How cheaper computational power has changed banking

I had a conversation the other day with someone much older than myself and I realize that the role and perceptions of banking have changed enormously over the last 50 years.

One of the things I think is most notable is just how much the banking industry has changed over the last 30 years.

Another thing I find notable is how much the perceptions of the banking industry have changed in the last few years within some social circles but not others. The global financial crisis that started in 2008 (which is still ongoing) really changed many people's opinions of the banking sector. With major collapses like Silicon Valley Bank lately we are starting to see various memes pop up about banking that reference this cultural shift in the industry towards higher risk and some make references to the past like this meme:

I've asked people why banking has changed and I got a lot of different answers:

• "Bankers have no ethics now"
• "Banking is run by different people these days"
• "Regulation has changed the industry"

I think many of these answers come from a mental framing of banking where people view the role of banks primarily as places that handle transactions and are responsible for assessing who to loan money to. The function of banks to make assessments of who to loan money to has radically changed in the last few decades and this has changed banking in profound ways. The other profound shift is the reduction in the costs of providing banking services. People don't tend to mention either of these factors as I think the average person isn't aware of how they have changed.

Microfinance

One of the interesting things that hints at massive structural forces changing the banking industry was the idea of expanding banking services to those in the 3rd world.

By providing better basic banking services you can do a lot of really good things for people. Unfortunately many people who didn't have access to basic banking services would have to deal with difficulties in paying for items and difficulties in getting various forms of finance that are important. The lack of functional banking was a massive impediment to building real wealth in many parts of the world.

So people decided that it would be an interesting idea to provide banking services to people instead of just sending aid. I think this is a particularly interesting idea, and so did the nobel prize people, as nobel prizes were handed out for this. Letting people be more self sufficient and productive is great, unfortunately unless extreme care is taken just distributing aid payments tends to interfere with both. Providing loans without collateral can be a good thing for poverty alleviation provided that the loans are given for poverty alleviation purposes as this is a far better alternative than just giving out aid money in many cases.

But what enabled this?

I think a large part of what enabled the provision of cheap banking to the 3rd world was a series of massive technological shifts that greatly reduced the costs of providing basic banking services worldwide. These innovations from the banking systems of the developed world were what allowed the spread of banking in poorer areas of the world. If people only make a small amount of income a day the issue with them getting banking services is not that they only make a few dollars per day but rather that the cost of banking is too high a portion of what they make.

But what if you could make banking extremely cheap? It turns out that you can with modern technology like mobile phones and that enabled many more people to get banking services in poor areas. So in many poorer areas people got more access to banking. Turns out that microfinance in many regards was just cost gravity allowing banking services to be given to more people. Turns out that microfinance still has a lot of the same problems as traditional retail banking and the hype has greatly died down about microfinance in recent years.

So what about rich countries?

Cost gravity and banking

The actual accounting work in banking used to be a very expensive activity. And before the age of reserve banks and "too big to fail" it also tended to be a lot more risky as well to be in the banking industry, the whole notion that a bank-run could destroy your bank and you wouldn't get bailed out must have been very stressful for those in the banking industry. As a result the banking industry used to be a lot more careful with who they loaned out money to, as making bad loans would create a lot of risk to the bank without enough potential reward to make those loans worthwhile. With bailouts becoming normalized to some extent and financial engineering changing the way in which banks manage risk for loans (see subprime, CDOs and various other "financial innovations" for example) the whole landscape of banking has changed. If the process of basic banking has become very cheap and increasingly commoditized and interest rates on deposits are very low it's not a surprise that the banks have started to become increasingly interested in other sources of income. Put simply if they didn't they'd have to downsize.

There's a lot of costs that banks use to have that they don't have to really think about anymore. For example without any gold standard in this new age of fiat currency many banks don't need to have big expensive vaults anymore. With reserve requirements set at 0% it's questionable if they need any hard assets to back their operations, at least while times are good. In terms of collateral you can run a bank now with a lot of treasury bills as your tier-1 capital which will work great, as long as interest rates don't rise too much and you find yourselves underwater like Silicon Valley Bank did, but more on that in a future article perhaps. If you want to know more about this incident there's a good summary video from Patrick Boyle.

With plastic-card enabled purchases that modify some rows in a database you don't need to have physical cash moving around as much either. I remember one place I visited when I was in Cleveland for the Pycon USA 2019 conference was an old bank building that converted their old high security vaults into a restaurant/bar/tourist attraction. Being that I'm interested in the history of old buildings and banking I went and had a look. Even though I'm not the type to typically go to bars I'm glad I went as I went with someone who was working in tech for a big bank and it was a good conversation starter for what turned out to be a good night.

This is an incredibly interesting commentary on resource allocation and banking, a bank vault that was once the state of the art is now a bar. To be fair it was a really good bar.

So I asked a question "how often do you see armored transport vehicles these days?"

