We find ourselves at a critical mid-point in the half-century-long transformation of the world’s financial markets that began in the 1970s and will continue well into the next century. The last decade has been one of extraordinary upheavals for financial institutions in the United States. The next looks as if it may well bring much the same disruption to the markets and institutions of Europe and Japan.

Many of the defining features of the financial sphere and the players that populate it are in the midst of profound and unstoppable change—change in how financial firms make money; in how and by whom they are regulated; in where they raise capital; in which markets they serve; and in what role they play in society. It is, of course, impossible to see exactly what lies at the end of this process of transformation, but an understanding of the forces that are driving it—technology, globalization, emerging markets, demographics, and the increased willingness of financial firms to compete with one another—can provide some glimpses of where this transformation is heading.

The limits of banking

Let’s begin with technology, since changing technology is in many ways the most fundamental of these forces. The first thing to understand about any technology and the production techniques associated with it is that all technologies have limits. It is easy to see how these limits will affect the performance and sales of a product when technology and product are closely associated. For example, the advantages of large graphite tennis racquets over wooden ones are apparent to anyone who has played the game. But limits are less apparent in something like banking, which draws on thousands of individual technologies. Yet one of the thoughts I’d like to stress is that I believe we are beginning to reach the limits of the "technology" we call banking.

When funds and effort are first put into developing a new product or process, progress is very slow. Then everything gains momentum, as the key knowledge and infrastructure necessary to make advances are put in place. Finally, as more dollars and activity are invested in developing a product or process, it becomes increasingly difficult and expensive to make further technical progress as the technology approaches its natural limits.

I believe we are beginning to reach the limits of the "technology" we call banking

As my colleague Dick Foster has noted,¹ no matter how much is invested, sailing ships can’t be made to go much faster. Vacuum tubes can’t be made to switch on and off much quicker. Mechanical cash registers can’t be made to work a lot better. And then along comes a steam ship to replace the sailing ship, or a semiconductor arrives to replace the vacuum tube, or an electronic cash register turns up to replace the mechanical one. In manufacturing businesses, the resulting discontinuity usually wipes out the existing producers, and the new manufacturers quickly ride a new "S-curve" of performance improvement until that, too, approaches its limits.

The rise of securitization

What does any of this have to do with banking?

Simply put, there is an enormous variety of new "hard" and "soft" technologies at work within the banking industry. Hard technologies include advances in telecommunications, computers, analytics, software tools, and video communications, which are enabling participants to have better information at lower cost; to integrate this information with thinking, communication, and analysis; and, finally, to use the resulting knowledge along with other technologies to distribute services to clients more efficiently, effectively, and economically. Soft technologies, or financial innovation—things like, say, the use of derivative instruments such as interest rate and currency swaps—often use these hard technologies to rethink the delivery of services. Out of these hard and soft technologies have come the securitization and globalization movements so often talked about in the press.

In the early 1970s, every country in the world had a self-contained financial system. In all of them, the financial economies were dominated by banks. In some, particularly the United States, Japan, and the United Kingdom, there were also smaller but well-developed securities industries whose main business was raising and distributing long-term debt and equity. Everywhere, even in countries with a securities industry, there were relatively stable systems, primarily because of regulatory limits that stifled competition and because of the lack of any alternative technology.

Bank intermediation—the use of banking institutions as "middlemen" in the allocation of capital—is very expensive and, by comparison with securities intermediation, inefficient at absorbing and diversifying risk. The total cost of intermediating a security over the life of an asset is well under 50 basis points. In contrast, the cost of bank intermediation is well over 200 basis points.

Traditionally, only a few borrowers had the creditworthiness and size to be able to issue securities. Most borrowers did not have direct access to the securities market: they represented complex credit risks, or were too small to be able to issue securities directly, or were private and did not want to disclose the information necessary for issuing securities. Another way of saying this is that there were barriers that prevented the use of the securities business system for most banking services.

