The Big Bank Theory

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Hugh McColl is what southerners call "a firecracker of a man." He is a tiny stick of dynamite: 5 ft. 6 3/4 in. tall, with a big mouth and a short fuse. Once, deep into a negotiation to grab a billion-dollar bank, he waited for words until an idea materialized somewhere out of that Marine Corps (1957-59) mind, and he unloaded over the phone at the poor gentleman on the other end: "My board is meeting, and we've gone too far. I've got to launch my missiles!" (The not-so-gentlemanly reply, reported later in the press: "Go the hell back to North Carolina.") McColl never fit with the other good ole boys sitting around Charlotte in the 1960s, talking about how they were going to get rich, what they were going to do with all their money. McColl--who worked for a bank!--didn't talk about money at all.

He talked about power.

These days he has plenty of both. In the past 10 years, as international banks have struggled with competitors from American Express to America Online, McColl has engineered a kind of banking miracle in homey Charlotte, a deus ex machina where the machina is his very own NationsBank automated-teller machines, and the deus wears cowboy boots. Last week McColl announced the boldest deal yet: a plan to merge NationsBank with California-based BankAmerica to create a golden Godzilla with deposits of $346 billion. On Wall Street, where financial stocks have sizzled this year, the marriage was greeted with huge plaudits. On Main Street, average customers (the combined bank will have millions of them) worried about what this would mean for their accounts. And in Charlotte? McColl wasn't talking, having unloaded the big news in New York City early in the week. But from his 50th-floor office, he was surely reflecting on the inescapable truth and beauty of the First Law of Godzilla: Size does matter.

To be fair, McColl isn't the only one to have figured this out. The past month has been peppered with the kind of earthmoving financial deals that would have seemed impossible a decade ago. On the same day last week that the BankAmerica-NationsBank deal was announced, Banc One chairman John B. McCoy (who once mused that in the future the industry would have just five or six major banks) announced plans to merge his $116 billion bank with the much merged $115 billion First Chicago NBD Corp. All this came just a week after insurance and brokerage giant Travelers Group announced plans to tie the knot with Citicorp, the second largest bank in the U.S.--a $76 billion marriage, not just of services but of two industry titans: Sanford Weill, who emerged from a messenger job at Bear Stearns to conquer Wall Street; and John Reed, the no-compromises Citibanker who manhandled his firm back from the edge of insolvency in the late 1980s. Suddenly the world of finance began to look less like the Norman Rockwell thrifts that built the great American economy and more like a Picasso impression of finance, all whirring shapes and color and noise.

Like the finest Picasso paintings, the collision of these financial giants hints at a deeper, more complex revolution. The neat little boxes in which we store our finances--mortgage, cash, savings, and so on--are being subdivided in a million ways. Soon you won't recognize them individually. For instance, all your assets could be wrapped into a wealth account that is constantly on the prowl for investing opportunity worldwide.

Cash is already headed for a whole new dimension. MasterCard, for example, has invested millions in the development of an E-cash system called Mondex. Smart Mondex cards have tiny embedded microchips that can store not only electronic dollars but also five other types of currency, an abbreviated medical history and even a personalized electronic "key" that can open everything from your apartment to your office. Says Henry Mundt, MasterCard executive vice president for global access: "The chip that we are putting on the card now will form the platform for the ultimate in remote access for consumers to their funds, anytime, anywhere. What we really see happening in the future is consumers being able to design their cards to meet their individual needs. We refer to that as moving more toward life-style cards." E-cash is already everywhere, from highway tolls to subways. Security? Privacy? The second is more troublesome than the first and presents a fearsome scenario for crimebusters and tax collectors alike.

In just two decades we've gone from a world of simple mortgages and passbook savings to a universe of Roth IRAs, 401(k) plans, personal-risk-management scenarios and collateralized-mortgage obligations. Years ago, some genius figured out that mutual funds might save investors the hassle of choosing among thousands of stocks. Yet today there are 7,000 mutual funds, almost as many funds as there are stocks. And more technology just means more change. Says investment banker David Shaw: "The whole financial industry will likely be turned upside down, with shrinkage in some areas and perhaps some outright failures among those firms that are unable to use technology effectively."