There was surprise followed by the realization "oh yeah I remember seeing a lot more of those before". Similar question about ATM's, where did they go? People only notice how many of them have disappeared when they stop to think about it. This is in part because people are using ATMs less and in part because many people have stopped thinking about how they pay for things

Banks were some of the earliest customers for computing systems that were targeted at automation. Banks have to do a lot of accounting to maintain their ledgers, this tedious but accurate accounting is the core of the banking industry, or at least what people traditionally consider to be banking. This made it a prime target for automation via computers. Even when computers were extremely costly and not powerful compared to the standards of today there was still a large amount of money to be made in automating banking work. In the early days expensive and physically bulky mainframe systems were installed at great expense in many parts of the world. Back when IBM was a company that made computers (they are now a consulting services company mainly) they supplied a number of these expensive mainframes to the banks.

These were incredibly expensive machines, so expensive that people made estimates that the entire world market for computers was under 100 computers. Much like Paul Krugman's famously incorrect prediction that the Internet would be less economically important than the Fax machine, those early estimated sales numbers made by mainframe computer manufacturers about the total market for computers were also famously off. What was perhaps most unexpected is the way in which the spread of computers and the increased connectivity of the internet changed almost everything in banking and finance. Things like online commerce which didn't exist just a few decades ago have now turned into massive industries, with companies like Amazon, Aliexpress and so on now being some of the biggest in the world. Such is the disruption of these companies that I can, as a private individual, go to Amazon Web Services and by the end of the day I can be running more powerful computers than a bank had available to it just a few decade prior. The reduction in the costs of computing are nothing short of staggering.

But we can see with all these cost reductions of providing basic banking the economics would suggest that the industry would be facing more competition for those banking services. These have come in a number of forms, from internet-only, "neobanks" that try to save operating costs by not having any branches at all to substitute goods like stablecoin tokens that offer some forms of transaction services using different ledgers and payment processing systems. As a result banks have increasingly looked for other areas to make money.

Technology and retail banking

One of the trickiest things for those working in the banking sector must have been the falling costs of providing services. There was a time when banking just cost more to provide than it does now, as a result people had to pay for these services. As things have changed competitive pressures and technological changes have cut into the profit margins that the banks could charge. Good customer service has always been something that people have liked, however there's been a sinister rise in the number of companies that have decided to make customer service as hard as possible to access. Google is one of the most famous examples of this, they have as a general strategy invested more in pushing growth and less in customer support. In this mindset customer support is seen as a function that can be automated or outsourced. This is part of why we have seen the rise of automated chatbots and other technologies that try to remove the human element from customer support. Ultimately the idea is based around cutting the costs of hiring those humans.

Part of why working in retail banking would now be so difficult is because many modern organizations in the current climate of the corporate world are obsessed with growth at all costs and cutting operational expenses if possible. Cost gravity when driven by technological innovation is highly deflationary but this poses a dilemma for many corporate entities. If you use technology in these ways you will likely shrink the size of your business in terms of staff, in some sense this directly drives financialization. At least on the open market many investors see the size of companies as an important factor, larger companies are often seen in a different light to smaller ones.

But when something gets cheaper to provide due to a lot of automation how do you justify a large organization size? What ends up being good for the organization, in particular the shareholders, can be bad for the employees and management in the organization. This conflict is particularly obvious when efficiency gains are made in organizations that don't have growth, if there's growth you can get efficiency gains while keeping the staff and if there's a lot of growth you might even be able to hire more staff while gaining efficiency. But in industries that are stagnant or declining more efficiency might directly lead to layoffs in order to realize the financial gains of those efficiency increases. The other difficulty is that as a service becomes more and more commoditized there's less money to be made it in. All of these factors have pushed banks into areas they traditionally wouldn't have been involved in. We see this especially in the case of banks making investments into risky assets in the pursuit of higher yields. Because the cash rate is lower than the rate of inflation banks are in a difficult situation, keeping customer deposits segregated in reserves might actually be a financially losing play. But putting customer deposits in risky investments means the customer deposits are actually at risk.

In the case of banking perhaps it could be seen that the introduction of the automated teller machine, which became so ubiquitous that they are the acronym ATM entered into widespread use, led to a reduction in the need for bank teller staff. At the time ATMs were introduced the economy was doing better than it has been in the last decade. More recently contactless payments and internet banking have created efficiencies in transaction services that have removed even more need for staff at bank branches. As a result its now possible to outright close bank branches without losing as many customers, and bank branches have been closing in rather large numbers. The other factor at play is that there has been a silent recession the entire time since the 2008 global financial crisis. This is because the 2008 global financial crisis never got fully resolved and the workarounds that were introduced during it have impeded economic growth ever since. This has led to a large number of banks closing down or being merged into other banks. Now we see an acute crisis where banks are failing due to those reasons but retail banking was already in a downtrend for many decades before these failures started.

Many people who still hold the old mental model of what banking is will likely not be in a position to really understand what is happening in the banking sector today. You need to understand how banking has changed to be able to understand the current crisis that's happening in the banking sector. Banks like SIlicon Valley Bank were not operating like the banks of old, they had many highly risky things on the books and ultimately this put their customers deposits at risk.