Traditionally, there were barriers that prevented the use of the securities business system for most banking services

What then happened was that the securities industry used hard and soft technology to overcome these barriers, particularly in the United States. Volume in money-market funds, bond funds, commercial paper, mortgage-backed securities, and pooled receivable notes has exploded—at the expense of deposit-based intermediation. This process will, I believe, unfold in Europe and elsewhere, with about a six- to ten-year lag behind the United States. In Europe, the major securitization so far has been the movement of customers in countries without strong indigenous securities industries to the Euromarkets for Eurobond and Eurocommercial paper, plus the growth of the mutual funds industry in many countries.

What’s left

This extended time frame gives European bankers far more time to adjust than, for example, computer manufacturers have enjoyed, but adjust they must. Ultimately, the only limit to the process is its lack of relevance to those assets where the costs of securitization exceed the value. Everything else is fair game. Even developing country debt is now being actively traded. But the limits to securitization are real. In the United States, for example, there has been little securitization of small business and middle market loans because turning these diverse loans into securities simply costs too much to make it worthwhile. We call the residual business, which cannot be securitized, the "core banking business."

Although there are limits to how far the securitization process can go, its direction is clear. In the United States, the trend is steadily to diminish the importance of bank deposits in the flow of funds. In 1980, 46 percent of US household assets were in bank deposits. In 1990, it was 38 percent. I estimate that by 1995 it will be 32 percent, and I would expect the number to fall by the year 2000 to between 20 and 25 percent. The long-term question for banks is how big the residual base of core banking business will be after the securitization process has reached its new limits.

The process of globalization

The story grows more interesting when securitization is combined with the simultaneous globalization of the world’s capital markets.

Until 1973, when exchange rates first floated, the various national financial economies were closed to one another. Essentially, the only integration between them came about through traded goods. With the floating of exchange rates, these economies were first linked together in the foreign exchange markets.

By the mid-1980s, all tradeable instruments were beginning to be linked together

Over time, primarily through the application of some of the technologies described earlier, and in particular through the use of derivatives, the various financial instruments in each national economy became more closely linked to each other and to the global foreign exchange market. In 1976, for example, there was little correlation between price movements in the S&P 500 stock index and movements in FX rates or in US government bond rates. However, by the mid-1980s these linkages had become quite strong. Since processes such as covered interest arbitrage were causing tight linkages between short-term interest rates and foreign exchange rates, the result was that all tradeable instruments were beginning to be linked together. Over the intervening years, the linkages have grown tighter and tighter.

Coupled with securitization, this process has resulted in an enormous growth in trading relative to the underlying growth in the real economies. For example, in the mid-1980s, equity trading in West Germany grew by 69 percent compounded annually and bond trading by 32 percent, but the real economy grew at a rate of only 2.4 percent. Even in the United States, where the markets were more mature, trading grew by about 20 percent compounded annually, while the real economy grew at 4 percent. In the FX markets, annual FX trading grew more than seven-fold from 1983 to 1992, from $20 trillion a year to $160 trillion, although world trade growth only doubled.

In 1980, 46 percent of US household assets were in bank deposits. By the year 2000, I expect it to be between 20 and 25 percent

What has emerged is a global capital market that continues to grow in scope, size, and power. The more that flows of funds are securitized, the stronger the linkages become through arbitrage and derivatives, the greater the number of instruments that are linked together, and the more numerous the countries that open up their financial markets, the more overwhelming is the result.

New opportunities

Over time, increasing numbers of countries are joining the global marketplace by opening up their financial economies so as to attract the capital they need. When this is combined with imported technology and the countries’ own relatively high-quality, low-cost labor, they are able to gain competitive advantages in the global real economy. This, in turn, has led to some very rapid growth. Even in the face of slowing growth in the developed world, the newly globalizing markets—Asia is just one example—are experiencing remarkable expansion.

The potential size of these new markets is awesome. Take mainland China: while the average income per person will stay relatively low for some time, the number of reasonably affluent consumers will grow exponentially. For example, today there are 60 million Chinese with average annual incomes of $1,000 or more, a level of wealth equal to that of the whole of Thailand. By the year 2000, there will be over 260 million.²

Growth in the number of people who meet "threshold" levels of affluence is, of course, only a proxy for the opportunities to finance businesses and to bank individuals. As China gets closer to opening its financial economy fully, the opportunities for non-indigenous banks may be enormous, given that Chinese banks are relatively weak—particularly in providing access to the global capital markets.

