A financial widening, not deepening

March 3, 2011

While Treasury Secretary Tim Geithner prepares for a “financial deepening” he hopes will be a boon to U.S. banks, we may be steering instead for broader, shallower waters which will drive down margins in financial services and favor simplicity.

Geithner told The New Republic that he sees a coming boom for demand for financial services from emerging markets as a newly affluent middle class seeks new and more sophisticated financial products.

“I don’t have any enthusiasm for … trying to shrink the relative importance of the financial system in our economy as a test of reform, because we have to think about the fact that we operate in the broader world,” Geithner said.

The vision, perhaps unspoken, is for a recapitalized U.S. banking system with strong enough titans at the top to compete globally to sell complex financial services to Indian corporations as well as Chinese households.

On this reading, the decision to not take effective action to whittle down the too-big-to-fail banks makes sense; the new world will need Citigroups, not community banks.

Besides the false underlying assumption that regulation can mitigate the risks of TBTF banks, the financial deepening thesis is likely wrong on at least two additional counts. First, it assumes that the newly middle class of the world will want the kinds of products that only a huge bank can provide, and second, it assumes that the financial landscape of the future is like that of today, only bigger.

Now, to be sure, if you subsidize something it will grow. So, TBTF banks, enjoying a U.S. backstop and the funding advantage that goes along with it, will have some success in devising products to sell in emerging markets that arbitrage that subsidy. There is doubtless an unmet need for these products in India just as there was an unmet need for liar loans in California’s Central Valley. Look at some of the horrific experience with micro-credit in India, where the poor borrow to simply finance current consumption.

What is not clear is what complex financial services this new world will need, and why only a large global bank enjoying an implied government guarantee will be able to provide it. Certainly there will be capital markets services needed in emerging markets, such as share listings and bond financing, but it is unlikely that the advantage that a TBTF bank will get based on its size alone compared to the cost, to taxpayers and to the economy, is justified. Surely a smaller Goldman Sachs could compete in this arena without an implied guarantee.

The real action will be not in fancy products devised by math PhDs, though devise them they will, but in simple utility-like functions like transfers and simple risk sharing such as life or property insurance.
Economist Barry Eichengreen, writing in the Wall Street Journal, argues compellingly that the dollar will lose its role as the main global reserve currency over the next decade.

One of the forces he cites is technology, which will make it easy for trade to happen outside of the dollar, for example between Korea and Chile, where before trade had to be routed through the dollar as an intermediary step.

This kind of round tripping into and out of the dollar is one of the main drivers for foreign exchange market volume and for hedging. If it goes away we will not see a deepening, but a shallowing. We would see just as much global trade as before, but a heck of a lot less foreign exchange trading and dollar hedging. The same thing may also be possible in the oil market, which is denominated in dollars and which drives a huge market in foreign exchange and hedging as a result.

It does seem likely that many hundreds of millions of additional people will become consumers of financial services, but like telephony this growing demand will likely come with falling margins.

Think, for example, of the agricultural middlemen in India who have lost their advantage now that farmers can easily access prices via mobile phones. Banks may find themselves in the same position, because of the same forces.

The payments and transfers business will grow tremendously, but this is a utility function and, likely as not, competition from outside of financial services, from technology or communication companies, will drive margins down.

My guess would be that, if the market were left to itself, the financial deepening will belong to Google Bank rather than Citigroup or J.P. Morgan. The too-big-to-fail subsidy may slow or distort that, and that is bad policy.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.  Email: jamessaft@jamessaft.com)

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