At the center of this new world is a conflict between consolidation and disintermediation (a word that sounds like a tropical disease but means the removal of intermediaries, such as banks, from financial transactions). The disintermediation camp--led by software firms like Microsoft and Intuit--believes that the future will belong to companies that master the technology of this new era, firms that give investors subatomic-level control over their finances with sophisticated products that balance risk and reward, cost and value. The opposite camp--led by McColl and others--argues that the future belongs to huge financial institutions that will package investments and provide investors with cradle-to-grave services: everything from insurance to car loans to airplane tickets.

It is not an either/or proposition: McColl and company recognize that technology is their business and size is poor insulation from change (just ask Japanese banks, among the world's largest, now immobilized by bad debt, weak management and a stunted economy). The future lies in being both nimble and smart. "We have a lot of competition these days, even from people like Microsoft," said McColl recently, revving up his engines. "Software is becoming everything."

And, sure enough, one of the selling points of these megadeals is the idea that smart software will reshape the relationship between banks and customers. In a nonstop tango of bits and bills, the computers at the new Citigroup or at BankAmerica will zip through accounts looking for better ways to make money for both you and the bank. And the banks will use that efficiency to lever into the most profitable parts of the financial world: investment banking, stock underwriting and insurance.

Those that don't will be casualties. McColl (who gives crystal hand grenades to prized employees) understood early on that one day banking was going to be like war. Call it semper finance. Says David Chaum, the visionary guru behind DigiCash, a Net-based currency: "What you find in retail banking today is that some banks see themselves as acquirers, and others see themselves as, well, acquirees." On the day the Travelers deal was announced--creating a giant with $42 billion in equity--vice presidents at still independent Goldman Sachs nervously fingered their E-mail with questions about when the famously private firm might seek a public offering to raise more cash in order to boost its size. Technology and deregulation have--even for a firm with profits north of $3 billion--turned the competitive heat way, way up. "In five years this firm may be run by a software guy," Goldman CEO Jon Corzine once mused to TIME. A geek at the helm of Goldman? Goodness.

There are few permanent rules in the world of finance--maybe only one: make money--and even those are starting to come unbuttoned. In the past 10 years, decades of regulations--such as the Glass-Steagall Act, passed in the Depression to help limit risk following a banking-system failure--have been all but abandoned, a testament to the fact that all markets move on--and none faster than money markets. The last time this happened was in 1982, when the Garn-St. Germain Act repealed old regulations and allowed savings and loans to graze for investments in areas like real estate and mineral development. The result was an unmitigated disaster, with taxpayers getting stuck with a $500 billion mess.

What are the risks associated with a brave new world of Cayman Island trust funds and retirement accounts built on leverage? No one yet knows. But some suspect. Sholom Rosen, vice president of emerging technologies at Citibank, has what may be the perfect mantra: "It's definitely new, it's revolutionary--and we should be scared as hell."

The fundamental idea driving this revolution is that technology and finance have become one and the same. As William Niskanen, chairman of the Washington-based CATO Institute, puts it, "The distinction between software and money is disappearing." And nowhere is that truer than in the world of cold, hard cash.

Paper money is, in its way, amazing stuff. It is, for instance, easily transferable and widely accepted. You can pay the baby sitter without even thinking about the complex financial dynamics underlying the transaction. Cash--especially U.S. dollars--is also portable, storable and exchangeable. (Just ask the thousands of Russian mafiosi who pay for nearly everything with crisp $100 bills.) And it holds up pretty well. If you're afraid of banks, you can still grab a coffee can, dig a hole in the backyard and have a pretty secure deposit. But paper cash does have some awful drawbacks. Lose it and it's gone; sit on it and it may lose its value overnight: think about what just happened in Asia, or earlier in South America.