China is only one emerging market, albeit a huge one that is growing extremely rapidly. If India can keep itself from fragmenting, it could rival China’s growth potential.³ By the year 2000, the Asian market excluding Japan will have well over 800 million people with incomes above $1,000 a year. At a higher income level, there will be at least 125 million people in Asia with annual per capita incomes of $5,000, plus the entire 70 million population of South Korea and Taiwan who will probably be enjoying median incomes of above $15,000 per capita. To put this in perspective: there will be some 200 million people in Asia with a median income of around $9,000 each. This population, about two-thirds the size of Western Europe’s, will have per capita incomes that are two-thirds of those in Western Europe today.

Japan will hit its peak in the high-saving cohort in the late 1990s, followed by a slow decline over the next 25 years

Adding in other emerging markets, such as Mexico, Chile, Eastern Europe, and parts of the former Soviet Union, shows how big are the potential opportunities for outsiders in these countries: all have indigenous banking systems with weak skills in the global markets, corporate finance, and private banking.

Demographic trends

A final force at work is the changing demographics of the world’s population.⁴ The developed world is getting rapidly older. At the moment, there is brisk growth in the 40- to 65-year-old population in the United States, Japan, and Germany. This is a particularly important segment for the world’s capital markets because it is the one that produces almost all the savings. In general, people under the age of 40 are net borrowers; people over the age of 65 spend more than their income by drawing down savings.

Japan will hit its peak in the high-saving cohort in the late 1990s, followed by a slow decline over the next 25 years. The fastest-growing population segment after 1997 in Japan will be the group of people over 65. The same holds true in Germany, where the high-savings group peaks later, in 2010, at 37 percent of the population. As in Japan, the fastest-growing population segment after 2010 will be the over-65 set. In the United States, there will be a steady rise in the high-saving segment over most of the next 20 years. Even so, the over-65 population will continue to grow rapidly after peaking in 2010, and the under-40 population will also show some growth.

People under the age of 40 are net borrowers; people over the age of 65 spend more than their income by drawing down savings

Real interest rates are affected by many factors, demographics among them. It is probably no coincidence that Japan’s interest rates fell in the 1980s as the large percentage of 40- to 65-year-olds saved for retirement. Similarly, in the United States in the mid-1980s, when baby boomers were in their peak borrowing years, real interest rates rose and savings rates fell. Taken by itself, the increasing percentage of the developed-world population in their peak savings years should lead to lower real interest rates.

The other side of the picture

However, there is more to the demographic story. In the rest of the world, the demographics are heading the other way. Despite the demands for capital from their young and growing populations, the developing countries of the world were actually net suppliers of funds during the 1980s, as they struggled to repay debt.

In the coming decades, what will be their demands for funds on the global capital markets? Most of the funding for these nations will, with any luck, be in the form of equity. Early signs suggest they are likely to be able to raise it. If the global capital market works as it should, the equity returns from these nations should provide comfortable retirements for the aging populations of the developed world, to the benefit of all concerned.

The pressures

There is a dark side to this happy prospect, however. It is unclear whether the democratic processes in Europe and the United States will allow the governments of those nations to curb their appetite for borrowing to finance consumption.

While birth rates are lower, advances in health care in the developed world promise to extend life expectancy. The best estimate is that the life expectancy of the average white male reaching his fiftieth year in the United States will be another 35 years. This increased lifespan will swell the ranks of the politically active elderly. The combination of lengthening lifespans, the shrinking relative economic power of younger people to pay taxes, and a growing sense among the elderly that they are entitled to a comfortable government-funded retirement and subsidized health care will put brutal pressure on many governments to continue running budget deficits.

The developing countries of the world were actually net suppliers of funds during the 1980s, as they struggled to repay debt

To me, it is incredible that Japan is the only major developed country forecast to run a budget surplus in 1993, even though none of these nations has yet faced the demographic time bomb of aging populations. What will be the pressures on developed-country governments to borrow to finance pensions and increasingly expensive health care some twenty years from now when the bomb explodes? If governments yield to these pressures, and increasingly issue their securities directly to investors for cost reasons, the flow of funds through private-sector intermediaries will decline further, adding to the securitization pressures on banks.

