The Bid - 150. The Future of Finance
Episode Description
The face of finance has evolved considerably of late. From changing financial architecture and payment applications through to regulatory developments and the impact of AI, all of which have major implications for banking’s business models.
Alex Brazier, Deputy Head of the BlackRock Investment Institute joins host Oscar Pulido, to talk about the first of these big megaforces, the future of finance. Alex will explain what this big shift will entail for banks, companies and investors as we grapple with a changing economy and structural changes.
Written Disclosures in Episode Description:
This content is for informational purposes only and is not an offer or a solicitation. Reliance upon information in this material is at the sole discretion of the listener.
For full disclosures go to Blackrock.com/corporate/compliance/bid-disclosures
TRANSCRIPT:
<<THEME MUSIC>>
Oscar Pulido: Welcome to The Bid, where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm your host, Oscar Pulido.
The face of finance has evolved considerably of late. From changing financial architecture and payment applications through to regulatory developments and the impact of AI, all of which have major implications for banking’s business models. So with all of this rapid change, what should investors be considering?
In our midyear outlook we discussed a new regime of greater macro and market volatility is being shaped by five major structural forces that we’re calling megaforces. Alex Brazier, Deputy Head of the BlackRock Investment Institute joins me to talk about the first of these big forces in detail, the future of finance. Alex will explain what this big shift will entail for banks, companies and investors as we grapple with a changing economy and structural changes. Alex, welcome back to The Bid
Alex Brazier: Hello again, Oscar. Thanks for having me back.
Oscar Pulido: Alex, you introduced us to the idea of megaforces in the mid-year outlook earlier this year, but perhaps you can remind us what a megaforce is, and what are we talking about when we say the future of finance?
Alex Brazier: These megaforces, they're big structural shifts in our economies. Things like demographic change. Competition between great global powers, the development of artificial intelligence, and the transition to a low carbon economy. All these things are changing the way we produce, the way we consume, and the way we work. And they are enormous, sort of powerful forces in our economies, and they're absolutely relevant to investment. They might be forces that are here with us for very many years to come, but they're actually shaping investment. returns right now.
And this week we're talking about reshaping the financial system, the future of finance. It's a big topic, I don't pretend that what we've got to say on it right now is in any way the last word. There's loads more to explore, and we'll be exploring it. But what we're really looking at here is how the way the financial system serves savers, borrowers, how stable the financial system is, and most importantly, as it evolves, what investment opportunities does that create? And what risks does that create? That's what we're exploring in the future of finance.
Oscar Pulido: Okay, so as you said, you're thinking about these as thematic shifts. So, moving on to today's topic, the future of finance, as we're looking ahead and considering what that might look like, maybe we can start by thinking about the fact that US banks have been experiencing deposit withdrawals. At an unprecedented pace. So, can you tell us what's been happening that's led to this change? And what is the ultimate impact?
Alex Brazier: Yeah, when we talk about deposit withdrawals at an unprecedented pace, it sounds like really bad news. we're normally used to people taking deposits quickly out of banks when they 2008.
But this is actually pretty good news, because part of what's happening is just due to what the Federal Reserve has been doing with, first of all, QE - purchasing assets. Every time it purchases an asset, it puts money in someone's deposit in a bank. And now it's doing QT, Quantitative Tightening, it's, selling the assets that it had and draining deposits out of the banking system.
It's inevitable given that monetary policy, but there's something deeper going on as well, which is the good news here. Really what's happening is that savers are searching around for the best return. We're now in a very different environment, We're not in a zero-interest rate environment. And savers are looking for other options. And most importantly, they found them as well. And they found them in things like money market funds.
And we've seen around two trillion dollars’ worth of deposits over the last few years flow out of the banking system into money market funds. And, as I say, that's not largely because people have any questions about the safety of the banking system. There was a bit of that back in March, this year. But largely it's because banks have been slow to raise deposit rates as the fed has raised rates, but money market fund rates have basically followed the Fed's rate. So, people are looking to earn a higher return on their deposit. They're putting money where it earns the higher return. So, what it's telling us is that there are now credible alternatives to bank deposits. Money market funds have been substantially reformed since the financial crisis in 2008.
They put their money mainly in short term treasury bills and even on deposit at the Fed. So having this alternative to bank deposits is great news for savers. They can find the best returns. They've got choice. That's a new development, and as a result, they're looking around. Now, it's good news for savers, but it's going to be a challenge for banks. And they're going to have to face up to this more competitive market for people's savings, effectively. But broadly, big outflow of deposits, not the usual bad news story. Actually, a good news story about choice for savers.
Oscar Pulido: Certainly, sounds like a really good story for consumers, and they have better options, and sounds like banks are going to lose out if they can’t compete. So how are they going to adapt to this change?
Alex Brazier: Well, they will, over time, have to. for the bank, as we talk about in our paper, it's not really an urgent problem for the banking system as a whole. It's still pretty flush with deposits, largely thanks to the Fed's monetary policy actions. But what this is revealing is that banks can't rely on continually paying rates on deposits that are much bigger.
So, they're going to have to compete more aggressively for deposits over time. Now, there will come a point over the next few years where that. they really have to do that. And for some banks, they really have to do that now. We're particularly seeing that with smaller banks who perhaps aren't so flush with deposits.
And they've been repricing their deposits. That's a sign of what's going to happen in the system more broadly. What does that mean for them? Well, for banks, it means two things. It means squeezing of their profits, their so-called net interest margin, the difference between their lending rates and the rates they pay on their deposits.
