Regulators must wake up to banking’s branchless future

Numerous commentators have pushed back against regulators’ unfavorable view of brokered deposits, arguing that they are safe and sound and do not deserve criticism. I would like to take that a step further and describe why brokered deposits are necessary to the normal evolution of banking. Regulators must facilitate rather than obstruct the natural development of the nation’s banking system.

To understand that evolution, similar trends in the retail world are illustrative.

Many major retailers that primarily sell through brick-and-mortar stores are failing. Rumors are rampant about the looming bankruptcy of several iconic stores. Even some comparatively strong retailers report declining store sales and have been forced to retrench. Look no further than Nordstrom’s new store about the size of a house that has no inventory but only helps customers select things that are ordered online. Amazon and other online retailers with classically disruptive technologies are the main culprits.

Victor J. Blue/Bloomberg

Thanks to mobile banking technology and the growing obsolescence of physical branches, traditional banks face many of the same headwinds. To be sure, there will always be people who want to shop at a store, pinch the fruit, feel the cloth and chat with the clerks. The same is true for bank customers who will always want to deal with people at a branch.

In retail, some stores can survive and even thrive operating under the traditional model. But to endure, retailers and banks must be prepared to adapt to the trends in their part of the market or go in a completely different direction.

The risk in not going with the flow of the market is clear. In recent history, several traditional retail leaders stubbornly stuck to their traditional business model and failed to retrench. The decline of Sears is especially noteworthy; it was the original Amazon, having pioneered catalogue sales in the 1800s primarily to people in rural areas who had little access to stores. Sears should be Amazon today, but it did not see the significance of online sales until it was too late. Xerox is similar; it should be Apple since it developed much of the technology Apple uses in its computers. Kodak should be the world's leader in digital photography.

How did all of these once-market-leading companies miscalculate so badly?

One explanation is that they were victims of their own success. These companies could not bring themselves to abandon or cannibalize their traditional businesses, which is what they needed to do to remain successful. Kodak actually invented digital photography in the 1970s but the company's board would not allow it to develop that technology because it would reduce sales of film.

Fortunately, most banks have done a better job than many retailers of adapting. Some have become market leaders in new technologies, while many traditional banks continue to thrive by focusing on customers who like the traditional banking experience supplemented with some technology.

The branchless banking model is rapidly developing on a parallel track with traditional banks. Branchless banks represent a new business model that does not rely on depositor relationships. For those banks, deposits are just funding. To a large extent, the branchless model is already adopted by the major credit card issuers, which attract customers through rewards programs rather than deposit relationships. Their national credit card programs are essentially branchless.

Other branchless banks engage in specialized lending, or offer complementary products and services to established customers of the bank’s parent company, affiliates and marketing partners. They include industrial banks, but branchless institutions are not limited to the IB model. These institutions still practice relationship banking, even though they utilize different relationships.

This trend toward branchless banking is driven in large part by a significant increase in profitability due to savings from not maintaining branches. Some large branchless banks have efficiency ratios in the low 30% range compared to between 50% and 80% for banks with branches.

The cost efficiencies of branchless banking and the opportunities to market financial services through different kinds of relationships will inevitably drive a broad segmentation of financial services and potentially expand the size of the banking industry dramatically.

Yet the branchless model still faces significant challenges. One big challenge is funding. Most branchless banks cannot rely on core deposits that require conveniently located branches offering a full array of financial products and services. Most must rely on brokered deposits or deposits obtained over the Internet. Both funding strategies work well. Brokered deposits have matured into one of the most stable and inexpensive sources of funding available. Some branchless banks have turned to raising deposits over the internet, but they are today’s version of “hot money,” with rates that tend to be significantly higher than traditional and brokered deposits, and they must be processed through service centers that eat up much of a bank’s cost savings from brokered deposits.

The biggest impediment perhaps to the development of branchless banking is the attitude of regulators who don't like brokered deposits or specialized bank charters.

The Federal Deposit Insurance Corp. has made clear to applicants for a de novo charter and existing banks that only retail “core” deposits get a full stamp of approval. The FDIC’s current leadership considers a bank reliant on brokered deposits or a specialized business plan inherently risky, even though, prior to 2008, the FDIC approved many IB applications that relied entirely on brokered deposits. Those banks generally weathered the Great Recession without problems.

The FDIC is certainly right to require a detailed analysis of the risks in some specialized plans and robust liquidity strategies when using brokered deposits, but many of those plans will actually be less risky than a bank with diversified products and services. Well-conceived plans that will be carefully implemented by competent managers should be approved.

Meanwhile, the Federal Reserve’s obstruction of the branchless banking model is seen in its rejection of the industrial bank charter. The Fed actively lobbies to terminate the charter because IB owners are exempt from regulation by the Fed (but not by the bank's primary regulators) under the Bank Holding Company Act. In practice, the Fed's holding company model only works for a traditional community bank or the largest “systemically important” banks.

The Fed opposes the development of industrial banks — which are almost all branchless — to avoid the erosion of its monopoly on regulating holding companies, not because it has identified any real risks in the newer model for regulating industrial bank parents and affiliates.

Classifying all applicants with specialized plans relying on brokered deposits as higher-risk reflects bias, not experience. Ultimately, these policies can only be understood as a backdoor way of blocking the development of non-traditional banks. This is a serious mistake. Banks ultimately live or die in the markets. If the current regulatory trend continues, there will ultimately be some small localized banks and a few ginormous banks while the majority of the nation's credit is provided by less stable nonbank lenders.

Clearly market forces are redefining much of the banking industry similar to how increasingly obsolete brick-and-mortar stores and online disruptors are redefining the retail industry. Regulators should be embracing the development of new banking models for the sake of the industry and the national economy, not standing in the way.