Banks" adjustment to IT threat barely begun What is a banker to do? Banks" shares are on a roll and the banking crisis in the eurozone appears to be abating. Bankers have also succeeded in pressing their case with regulators, winning much more lenient terms for maintaining their liquidity buffers under Basel III. Yet banks are in evident pain. Barclays, Commerzbank and Lloyds all announced lay-offs last week. Morgan Stanley cut its CEO's pay. JPMorgan's Jamie Dimon furiously complained that regulators were doing "too much, too fast." All this pain is justified, for reasons that go deeper than the financial crisis. Profits are never returning to their levels during the mirage years in the middle of the last decade when distortions in credit prices warped banks" entire business model. But the problem lies deeper than that. The sector must also contend with the growing ability of new entrants to use information technology to strip away their business, a threat at least since Microsoft's Bill Gates labelled banks "dinosaurs" in 1994. Lending officers still see business seeping away to market traders in a process that began in the 1970s when the growth of commercial paper and money market funds robbed commercial banks of core functions such as savings accounts and short-term corporate loans. Two big consultancies, McKinsey and Oliver Wyman, this week proffered plans for banks to deal with the problem. Even if the proposals do inolve paying a lot of money to consultants, their reports do get to the heart of the problem. McKinsey's report on capital markets and investment banking suggests that profitability has been permanently lowered. It estimates new regulations meant that return on equity of about 20 per cent for the top 13 global investment banks (all of them, bar Morgan Stanley and Goldman Sachs, part of universal banks) would fall to 7 per cent, less than their cost of capital. To avoid this, banks would have to cut costs and shift business towards lines requiring less capital, like foreign exchange. But in fact ROEs dropped to 7 per cent in 2011, before new capital and liquidity rules started. McKinsey now says that ROEs would fall to 4 per cent when Basel III finally comes into effect. The moves to boost profits already enacted, with cuts of $15bn in costs and $1trn in assets, will merely get banks back to 7 per cent ROE. Understandably, therefore, McKinsey reckons that investment banking divisions now are valued at only about 60 per cent of their book value. Its suggestions on how to get back at least to one times book value suggest that there will be some big losers. Capital markets businesses tend to reward scale with the biggest three in each asset class tending to take more than two-thirds of business. So a few banks will become "flow monsters" (bad news for clients hoping for some price competition), while others will hang on as "universal-plus" banks in their own countries, or "focused wholesale players" who focus on lines that require little capital (like forex) or genuine ingenuity (which McKinsey suggests might include structured credit). On this reading, investment banks" adjustment has barely begun. For those banks that have lost business to capital markets, things are even worse. Oliver Wyman sees a growing conflict between "money" and "information" businesses. With US households spending as much as 8.55 per cent of their income on information, they are now increasingly using non-bank data aggregators to access financial services. In sub-Saharan Africa, mobile telephone payments systems are disaggregating even banks" basic payment systems. In the US, the likes of Square and PayPal have much the same effect, while peer-to-peer services like Kickstarter are threatening banks" role in raising longer term capital. Other firms are moving into the realms of client advice. By Oliver Wyman's arithmetic, the trend for easier access to information cut the net interest margin that US banks earned on deposits by a third from 1992 to 2007. That alone was equivalent to annual revenues of $65bn. Meanwhile, in the US, "financial services information companies" (including exchanges and payment groups like Visa, as well as the likes of Square and Kickstarter), now have a market value 45 per cent that of US banks. Oliver Wyman rightly says that banks must find ways to use their information for greater advantage. This is not new. From Citicorp's attempts to buy into the information business in the 1980s, to the sophisticated market segmentation by specialist credit card issuers like Capital One in the 1990s, banks have already been forced to raise their information game. But information is ever cheaper and the pressure on banks" profits keeps rising. "Tail risks" of disaster are much reduced and banks" share prices are recovering as a result. There is good reason, though, why bank executives seem so unhappy.