Evolution of the Modern Banking Structure

  • The rise of central banking in the twentieth century underpinned the expansion of commercial banking
  • The evolution of commercial banking after the 1929 Wall Street crash introduced regulations that shaped banking in the twentieth century, but were liberalised in the 1990s.
  • Following the global financial crisis of 2008, regulators again reacted to markets to introduce more competition, looking to financial technologies in particular.

Central banking was first established in Europe in the 1600s, first with the Riksbank in modern-day Sweden and then in the 1690s in London with the Bank of England. Central banking arrived in the US in Philadelphia  in 1791 but the bank was allowed to dissolve in 1811 when its 20-year charter came to an end. The need to finance the US’s 1812 war with the United Kingdom led the US to create the United States’ Second Bank in 1816, which again lasted just 20 years. After 1836, state-chartered banks and unchartered banks took over and issued their own notes.

Prior to banking, government would borrow from wealthy individuals and repay them with interest gathered from taxation revenue. Particularly during wartimes, governments needed more money than they could borrow from individuals and merchants. Europe of the 1690s was a time of great upheaval and transformation, and England and France fought through the decade in what was known as the Nine Years War.

The Bank of England was thus established in 1694 to provide the government with a loan. In return, interest on the loan and the right to issue notes were earned by the bank. The Bank of England began the permanent issue of banknotes in 1695 as the first major central bank and made London a world financial hub. Subsequently, several small banks were established in English regional towns in the late 18th century with the first traveller cheques coming out in England in 1772. This period also experienced many crises, with bank runs in 1793, 1814-1816 and 1825, resulting in loss of consumer trust and a surge in bank failures. Regulatory changes in 1826 allowed large banks to be founded with multiple investors, leading to banks combining with larger banks in many countries across the British Empire.

In England, the Bank Charter Act of 1844 divided the Bank of England into two branches, a banking department and an issuing department, and thus began modern banking. The Bank of England could only issue notes backed by gold or government securities. New banks were also barred from issuing banknotes, and as banks slowly consolidated, the Bank of England became the country’s only note-issuing bank.

The rise of central banking globally was a 20th century phenomenon, and included the U.S Federal Reserve, which was established in 1913. Increased global trade, technological advances and financial regulations throughout the 20th century led to the growth of global banking and capital market services. As we know today, this has led to a dramatic increase in the size and scope of banking operations across wholesale, commercial, institutional, investment and retail banking.

The 20th century witnessed a series of banking system failures. The first was  the US stock market crash of 1929 that led to the Great Depression and helped usher in the second world war. Regulation in the US in the 1930s separated commercial banking and investment banking but was liberalised in the 1990s. In the following decades, the world’s financial system saw several crashes and failures in all shapes and sizes, right up to the global financial crisis of 2008.

However, the banking sector has also benefited from deregulation, the globalisation of trade, and introduction of new technologies which created market growth throughout derivatives, online banking, credit cards, ATMs, and other innovations. This has helped to maintain high rate of revenue growth in the banking sector, which, combined with low cost of capital, resulted in strong equity (ROEs) returns.

After the 2008 Global Financial Crisis

The profitability of banks decreased after the global financial crisis as revenue growth slowed and banks needed to focus on cost and capital management to improve profitability. It has not been easy for banks to make this fundamental shift from an age of high revenue growth to one of slower growth and ever higher capital and compliance costs.

European banks’ return on tangible equity (RoTE) declined from mid-teen pre-crisis levels to single-digit post-crisis levels. Similarly, in this era, U.S. bank RoTEs fell from high teen to low teen rates before being aided by tax cuts that led to a profitability boost.

Banking technology appears cyclical: banks bring technology in-house and later outsource it again as the technologies change. For instance, banks have moved from the standard in-house IT development to outsourcing technology to Technology-as-a-Service providers and cloud computing providers.

The early focus of banks was automation, as a way to cut the costs of handling information. Online banking evolved rapidly, but only in small pockets across the world in advanced markets, and until the mid-2000s, fewer than 500 million people used online banking around the world.

In 2010, banks became conscious of the opportunity of the ubiquitous mobile, which in those days was rapidly evolving from feature phone to smartphone. In the early days, mobile banking and Apps failed to enthuse consumers, despite their heavy marketing and promise, except in a few advanced markets where internet data speeds were fast, and people enjoyed remote banking. The number of users of online banking was still under 10 percent of the total base.  Some banks develop their mobile banking technology in-house while many banks have outsourced this work to multiple vendors. Many banks did not understand their customers’ mobile banking needs and ended up having more than ten apps in their stores for various purposes.

By 2015, it became clear to banks that the technology and ecommerce giants along with (highly capitalised) Fintechs could eat into their market because they offered better mobile experiences. In many markets (Europe for example) Central Banks and governments have opened the financial services sector to non-banks to provide greater access and efficient service delivery, often under ‘Open Banking’ initiatives. Banks had to respond to compete effectively. They had no choice but to make huge investments and go back to the primary differentiator of innovation. In adapting to the new challenges, they had to collaborate with innovators and develop in-house engineering teams around mobile and AI. But now technology has become the core selling proposition for several banks. Banks around the world responded differently. Some have created funds to acquire technology talent for creating digital banking experiences. Others have put in place project arms for investment and software acquisition. Some banks have set up incubators for innovation to engage with fintechs and technology firms.