Where is the system heading?

What does all of this mean for banks? To some extent, it depends on how pervasive securitization is in a country’s banking system. The United States started the securitization process first, and its financial system is now in the midst of discontinuous change. In contrast, the Japanese and European banking systems have begun to change, but the bulk of structural change still lies ahead of them.

In country after country, banking systems tend to follow a predictable track when faced with mounting pressure from securitization. The better banks respond to the competition by increasing their skills and improving the value proposition for the business that cannot be securitized. However, as they struggle against increasing competition both from securitization and from their better rivals, many banks take the easy way out: they take more risk.

In the process, they put real pressure on good credit underwriters either to lower their own standards or to lose business and suffer real declines in risk-adjusted margins. In the United States, this tendency led to massive loan losses in the S&Ls and in commercial banks, and to lower profits generally, even for the better participants.

It also led to massive misallocation of capital into commercial real estate. For example, from 1979 through 1990 the United States built more office space than growing office employment needed. It will take at least a decade to work off the resulting overcapacity.

The Japanese situation

In Japan, a number of large banks also took big risks driven by the excess liquidity in their home market. Huge savings from the 40- to 65-year-old generation, combined with the absence of attractive and safe investments accessible to the Japanese investor, led to low interest rates and a speculative boom. The banks, supported by the Ministry of Finance and the Bank of Japan, lent money to corporations and individuals, who then engaged in speculation in equities, real estate, and currencies. Benefiting from compounded appreciation rates of 25 to 35 percent, some investors became very rich.

Faced with mounting pressure from securitization, banks take the easy way out: they take more risk

Moreover, this speculative boom took place in a country with a relatively inelastic supply of equities and real estate. In equities, something like 80 percent were closely held and not traded. In real estate, there are 130 million people living in a country with a usable land area approximately the size of Belgium.

On the demand side, a huge surge in liquidity was followed by a multi-year surge in "reflexive" speculative demand. Reflexive demand is a characteristic of financial markets. In markets for goods, an increase in price leads to a decrease in demand. In financial markets, however, a rise in price is often followed by increasing demand from other investors betting on the price rising even further.

As a result of these factors, the price of real estate and equities was bid up almost beyond belief. Land value in Japan went from roughly three times GNP to six times GNP during the 1980s. As a concrete example of what speculation did to real estate prices in Japan, take an apartment of, say, 1,200 square feet. Such an apartment in a ski condominium on a mountain in New England might have had a peak value in the 1980s of roughly $200,000. An apartment of similar size in mid-town Manhattan had a peak value of about $500,000 in the same period. But in Tokyo, the same kind of property reached a peak value of $6 million.

In truth, the price of real estate, and to some extent equities, got detached from reality in Japan. The problem is, of course, that this upward spiral in price was funded by bank lending, and banks now hold loans secured by real estate that is worth far less than their outstanding loans. Indeed, it has been estimated that Japanese banks hold some $400 billion in problem real-estate loans alone. At the moment it is not clear whether the Japanese government is willing to deal fully with these issues. It is possible that it will take years for the Japanese banking system to confront the structural changes it needs to make.

Is Europe next?

Certainly, there are signs of coming trouble in Europe. UK banks have suffered significant losses. Scandinavia’s banking losses are rivaling those of the United States in Texas. Italian, Spanish, and French property markets all show signs of strain.

The intensity of competition in the United States has led to a productivity advantage of nearly 50 percent over German and UK banks

Increased competition does, however, bring benefits as well as problems. The intensity of competition in the United States has led to major productivity improvements compared with other countries, as competition spurred US banks to apply new technologies. McKinsey’s Global Institute did detailed work measuring the productivity of retail banking in three countries: Germany, the United Kingdom, and the United States.⁵ To their surprise, they found that the latter had developed a significant productivity advantage. They attributed this to the pressures of competition both from other banks and from the securities industry. Indeed, the figures showed the United States enjoyed a productivity advantage of nearly 50 percent over German and UK banks.

