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The banking system is going through massive changes. The morning papers are filled with stories about what is happening in the banking area, although they cover only a minor portion of what is going on in the industry.

The Wall Street Journal trumpets, “Bank of America Ponders Retreat.” The current Bank of America (BAC) represents, perhaps as well as any organization, the excesses of the financial institutions over the past twenty years or so. Currently selling at 33 percent of book value, Bank of America can be potentially classified as one of the “Zombie” banks that now meander through the environment.

The Journal article does not give us much faith that management has a firm grasp on the situation ... or, at least, is not revealing to us the reality that they face. “Bank of America Corp. has told U. S. regulators that it is willing to retreat from some parts of the country if its financial problems deepen ...

The crucial hedge word is “if”.

Commercial banks have to recover from the binge that has taken place in the banking industry over the past fifty years. This binge has seen commercial banks grow to enormous size and many have become “too big to fail.” It has resulted in a massive shift in employment in the United States as the proportion of people working in the manufacturing trades has declined substantially relative to those working in the financial industry. It has resulted in a huge shift in risk-taking in the industry, a move to more and more financial innovation, and a substantial increase in the amount of financial leverage used in the industry.

Several of the articles in the morning paper discuss the reductions that are taking place employment. For example, yesterday the Royal Bank of Scotland Group PLC (RBS) announced that it will be laying off 3,500 people. Cutbacks have also been announced by UBS AG (UBS) and UniCredit SpA (OTC:UNCIF) and well as Credit Suisse Group AG (CS) and many other major players. The reductions in staff of the smaller institutions do not get as much publicity and play in the press.

Some have argued that the industry is going through a cyclical shift that generally happens after a downturn in the economy but more and more industry analysts are claiming that they see a more permanent shift taking place. And this is true of other parts of the financial industry than just the commercial banks.

It isn’t just the lackluster business environment that is prompting banks to rein in their lofty investment-banking ambitions. A realization is sinking in among securities-industry executives that because of the huge potential losses they are exposed to in bear markets, the business just isn’t as attractive as it once seemed.

The fifty year period of credit inflation bought out over time many of the bad decisions and allowed the banks to go merrily on their way. As “Chuck” Prince, former CEO of Citigroup (C), expressed it, ”As long as the music continued to play, people had to keep dancing.”

But this continual pressure to grow and expand and take on more risk resulted in a massive change in the banking industry itself. Going from around 14,000 commercial banks in the 1960s, the commercial banking industry now contains less than 7,000 banks. My forecast is for this number to drop below 4,000 in the next several years.

And, the banking industry is bifurcating: almost two-thirds of the assets in the banking system are owned by the largest 25 banks in the country. That leaves just one-third of the assets in the hands of about 6,300 banks. More and more wealthier personal banking relationships are being handled by firms that cannot be considered to be community banks. The products and services in these banks are many and the electronic interchange and access between financial assets and transactions are seamless and almost instantaneous.

One could imagine a banking system in which the wealthier people worked with institutions like these and the less wealthy “banked” at non-profit credit unions, the non-profit institutions being the only ones that could provide the products and services needed without having to achieve a competitive return on shareholder’s equity.

The last factor producing major changes in the banking industry is the advances taking place in information technology. Finance is nothing more than information. That is, finance can ultimately be just a recording of 0s and 1s. Thus, as information technology advances, so does the innovation in the financial industry.

Don’t think of how you use banking services right now; think about the electronic gadgets that your children or your grandchildren are using. This is where you will see what financial institutions are going to need to provide for in the coming years. What goes on in “electronic stuff” is real to these children and will become a part of the financial system as electronic finance becomes ubiquitous in the future.

Furthermore, as advances in information technology have allowed “finance” to become more innovative, my guess is that for the future, we haven’t really seen what financial innovation can do.

This has tremendous implications for the regulatory efforts going on in the United States and the world. I have argued for three years now that the efforts of the United States Congress and others throughout the world have been to create a regulatory system that will prevent a 2007-2008 financial collapse. To me, the commercial banks in the United States are way beyond this system already. Oh, the banks fight Congress and the regulators all along the way -- but how much of this is real and how much of this is a smokescreen?

Throughout my professional career -- and I have run three banks -- the banks have always been ahead of the legislators and the regulators in terms of what is going on in the banking system. I am no less confident now that the banks are still far ahead of legislation and regulation and will continue to be so into the future.

I can’t imagine what banking will be like in five years. But it will be something substantially different than it is now. It will be more electronic, it will be more innovative, and it will be harder to control. The only way we can hope to keep up with what is going on is to increase the openness and transparency with which the banking system operates.

Source: The Banks, They Are A-Changin'