There’s a revolution — in banking

In 1925 Winston Churchill, then Chancellor of the Exchequer, famously declared that he wished to see ‘finance less proud and industry more content’. In the light of the financial crisis, much the same refrain has been heard from policymakers and politicians over the past five years. How are we to avoid repeating the mistakes of the past? And how might the financial sector reinvent itself for the future?

I wish to argue there are grounds for optimism. Out of the ashes of the financial crisis a new type of banking is emerging. Old business models are being rewritten and new entrants are driving change. Indeed, it’s possible that the financial sector is in the early throes of a miniature revolution, the like of which has swept through a number of other industries recently.

For the past 200 years or so, the business of banking has been essentially unchanged — let’s call it Banking Version 1.0. This model has fared reasonably well in its core task of providing payment and credit services to the general public. For example, the assets of the banking system, including loans to households and companies, have grown much more rapidly than the economy as a whole. Driven by liberalisation, this ‘financial deepening’ has taken place in two waves.

In the first, century-long wave, between 1880 and 1980, bank balance sheets relative to national income (or GDP) rose on average by around 1 per cent a year. In the second, single-generation-long wave between 1980 and 2007, financial deepening rapidly picked up pace, with bank assets relative to GDP growing five times faster than in the previous century.

Until the financial crisis, this deepening was seen as positive from a growth perspective — companies and households, freed from credit constraints, would be able to finance increased spending and investment, stimulating growth.

As bank credit grew, the contribution of the financial sector to GDP rose in lockstep — in the UK, from 5 per cent in 1970 to 8 per cent by 2007.