Enter electronic cash. The idea of digital money is simple enough: instead of storing value on paper, find a way to wrap it in a string of digits that's more portable and (most important) smarter than its paper counterpart. Smart money? Well, yes. Because digital cash is endlessly mutable, you can control it much more precisely than paper money. Think about the $2,000 check you send to your daughter at college for expenses. How is that money really spent? Books...or beer? Electronic cash takes that relatively simple transaction--passing an allowance--and makes it into a much more intelligent process. And one that hardly requires something as old-fashioned as a bank.

For starters, you can send the money over the Internet encoded in an E-mail instead of sending a check. This saves you the trouble of balancing the checkbook at the end of the month, and it gives you the option of transferring the money from wherever you want: mutual fund, money market, even an old-fashioned checking account. Your daughter can store the money any way she wants--on her laptop, on a debit card, even (in the not too distant future) on a chip implanted under her skin. And, perhaps best of all, you can program the money to be spent only in specific ways. You might instruct some of the digits to go for books, some for food and some for movies. Unless you pass along a few digits that can be cashed at the local pub, she'll have to find someone else to buy the drinks.

Smart, digital cash may also address some of the other problems of paper money. If you lose your digital cash, for example, you will be able to replace it instantly by asking your computer to invalidate the disappeared digits and replace them with a fresh set. And unlike paper money--which stops earning interest as it shoots out of the ATM slot--smart money can keep earning interest until the moment you spend it.

This "cash-interest phenomenon" may sound trivial, but it's a link to a whole other revolution in finance: the dissolution of the government monopoly on money. After all, if some small bank in Luxembourg or Belize is willing to pay you more interest on your digital cash, who are you to argue? As long as the bank's digits are widely accepted, there is no need to stick with government-issued numbers. Government money will still exist, but so will dozens of other currencies, each tailored to a specific need and endlessly convertible and exchangeable. The best money, in short, will be the smartest money. Says Howard Greenspan, president of Toronto-based Heraclitus Corp., a management consulting firm: "In the electronic city, the final step in the evolution of money is being taken. Money is being demonetized. Money is being eliminated."

Maybe. Digital cash, for all its charms, is still climbing a tough road to acceptance. "Between 40% and 50% of transactions today use cash and checks," says Steve Cone, an executive at Fidelity Investments. "The percentage is going down, but slowly. It's like Chinese water torture." And there are plenty of folks who still like cold cash just fine. Says economist Bruce Skoorka: "Look, every day there's a guy who shows up at a bank in Bogota with a big box full of cash. You think he wants to travel with a traceable digital-cash card?"

In fact, in the eyes of some digital-cash Pollyannas, one of the great things about traceable, bit-based cash is that it will do away with whole categories of cash-based crime. "Paper money is, I hate to say it, the root of all evil," says DigiCash founder Chaum, who argues that the traceability of electronic cash will mean the end of some types of crime. "What kidnapper would take a ransom payment by check? Once you build the infrastructure for electronic cash, the incremental cost of replacing paper money is small. And the social benefits could be amazing."

But Chaum assumes that these electronic transactions will be traceable--something that's sort of a jump ball in the theory of electronic finance these days. One school of theorists, led by Chaum, argues that electronic cash needs to be "one-way anonymous" so that people transferring money can always see where it goes, while people receiving money won't know where it comes from. This one-way-mirror transfer solves some of the problems of paper money, since it makes it easier to keep track of where money is spent and why. But who really wants to leave "money tracks" wherever he goes?

Electronic cash can also be two-way anonymous--totally untraceable and a dream for international criminals. Even old-style tax cheats would be entranced by an anonymity that would allow them to earn income without forking over a chunk to Uncle Sam. And that means rejiggering the IRS--and quickly. "Digital cash has no boundaries," explains Richard Rahn, president of Novecon Ltd., a technology consulting firm. "The cybermoney revolution makes some forms of tax evasion very easy." And these innovations even call into question the role of the Federal Reserve as arbiter of the nation's money supply. "The more such innovations succeed, the less the public has to rely on central banks as direct sources of exchange media," University of Georgia economics professor George Selgin has written, "This seems to me to be particularly obvious in the case of E-money."