US banking now

The US banking system itself has entered a new strategic era, thanks partly to the government’s willingness to push poorly managed institutions into stronger hands. The current strategic discontinuity is causing massive market-share shifts, widening risk-adjusted margins, and efforts to acquire or merge with other institutions. In circumstances like these, your starting position as you enter the discontinuity determines how you will do. For example, Banc One, Bank of America, and NationsBank have been able to capitalize on the discontinuity, although New York money center banks have not. In the process, industry structure changes rapidly as the winners consolidate the weaker institutions that took excessive risks. The winners are rewarded, in effect, for the skills they have built up in the past.

The effectiveness of banks in using technology will be a key determinant of just how much business remains in the banking system

However, even the winners in the United States face a dilemma in their domestic core banking business. What strategy should they pursue as securitization continues? Should they get better at executing domestic core banking? Or should they attempt to shift more to the securities business system?

Banks can use technology to rethink how they operate their domestic core banking businesses. It is possible, for example, to envisage a world in which interactive video replaces many of today’s branch-based services. The potential for redesigning the business system through technology is vast. Despite US banks’ productivity advantage over European banks, American banking still uses $100 billion in non-interest expenses to operate its core banking businesses. Technology offers huge opportunities to provide much greater value to customers at far lower costs. Indeed, the effectiveness of banks in using technology will, I believe, be a key determinant of just how much business remains in the banking system as the securitization process continues.

Moreover, most banks will want to participate actively in the securities business. Certainly they will want to sell mutual funds through their branches and to develop non-branch-based distribution channels. However, the option to convert fully to the securities business system is not a real one for most players. Their shared cost bases are simply too massive, and there is already (at least in the United States) plenty of capacity from established players in the securities business.

Global opportunities

If the domestic core banking challenge is too great, what about global opportunities? In general, I see three major areas opening up in the near future.

In private banking and investment management, the forces of globalization, technology, newly emerging markets, and demographics are all working to increase the number of private individuals who will want to manage their affairs as citizens of the world rather than as local nationals. The critical limitation in serving this opportunity is the number of highly qualified relationship bankers and investment advisers available. However fast you can grow these people, it will not be fast enough to service the growth in market demand.

In a discontinuity, as recent US history clearly shows, your starting position determines where you will end

In the global trading business, there will continue to be enormous opportunities for a few highly skilled participants in making markets, in undertaking arbitrage, and in proprietary trading—particularly as a shake-out occurs among weaker participants, which cannot sustain the necessary investments in technology and people.

In corporate finance, the opportunities will be large for those few players that can find the means of combining "local touch" (local presence) with the ability to integrate knowledge and deliver service globally. The key will be a willingness to manage a relentless meritocracy that enables you continually to upgrade the quality of the people you put in front of clients.

Going forward, however, there is probably room for no more than a dozen or so fully global players in these businesses, even though there may be fifty or more that aspire to such a role.

The scale of the challenge

It is hard to overemphasize the difficulty of being successful in both domestic core banking and global banking. For most large banks, the challenges to their domestic core businesses will consume all their available energy. Many will fail and be absorbed by others. The challenge will be particularly great for those large European and Japanese players that have been the slowest to adapt to competition and that simply refuse to believe that change is inevitable. Their US counterparts that used to think the same way have mostly been sold to stronger competitors.

The United States does offer a glimpse of the future. The US banking system is recovering well from its crisis and heading toward having some five to ten mega-banks that enjoy both excellent skills in their core banking businesses and the benefits of enormous scale. They will also be active players in the domestic securities business as they sell securities both through branches and through non-branch channels.

After the discontinuity caused by the transfer of all possible business to the securities system, the remaining core banking business is likely to return to a relatively stable state. Consequently, the stakes in this effort are huge. Although there will be fewer banks, the remaining business will be concentrated in a small number of very large and very profitable banks operating on a regional basis—Europe-wide, North America-wide, and so on. The European core banking businesses are already heading, it seems to me, toward the same discontinuity that has been experienced in the United States. And remember: in a discontinuity, as recent US history clearly shows, your starting position determines where you will end.