And it also means they're going to be trying to pass through some of that higher cost of deposits. into lending rates, into the rates that borrowers pay them. And that means that over time, bank credit is probably going to get a bit more expensive relative to other forms of finance. That sounds like bad news as well. But actually, it creates an opportunity for reshaping or reinforcing a trend in the financial system that's been going on for many years actually, which is diversification in the sources of finance, particularly for companies.
So over time, companies have come to rely less on banks. They've been reliant more on using public markets in particular. Now this change, bank credit becoming a bit more expensive is actually going to encourage companies to continue to look for other sources of finance from outside the banking system. And ultimately, it's going to mean a financial system where companies have more choice as well. They've got more options, they've got a more diversified system to finance growth and jobs, in the economy. and that to us is one of the more exciting things of this, this tectonic shift we see going on.
Oscar Pulido: And if we think about the public sector for a moment, what are regulators proposing and what's that going to mean for this, change in bank lending?
Alex Brazier: Yeah, regulation is clearly in motion here and bank regulators, particularly in the u. S., are likely to make changes. They've made some proposals, and those proposals, could change, over time. But the thrust is that they're probably going to expect banks to fund more of their lending with shareholders cap their own shareholders capital. Now, that's great for the stability of the system, because it means banks are funded more with something that can absorb losses. if they take losses on those loans. but it also means that for banks, funding themselves in the mix the regulators want is going to be more expensive. if these proposals go through, it's likely going to reinforce this trend to make bank credit relatively a bit more expensive than other forms of, credit. And there's one other aspect to the proposals as well, which is, in large part, u. S. regulators are responding to global agreements reached a few years back,
But they're also responding to what happened back in, in March, and the failures of some mid-sized banks, in the u. S. And what they're proposing to do is to extend some of the more stringent regulations. that apply to the biggest banks Down to some of those mid-sized banks as well.
So that's going to be a particular tightening for that segment of the banking system in the U.S. it's going to take away some of the advantages to being middle sized rather than big which as a result we think is going to encourage some consolidation in the industry but it's also going to add to
This sort of tightening of supply of bank credit, because these mid-sized banks have actually been pretty important in the supply of credit to the U.S. economy over the last few years. they've been playing an outsized role. So, for all these reasons, regulation we think is a kind of added factor, added to competition for deposits, that means bank credit is going to become relatively a bit more expensive.
Oscar Pulido: So overall banks are raising rates, regulators are making proposals for more regulations and stricter regulation I should say. So, what does this mean, perhaps, for the broader economy and maybe what opportunities do you think this is going to create?
Alex Brazier: Yeah, we've talked about how it's good news for savers. It's probably good for the stability of the financial system as well. But it does mean slightly more expensive bank credit.
So, what does that mean we're going to see? we're likely to see some innovation in the way finance works. We're probably going to see growth of non-bank forms of finance. and for many years, we've seen companies diversify finance away from banks towards public markets by issuing bonds. This is going to reinforce that trend. And it's also going to broaden it out a bit as well. Because many companies want smaller deal sizes than the public markets can serve them with. And so maybe we're going to see partnerships between banks and other parts of the financial system where the banks do the lending, but the loans are held outside the banks on other balance sheets. But we're also probably going to see the growth of things like private credit. by which we mean loans that are directly negotiated between a borrower and a non-bank lender like an asset manager. And they're held in funds financed directly by investors. Now, this market's still pretty small relative to public debt markets and bank lending. But we think we're likely to see it grow. And that's going to be good for diversifying the sources of finance that companies have to drive growth and drive, drive job creation.
But it also potentially creates a pretty big, investment opportunity over the long term, and we actually see some opportunities in private credit over the long term because as banks step back, we're Probably going to see more demand from borrowers for these alternative forms of credit. That's going to keep interest rates pretty high.
And that's what creates the potential opportunity, but we think we need to be pretty discerning here because private credit loans are not immune from credit losses in a higher interest rate environment. So, we focus on companies that are better placed to navigate that as borrowers. And it's really important to recall that much of the kind of interest rate premium, the extra return on private credit, reflects the so-called illiquidity of those loans. The fact that it's difficult to sell them quickly at a good price.
So, these are not investments suitable for all investors and investors who do hold them need to be able to manage their cash needs pretty effectively using other assets. But if they can do that, then actually there's a premium. To be harvested, and that's why we see the appeal in things like private credit, particularly in longer term, strategic, portfolios.
Oscar Pulido: So, Alex, it sounds like there's a lot to consider. and I'm just wondering, there's a lot of things happening in the world at the moment. Why are we considering the future of finance such an important megaforce?
Alex Brazier: Yeah, it's particularly important, I think, for the way our economies are going to function. In the same way that many of the other megaforces are as well. It's a big structural shift in the way a core part of our economy, the financial system, works. And we're not just interested in this because it's, close to home for us. We're interested in this because it reaches a lot of different parts of the economy. It's changing the way savers save. It's changing the way borrowers borrow. It's changing the way our financial system interacts with our economy. And in the process, potentially creating some investment risks, but also very importantly, investment opportunities. And that's our focus on this. So, it's a big force with big structural effects that's going to be at play for many years yet, but it's already having an effect on investment returns.
Oscar Pulido: Alex, as always, thank you so much for your time. we very much appreciate your insight leading the way in the first of these megaforces that we're considering. And I very much look forward to speaking with you about the upcoming outlook for 2024.
Alex Brazier: Great, thanks for having me, Oscar. See you soon.
<<THEME MUSIC>>
<<SPOKEN DISCLOSURES>>
This content is for informational purposes only and is not an offer or a solicitation. Reliance upon information in this material is at the sole discretion of the listener.
For full disclosures go to Blackrock.com/corporate/compliance/bid-disclosures
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