, which an underserved mass market will be demanding over the coming years as baby boomers age, Hedges said.

"Properly understood, it's a huge opportunity for someone to step up in retail banking the way that two decades ago Vanguard stepped up in the mutual fund business," he said. "For other institutions, it's going to be an enormous challenge to make up [lost fees] or reduces expenses to hold the P&L together."

One surefire target for cost cuts is the branch network, an already bloated infrastructure bound to become more so as "smart" phones make in-person banking less critical.

"Consumers already are researching and comparison shopping online, and then going to the branch to open up the account. It's just a matter of time when that last step in the process can also be done comfortably by consumers over the phone, through the mail or online," Hedges said. "It's not there today, but it will get there. Five years from now, [mobile banking] is going to be as commonplace as online banking is today."

But Hedges predicts that "the pressure to do something [about scaling back] on the branch side will probably be greater than what actually happens."

Either way, the number of traditional branches is bound to shrink, after climbing from about 85,000 to more than 99,000 over the past decade. And banks will have to put more effort into training employees at the branches that remain.

"As you drive all the routine kinds of work into the mobile sphere, only the tough stuff remains," said Novantas' Spitler. "The capabilities of people in the branches are going to have to go up," with a de-emphasis on rote transactions and increased focus on problem-solving skills.

Such training will require investment, but the cost should be more than offset by the savings wrung from branch closures, while the advent of mobile technologies helps allay concerns that a smaller physical presence will harm the ability to capture deposits.

Banks should get additional deposit stability as the government puts stricter controls around money market funds, one of several regulatory developments that Jim Reichbach, head of the U.S. banking and finance practice at Deloitte LLC, expects to see out of Washington.

As a result, he said, "the deposit-based system will be more competitive with the money market system."

And that will help ensure that banks are properly compensated for risk, reducing the likelihood that the abrupt repricing of credit that paralyzed markets last fall gets repeated anytime soon.


Though Congress and the Obama administration may have lost momentum on financial and regulatory reform by focusing this year on health care, Reichbach said there is little doubt that Senate Banking Committee Chairman Chris Dodd, facing the toughest re-election campaign of his career, will seek to capitalize soon on his position as Senate Banking Committee chairman.

"Dodd is in a race for his life, and I think he picked that committee" — rather than succeeding Sen. Edward Kennedy of Massachusetts as chairman of the Health, Education, Labor and Pensions Committee as many Washington pundits suspected he might — "because he thought [banking] was where he could really get something done."

Deborah Bailey, who recently joined Deloitte from the Federal Reserve Board, where she was deputy director of banking supervision and regulation, predicts that the government will develop prescriptive regulations not just for specific products or for capital cushions and liquidity standards, but for entire markets. Participants in a variety of trading markets — whether they are in the regulated banking industry or not — should expect new requirements for registration, position disclosures and the reporting of data that will help authorities monitor risk, she said.

The level of specificity in the recently adopted credit card legislation "is just a forerunner for what you will see" in the regulation of other areas of banking, said Bailey, who has been director of Deloitte's governance, regulatory and risk strategies practice since July.

Bailey acknowledged that politicking may slow down efforts for a truly radical overhaul of regulation. But tighter capital requirements can act as a catchall measure for risk issues not specifically addressed by regulators, she said, with an additional backstop supplied by bank examiners.

"Regardless of what happens in regulation, the supervisors are going to be very aggressive over the next three to five years," Bailey said.

Market regulations, especially those covering previously juicy businesses like derivatives trading, will serve as a fresh reminder to the money-center banks that they must focus more on fee-based businesses and less on asset returns, said Christopher Whalen, managing director of Institutional Risk Analytics.

But Whalen predicts that, even as banks continue to rebalance their earnings mix, return-on-equity ratios will recover from the single digits to about 12% over the next two and a half years.

That said, with an estimated 1,500 fewer banks around and ongoing pressure to keep the Deposit Insurance Fund replenished, the crisis is sure to continue to loom large over the industry.

"A five-year time horizon is not as long as you'd think," Whalen said. "In five years, we should be two years into normal profitability, but we'll still be paying off the party."

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