Why Banks Are Still Important In Modern Society
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In the past, banks served as the primary source of financing for individuals and businesses alike. People relied on them to finance their homes, cars, and the businesses that drive the economy.

That reliance has significantly diminished over the years. In 1975, banks accounted for approximately 60% of total lending to US households and nonfinancial businesses. Today, that figure is closer to 35%. There are now many alternative credit providers competing for lending business, including mortgage originators, consumer finance companies, money market funds, corporate bond markets, and private credit.

But unlike many alternative credit upstarts, banks perform one essential function in the economy: during times of crisis, companies and investors count on them to be a safe haven for financial assets. They provide stability and confidence when credit markets shut down, as was the case at the onset of the COVID-19 pandemic.

While banks’ market share may be diminishing, their central role as a safe haven endures. But it does not come for free.

Ensuring bank resilience through policy and regulation

Banks can serve as safe havens because they operate within a well-tested financial safety net of regulatory frameworks and mechanisms. That safety net provides two critical resources to banks: deposit insurance, which allows on-demand deposits to act as stable funding for banks, and central bank liquidity, which converts illiquid assets into cash, providing liquidity support to banks when needed.

In return, banks are required to hold significant capital and liquidity buffers to balance against potential losses from their business. They are also required to invest heavily and continuously in risk management and controls infrastructure.

These requirements have become increasingly onerous each time the system has been tested, particularly after the global financial crisis. Following the crisis, banks faced a series of new prudential requirements introduced by US and global financial regulators. They adjusted to the new reality by restructuring their balance sheets. Loans and trading assets as a percentage of total assets on US commercial banks’ balance sheets declined from 73% in 2000 to 59% today. Meanwhile, the safest and most liquid assets like cash equivalents climbed from 27% to 40% over the same period. Has the pendulum swung too far?

Exhibit: Evolution of the banking business model. Balance sheets shift toward cash and securities
Assets composition breakdown, US commercial banks, 2000-2024, $ trillions
Basel III Endgame Scenario
Notes: Goldman Sachs and Morgan Stanley transitioned to bank holding companies in 2008, leading to an increase in trading assets in the time series. In 2010, GS and MS constitute 35% of total trading assets

The impact of regulation on banks and the financial ecosystem

There is a real cost to intense regulation and supervision. Banks cannot engage in some activities, must live with constrained innovation, and the pricing for bank capital and liquidity must reflect current market conditions as well as extreme stress scenarios. This has opened the door to competition across many parts of the value chain, as detailed in the Outlook For Wholesale Banks report.

While the financial ecosystem has become more diversified through innovation and competition, and more choices are now available to households and firms, this has come at a cost. It has reduced the capacity of banks to deliver capital and liquidity to the economy in good times and bad. If banks can’t play the shock absorber role, central banks must step in.

Our base case is that the banks disintermediation trend will continue on its current trajectory. Banks share of global financial assets has declined from 42% to 33% since the Financial Stability Board started monitoring the role of non-bank financial institutions in the economy more than 20 years ago. This will present challenges for banks, which will continue to bear the costs of insuring the financial sector against catastrophe while capturing a smaller share of the economics.

There is renewed optimism in the banking industry with the incoming administration, which speaks to the volatile history of banking regulation in the US and the ability of banks to adapt to changing circumstances. Some surprises could disrupt the balance that has emerged over the past several years:

1. Renewed optimism in the banking industry

The competitive balance shifts back toward banks (at the margins). The reduced intensity of existing or proposed banking regulations (or the introduction of regulations that restrict some of the growth of nonbank competitors) could allow banks to rebuild share in good times — and play a more robust shock absorption role in periods of stress.

2. PRIVATE CREDIT THRIVES UNDER STRESS

The private credit industry provides a backstop. The private credit industry, with its long investment horizon and experience in high-risk lending, manages through the next credit downturn far better than banks — accelerating the secular trend toward bank disintermediation in credit provision.

3. Deregulation triggers the next crisis

The push for deregulation of the industry could become overly enthusiastic and remove some of the checks and balances in place today, sowing the seeds for the next crisis and another wave of shifts in regulation and market structure in the aftermath.

This article is part of our Known Unknowns report highlighting the debates that will shape the future of financial services