The first quarter earnings season is over for the big banks and the basic conclusion that can be drawn from their performance is that they may need to change their business models.

The basic business model of the big banks leading up to the Great Recession was one built during the fifty-year period beginning in the early 1960s. This model was constructed upon the assumption that the U.S. government would continue to underwrite an expanding economy indefinitely. The basic policy prescription was one of continuing government budget deficits and monetary policy that would underwrite the credit inflation created by the government budget deficits.

We saw that the credit inflation created produced a financial system that assumed an increasing amount of risk; remember the "Greenspan put" that protected against a stock market decline? It also resulted in financial institutions taking on more financial leverage. And, it saw an industry that produced a steady stream of financial innovations.

In pursuing these ends, the financial industry substantially expanded its share of the economic activity of the country and employed a greater proportion of the workforce.

The big banks excelled in all three of the pursuits, especially emphasizing riskier strategies like trading fixed income securities, commodities, and currencies, and in producing exotic financial innovations. And, the big banks produced results where their returns on shareholders' equity reached 15% or more.

But something happened after the Great Recession. The federal government continued its efforts to create deficits. And the monetary authorities attempted to underwrite further credit inflation, especially with the three rounds of quantitative easing provided by the Federal Reserve System. 

But one big bank, Goldman Sachs (GS - Get Report) , has retained its pre-Great Recession business model. And, in the first quarter of 2016, really suffered for it as net income dropped by 60%.

In reporting this result, Nathaniel Popper of the New York Times questions Goldman's strategy: "Goldman Sachs has been betting that it will again see around the next corner better than its competitors. As other large banks have been cutting back the trading and investing businesses that have long defined Wall Street, Goldman has fearlessly stuck to its guns."

The point is, things have changed and are continuing to change.

For one, interest rates are at historically low levels, with negative interest rates appearing here and there. And, economic growth is tepid, at best, and not expected to get much better in the near future. Also, the conduct of monetary policy has been erratic and confused, which has not helped the banks.

In addition, the banks are facing legislation, the Dodd-Frank Act, and its regulatory implementation that has attempted to solve the problems in the financial system discovered in the Great Recession. The application, even though regulators have not been able to apply a large portion of the act, has restricted and hindered the big banks from doing some of the things they did in the past.

Furthermore, the regulators don't seem to have a firm grasp on where the banking industry is. This is exemplified by the colossal embarrassment of the recent disclosure by regulators that five of the largest banks failed the recent round of "living wills" they must now file.

Maybe this is good. Peter Eavis writes in the New York Times that "Messing With Minds of Bankers Is Good."

I'm not so sure that this is true. It might be true if I had more faith that the regulators knew what they were doing in this uncertain environment that we've never before experienced.

This brings up the final concern, that of the spread of FinTech in the financial community.

First of all, the people in FinTech don't really know how their efforts are going to change the financial system and what will be the resulting industry structure five- to ten-years out.

And, one can assume that if the people in FinTech don't know what the future looks like, the regulators have even less of a clue as to what is in store for the industry. An "urgent call" has been issued by the organizers of the World Economic Forum "to do more to ensure the rapid growth of FinTech does not become a risk to 'systemic stability.'"

Note to the big banks: The economic and financial environment has changed; maybe you need to change your business models to take account of what is happening in the world.

 

 

  This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.