If there is a Magna Carta for this new world of electronic finance, a single document that spells out the terms and scope of the revolution that will shift money power away from central bankers and into the hands of consumers, it could be found in "Financial Markets in 2020," a speech delivered in 1993 by Charles Sanford Jr., then CEO of Bankers Trust, to a gathering of economics sachems in Jackson Hole, Wyo.

Sanford is a complex, brilliant figure in American finance and someone to know if you care to comprehend why your bank just got gobbled up or why your mutual-fund company has begun offering a hundred new ways for you to invest your money. He popularized the notion of risk management, one of the most important ideas in modern finance. He didn't come up with the notion (credit academia), but more than anyone else he helped pioneer a new kind of risk-aware investing that offered a first glimpse of a world of high-wire, high-tech finance. His legacy has touched every American with a home loan, a credit card or a checkbook. And it has not only made consolidators like McColl and Weill possible--it has also made them essential and inevitable.

All investments can be characterized by two variables, in the same way you might categorize a person by his hair color and height: risk and reward. They tend to be proportional. If you want more reward, generally it means taking a bigger risk. Home mortgages, for example, are fairly riskless propositions for lenders, but the reward is tiny--perhaps 6% a year in interest payments. On the other hand, lending money to the government of Malaysia is fairly lucrative, but it is not an investment for the faint of heart--the double-digit interest rate brings with it risks of a devaluation, a government coup or an outright default.

The idea was to take all investments--from insurance policies to vacation loans--and break them into tiny packages of risk that could be put into a computer and auctioned on a global network. Different investors, looking to buy different kinds of returns for their money at different times, would step up and buy the various chunks of risk. Because these risk bundles were derived from the underlying investments, they were called derivatives. To explain this new world, Sanford embraced what has come to be known as the theory of particle finance. Just like quantum physics, which involves looking deep inside atoms to understand how the physical world works, Sanford proposed looking deep inside every investment to understand better how markets work.

The idea proved to be hugely popular. By allowing institutions to manage their finances more carefully, derivatives offered the possibility of locking in greater rewards at lower risks. Suddenly what seemed to be the first immutable law of finance--you can't get a bigger reward without a bigger risk--was up for grabs. Alas, derivatives aren't inherently good: Just ask the citizens of Orange County who lost millions of dollars in public money when a derivatives deal blew up in 1994.

But the genie was out of the bottle. Derivatives have changed the rules of the game forever. Average investors who are now pouring money into mutual funds and stocks will soon have access to hundreds of other investment options. Think of the world as a landscape of opportunity--everything from distressed Japanese real estate to Russian oil futures--marketed and packaged by giant banks like BankAmerica or by fund companies like Fidelity Investments and the Vanguard Group. "This is like the automobile's coming," says Sanford. "We'd always had transportation--people walked, eventually they rode donkeys--but the automobile was a break from everything that came before it. Risk management will do that to finance. It's a total break."

In Sanford's vision of particle finance, every financial asset, from the mortgage you hold on your house to the items you've charged on your credit card, will become part of a giant, interconnected financial universe. And each piece of your superportfolio, called a wealth account, will be understood not simply as a "stock" or a "bond" but as an instrument designed to match your financial needs with the available options. In the same way a FORTUNE 500 treasurer may use derivatives to balance his or her need for pesos and yen, wealth accounts will precisely balance your demand for investment and consumption. Says Christos Cotsakos, CEO of online brokerage group E*Trade: "The wired household is the ultimate bank." Your checking deposits, for instance, might be programmed to scour an electronic Web looking for interest-bearing investments overnight while you sleep. If a Turkish real estate developer needs to use the money for a few hours while you doze (and is willing to pay you for the privilege), your wealth account will be smart enough to decide if that's a risk you'd be willing to take in exchange for the reward and then, if it is, to lock in the deal.

