How Will Commercial Banks Stand Up To The 'Third Wave' Of The Internet's Evolution?

by: John M. Mason

Summary

The "Third Wave" of the Internet is upon us and will be impacting the commercial banking system over the next five years.

Steve Case, co-founder of AOL and chairman and CEO if Revolution LLC appears to believe that commercial banks are "too clumsy to innovate".

What does this mean for investors in terms of investing in commercial banks over the next five years or so? Regulations and the structure of the banks must change.

Steve Case, co-founder of AOL and chairman and CEO of Revolution LLC, an investment firm, has written about the "The Next Wave in the Internet's Evolution" in the Wall Street Journal.

The "next wave," the "Third Wave," "will rapidly become ubiquitous" over "the next decade and beyond," and will be "integrated into our everyday lives, often in invisible ways."

Mr. Case begins his article by arguing "The real threat to Wall Street doesn't come from politicians, but from startups that are disrupting financial services at an unprecedented pace."

"Last year, investment in financial technology (FinTech) startups that aim to transform the industry rose to nearly $14 billion, according to American Banker. As they gain customers, the megabanks will lose ground. 'Too big to fail' also often means too clumsy to innovate. Already these institutions are finding themselves playing defense. Innovative blockchain technology-the magic behind Bitcoin-could drive further decentralization and disruption."

Banking, it seems, is due for some changes, and, according to Mr. Case, the big banks are "too clumsy to innovate."

This is a growing problem that has been recognized by many. Last week, I wrote a blogpost on

FinTech and the possibility that the banking industry, and especially big banks, is facing a tipping-point in terms of the introduction of new technology into the industry. A new report by Citibank, discussed in the post, states that the next five years are going to be "electric."

One point about this move that gets very publicity, but Mr. Case brings up in his piece is the role of regulators. Mr. Case writes that "Third Wave innovators will need to learn the lessons of the First Wave: the importance of partnerships…. They'll need to engage with governments, as regulators and often as customers."

In banking this is very important. In fact, one argument given by some analysts for the slow pace of the banking industry in introducing more advanced information technology is the headwinds that it would face from the regulators.

Well, with this Third Wave looming, this is going to become a real issue.

Part of the problem in moving faster is that the regulators are behind in understanding the changes that might be coming because of Third Wave ubiquitiousness. Not only do the big banks need to catch onto the wave, but the regulators also need to catch onto the wave.

And, one of the questions that seem to be growing in the minds of regulators is the structure of the banks. Are the banks constructed in a way that can deal with the risks that are inherent in the current banking structure, which would have face, an environment where everything could move much faster than they do now and would interact with more and more endpoints that many regulators can envision?

The problem here, according to Mervyn King, former Governor of the Bank of England, is the basic riskiness. He describes this in his new book "The End of Alchemy": "Banks pretended that short-term riskless deposits could be used to finance long-term risky investments…. the alchemy is, the apparent transformation of risk into safety." (Page 251)

That is, "The pretense that the illiquid real assets of an economy-the factories, capital equipment, houses and offices-can suddenly be converted into money or liquidity is the essence of the alchemy of the present system." (Page 253)

In a world where the Internet is ubiquitous, the speed that transactions and other transfers can take place and the fact that these transactions and transfers can be initiated from almost anywhere changes the riskiness of the whole banking system. Mr. King suggests that this situation cannot continue as it now is.

Proposals to change the system have been made in the past. One of these is 100 percent reserve banking. Mr. King proposes an alternative to 100 percent reserve banking, a system that is not quite as restrictive, but provides ample protection against the alchemy he is opposing.

Changes to banking regulations like this cannot be ignored in trying to determine what the banking system is going to look like in five years or so.

But, this gets into another concern that Mr. King explores in his book, "radical uncertainty." In terms of the banking system, we really have no real idea what this new banking system might look like. This applies not just to the payments system, but the lending system.

Also, what is going to happen to the structure of the non-bank banks as well as the credit unions? We can all take guesses as to what the banking and financial system might look like, but that is all they are…guesses.

Do I think that commercial banks are good investments right now?

Not really. Not only do the banks still have problems lingering over from the past financial difficulty. The banking system still faces a multitude of problem issues. And, banks, especially the larger ones, are still dealing with the "new" regulatory environment that grew out of the Great Recession.

Maybe this is why the banking sector is doing so baldly in the stock market. According to Barron's Market Laboratory on Stocks, the Dow Jones U. S. Total Market Industry Groups, the banking group year-to-date is down by almost 4 percent and ranks ninth out of ten industry groups in the analysis. It ranks seventh in its year-over-year result, down by about the same amount.

Not only do banks have to deal with what is left over from the past, they have to invent an unknown future. Not a recipe for high performance.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.