This week, one set of strategic rules – Basel III capital and liquidity requirements – was finalized and another – the FRB’s stunning approach to interchange fees – was launched.  The rules are aimed at very different problems, but we think they could combine with other initiatives to have the same, thoroughly unintended result:  the biggest banks will grow still larger.  They won’t be as profitable as before but, much like electric utilities, they’ll be the only meaningful providers of the services they proffer.

Why is this? It’s actually simple:  these rules and many others under consideration post Dodd-Frank mean that banks have to be a lot more efficient to glean return for shareholders.  Sure, we know that the Basel III rules might drop the cost of capital a bit to offset the increased requirements, but this is a relatively small counter to our general expectation that effective regulatory-capital rates will rise substantially, even for U.S. banks that have boosted capital in recent years and are long accustomed to a leverage standard. We’ve said it before, but we also think the new liquidity rules will be a major strategic driver, adding significantly to funding costs and, at the same time, shrinking a bank’s ability to hold long-term, fixed-rate assets.  The Basel III liquidity standards come in concert with the Dodd-Frank requirement that deposit-insurance assessments now be based on assets, not domestic deposits.  This creates a strong incentive for large banks to gather as many funds as they can in core deposits because these meet the liquidity requirements and, now, don’t cost them more for the valuable federal backstop provided by the FDIC.

All of this will force the biggest banks into the lowest-cost businesses based on the combination of capital, liquidity and other regulatory considerations.  Exotic businesses are particularly penalized in this new regime – see the Volcker Rule if you’ve any doubt on this point.  Thus, the biggest banks will need to become formidable intermediation machines to make anything like the buck to which shareholders once were accustomed.  This business is one in which economies both of scale and scope have tremendous power, especially in the array of products – mortgages, credit cards and the like – that are now largely commoditized.

Now, add to this the FRB’s interchange-fee proposal.  It will make merchants mighty happy, at least for a while.  For banks, though, it means that the only way to make money on debit cards is to drive as much return as one can within the hard cap priced into these once-lucrative products.  How to do this?  Add value?  Hard to do with debit cards, especially since the FRB’s proposed standards do not permit pricing offsets for features like card-use rewards.  So, again, it’s back to basics – run as much of this business as a bank can through as powerful a delivery system as it can to make the odd basis point or two for the bottom line.  For the biggest banks, of course, a basis point or two can mean millions.

Small banks should be very, very afraid.  They have opposed most of the changes that will squeeze them hard, but for naught.  Big banks, of course, won’t welcome any of these developments.  Increasingly, the business of retail banking is looking more and more utility-like.  But, over time and after lots of M&A, the business will settle into its new mode:  even more commoditized retail financial products delivered through even fewer large banking organizations.  The systemic-risk surcharge and other punitive rules will penalize them some for all this clout, but not enough to reverse the fundamental economics taking shape in the redefined regulatory framework.

 

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