These smoothly integrated accounts will make old "classical" transactions--like getting a loan or buying stocks--as charming and irrelevant as classical notions that the sun orbits the earth. Because the system will constantly monitor your net worth, you'll be able to draw instantly on assets in one area to create liabilities in another. These computer-run accounts will factor in everything from the weather to the age of your children in plotting out your future demands. "Yesterday's income and today's wealth will always be known with a high degree of confidence," Sanford predicted in his 1993 speech. "Wealth accounts will be instantly tapped via 'wealth cards.' For example, you will be able to pay for your sports car by instantly drawing on part of the wealth inherent in your vacation house." Finance, suddenly packed with microchips, could become a banker-free zone. Hence the drive of McColl, who is responding to an immutable merger of the laws of finance and the laws of modern business: reinvent yourself or die.

Of course, all this has risks of its own. Do you really want the banks running high-tech experiments with your money? One of the ideas behind these new superbanks is that with large customer bases they will be able to offer infinitely complex (and incredibly efficient) wealth accounts to the average investor. But taking complex finance out of the hands of Wall Street rocket scientists and putting it into the hands of consumers or even inexperienced bankers is hardly a riskless activity. "Banks have been making less and less money from traditional lines of business," says Douglas Gale, an economics professor at New York University who is considered a leading thinker about next-generation finance. "What they have found lucrative is designing derivatives. But if you're using derivatives and you don't understand the technology or you don't know what you're doing, there is a real danger here. It's like letting a child play with a nuclear reactor."

In fact, the China Syndrome aspect of all this interconnected finance is among its most worrisome features. What if the whole nterconnected computer network crashes? (Hell, what if just your part does?) What if a hacker breaks in at the wrong place? What if the bank "blows up," as Barings PLC did in 1995 after 28-year-old Nicholas Leeson bet the house and lost? Industry insiders--the folks who have designed the systems--argue that the infrastructure they have built is secure enough to survive any tampering and that the markets themselves will factor in the risks of rogue or inexperienced traders. "There is no chance that a money market will fail and threaten the underpinnings of the system," says Cone of Fidelity Investments. This new electronic world challenges everything we thought we knew about finance, but maybe not what we know about economics. Will a high-speed global economy put an end to the boom and bust of the business cycle, or will it create dangerous interlinkages across borders, where a bad year for the Mexican economy, say, might accidentally trigger a global depression?

But the risks of the new system do point up the problems of trying to regulate such a quickly changing world. In the week after their deal, Weill and Reed tipped their hats toward Washington, but it was just a courtesy. Banking, everyone seems to have acknowledged, has entered an era that may be larger than old-fashioned laws. Fed Chairman Alan Greenspan, for one, has abandoned the notion that it is possible to regulate this broad frontier with old-style rules. The burden, he says, has to rest with private industry: Regulate yourselves. "To continue to be effective, government's regulatory role must increasingly assure that effective risk-management systems are in place in the private sector," he observed in a 1996 paper. "As financial systems become more complex, detailed rules and standards have become both burdensome and ineffective." In fact, many governments are competing with one another to see who can offer the fewest regulations. And the money is following right along. Economist Skoorka calls this regulatory arbitrage--the flight of money from highly regulated markets to barely regulated ones.

Such laissez-faire battles delight men like "Missiles" McColl. If cyberspace really is the final frontier of finance, why not let it regulate itself, with a kind of frontier justice meted out by the market? And as these superbanks battle to survive against the Microsofts of the world--a battle in which the outcome is still anything but certain--the Wild West promises to get even wilder.

Consumers might find this terrifying, but the superbankers love it. Because their gigantic banks are "too large to fail," firms like the new BankAmerica and Citigroup will offer the safest possible havens for investors--safer, perhaps, than even government-printed money. In the end, what the semper financiers are after is not just new customers or new deposits but a kind of business immortality ensured by their gargantuan size and guaranteed by their killer technology. E-cash, wealth accounts and consumer derivatives will have made these firms as essential as cash itself once was. If business immortality can be purchased, these are the people who will figure out how to finance it. And they will be doing so with your money.