Conventional wisdom holds that although banks are making record profits, their business is still is a secular decline. Government is urged to do various things to reverse the decline; governmental policies are blamed for the decline, and the bugaboo of restricted credit availability is advanced as the reason to reverse the decline.

I believe it is true that banks, as investment intermediaries, are in decline.

But what does this really mean, and why? What should be done depends upon what is causing the decline.

The Causes

The forces at work are simply summarized.

The financial world has three types of investment intermediation:

* Intermediation as principal.

* Intermediation as agent.

* Electronic intermediation.

The theory that explains the decline of banks as investment intermediaries says that as reliable financial information becomes more readily available and assimilable to the public, the financial services business moves ineluctably from intermediation as principal toward electronic intermediation, with agency intermediation as an intermediate step.

That explains what has been happening to the financial service business for the last 50 or so years. It also is a forecast of what will happen until there is an entirely new technological breakthrough.

An Information Differential

Intermediation as principal means gathering funds at arm's length from unrelated parties and investing those funds in financial assets for the intermediary's own account in the hope and expectation of earning a risk-adjusted spread.

This type of business depends for its success on an information differential between the intermediary and others with respect to the type of assets in which the intermediary invests.

Without the information advantage, the spreads will be too thin, because this type of intermediation requires that the intermediary employ large numbers of people to gather and evaluate information, and it requires large amounts of capital to sustain the intermediary's investment in balance sheet assets.

Most American banks, savings institutions, and insurance companies intermediate primarily as principal.

Trading firms also intermediate primarily as principal. This information advantage inheres not in their trade but in the securities they trade but in their knowledge of the markets in which the securities trade. They can earn good risk-adjusted returns by trading the assets rather than holding them.

Trading and Agents

Examples of trading intermediaries can be seen in the several major banks that consistently earn good returns from trading in foreign exchange, treasury securities, and interest rate futures.

These are markets in which the intermediary does not have a long-term information advantage -- and therefore the intermediary would provide no advantage to investors by holding the assets for the long term -- but because of the intermediaries' information advantage regarding the markets, they can provide excellent intermediation returns.

There are two types of intermediation that function as agents. These the brokers and the money managers. The brokers act only with respect to financial assets that have sufficient publicly available information that the customers require only access to a trading market.

The money managers also act as agent, but they do so with respect to information analysis and decision-making as well as with respect to access to the market. Securities brokers and underwriters are in first category of agent intermediaries; mutual funds, investment advisers and bank trust departments are in the second.

(The mutual fund may appear to act as principal, but analytically it acts only as a conduit for the agency function performed by the investment manager or adviser). Intermediation as agent requires relatively less personnel than intermediation as principal and enormously less capital because assets are not held on the intermediary's balance sheet.

Electronic Intermediation

The pure electronic intermediary performs no judgmental functions at all. All judgments are made by the investor. The Nasdaq market operates as a pure electronic intermediary, although brokers and dealers in fact intermediate for customers using its facilities. Treasury securities also can be purchased through electronic bidding.

Perhaps some day companies and individuals with credit ratings will be matched electronically with lenders. The electronic marketplace requires few employees and needs little capital because it holds no financial assets on its balance sheet.

Electronic intermediation does not necessarily eliminate the other intermediaries.

The Future

If we assume that this theory -- that investment intermediation progresses along a path from intermediation as principal toward electronic intermediation as information becomes more generally available and reliable -- paints a correct picture of how the financial services world works, what does that mean for the future of banks?

Most generally, the theory says something that everybody knows: that banks and other financial intermediaries are in the information business.

The theory also says that information will become progressively more publicly available, more reliable, and more assimilable over time; it therefore says that intermediaries constantly must seek new information advantages or must move along the intermediation scale from principal toward electronic.

It means that the large wholesale banks are on the right track. They are holding fewer assets for the long term, earning more from trading, increasing the proportion of business they do as agents and building their money management capabilities.

Maintaining Advantages

The theory says that these are successful strategies for the foreseeable future, provided that these firms maintain information advantages and have the discipline to withdraw from markets when their information advantages disappear.

The theory also says that large consumer banks are on the right track if they are originating and selling products as agent, not just intermediating as principal.

Smaller banks that cannot replicate the information advantages of the giants need to concentrate on creating information advantages of different types or on gathering funds at low enough cost that they can productively intermediate by holding assets long-term as principal.

The theory suggests that the strategy of gathering funds at low cost and intermediating as a long-term holder of assets will have a shrinking market share (which has already begun from an historical perspective) because its success depends upon customers' being unwilling to make the efforts necessary to shift to more efficient agency intermediation.

Seeking Efficiencies

The theory suggests that over time information will become more readily available and assimilable (that is, not only does information become more readily available, but people's, ability to assimilate information grows as well).

Therefore, fewer and fewer people will invest through intermediaries which are inherently less efficient and therefore of necessity will provide lower returns, in this case to depositors.

The smaller banks therefore should try to serve their customers by the most efficient means available. For example, they may seek to manage and sell mutual funds and trust services.

They may emphasize their payments systems services. They may provide personalized service that other intermediaries may not provide to some customers. And they may profitably make local laws.

Small-Business Implications

For the lending markets, the theory suggests that the process begun long ago when long-term bonds first were sold to the public, which accelerated when the commercial paper market for prime credits came to flower in the 1970s, and which accelerated further with the securitization boom of the 1980s will continue.

Fewer and fewer loans will be intermediated by principals long-term. Credits as to which there is insufficient or unreliable information will become harder and harder to place.

Small banks, however, may have an information advantage in small local credits because of their knowledge of the people and local conditions. Small banks that actually have this type of information advantage and the towns in which they operate will benefit from the banks' advantage.

Increasingly, however, small businesses will have to use the inexpensive modern computer technology and today's improved accounting techniques to provide the kind of information that the market expects. Perhaps small businesses will tap equity markets in circumstances where they once might have looked for bank credit.

Public Policy

For government policy, the theory makes matters relatively simple. It should tell policymakers that the assets that the banking system intermediates as principal will continue to shrink -- but perhaps not drastically. It should tell policymakers that all of this is quite all right.

People still will be served; indeed, they will be served more efficiently. But it also should lead policy-makers to question the assumptions underlying many of the laws that regulate banks and investment firms because they are based on assumptions about financial services that are not correct.

These laws include the Glass-Steagall Act most prominently, probably the Bank Holding Act in its present form, and probably the remaining restrictions on interstate banking. The theory also suggests that we will continue to need deposit insurance for consumers who want the safety of investment intermediation as principal.

Those consumers will pay for the privilege of deposit insurance because investment intermediation as principal generally is less efficient that the alternative.

Adjusting to Change

Like most forms of progress, the progression from intermediation as principal toward electronic intermediation is viewed with alarm by many who are afraid that something is being lost as the process of financial services delivery changes.

I hope that the theory spelled out here makes clear that what is happening is beneficial to American consumers. Although change always results in danger, the theory says that the kind of change whereby intermediation becomes progressively more efficient benefits the public.

The participants who make their living in the financial marketplace, both individuals and institutions, must adjust.

Mr. Lowy is a partner in the New York law firm of Lowy & Tallackson.

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