'Banking Is Necessary--Banks Are Not' Why has banking become less and less important to America? Let us count the ways.
By Joseph Nocera

(FORTUNE Magazine) – Twenty years ago, back before he became Ronald Reagan's first Treasury Secretary, Donald Regan used to give a stock speech about the future of Merrill Lynch, the firm he ran with an iron fist throughout the 1970s. The speech centered around a branch office in Tampa, which had an unusual feature: four entrances, one in each direction.

Those doors were Regan's metaphor for where Merrill Lynch--and the financial services industry--was headed. As he saw it, the day was coming when each entrance would lead to a different part of a true "full service" financial firm. One door would still open to a brokerage office, of course, but another would lead to Merrill Lynch Insurance, and a third to Merrill Lynch Realty. The final door would open to Merrill Lynch Bank & Trust.

Regan's vision of the future was not only ambitious--it was impossible under the regulatory strictures of the age. The Depression-era banking laws, creating barriers separating banks from investment firms from insurance companies, were still very much in force. And yet Regan was not the only person in the industry who believed those barriers were doomed. Walter Wriston, the farsighted chairman of Citicorp during that same era, had a similar vision: "I have seen the future of banking," he used to say in his stock speech. "Don Regan runs it, and it's called Merrill Lynch Pierce Fenner & Smith."

Now, of course, the day Regan and Wriston foresaw has arrived--with a vengeance. And though Merrill Lynch is not a participant, Citicorp is at the heart of it: The $70 billion Travelers-Citicorp deal, melding as it does banking and investments and insurance, obliterates those old barriers once and for all. But that's not all it does: more than any other financial services merger, it signals where the future lies. By contrast, the BankAmerica-NationsBank merger represents merely a continuation of the past.

The essential fact about banking is that it is an industry in decline. Yes, banks are very profitable right now, but that's mainly because all the stars happen to be in perfect alignment. Once you look past the short-term profit picture, you can see a long-term problem that is not going away: As bank consultant Edward Furash puts it, banks used to be at the center of the intermediation process, and now they're not. In 1975, for instance, the typical American household had 36% of its financial assets in the bank; now that number is 17%. On the commercial banking side, the decline has been, if anything, even more pronounced, as the rise of the commercial paper and bond markets has eviscerated the commercial loan business. "As a stand-alone business," declares Norwest Chairman Dick Kovacevich, "banking is dead."

What has replaced banking at the center of America's financial life, of course, is the capital markets, a process that began even before the start of the great bull market. In the late 1970s, when interest rates hit double digits, people began turning to a little-known investment vehicle called a money market fund. Unlike regulated savings accounts, money market funds paid market rates of interest--a fact that was suddenly hugely important. Then along came the bull market. A radical shift had begun, as Americans moved toward investment vehicles. They've never looked back. "What people want--and what they're going to continue to want--is investment products," says Furash.

There is another part of the story, though. Over the years, nonbanks have had surprisingly little difficulty replicating basic bank services. As Kovacevich likes to put it, "Banking is necessary. Banks are not." The money market fund, for instance, has really become, in the minds of most people, a turbocharged savings account. Another example: the cash management account, which was invented at Merrill Lynch on Don Regan's watch. With a CMA you could borrow against your securities, write checks, deposit your paycheck--and do just about anything else you could do at a bank, plus a whole lot more. Meanwhile, the phone company got into the credit card business. Microsoft began making noises about taking over another essential bank function: acting as a "switch" that could move money electronically from one account to another.

Until recently, banks responded to these encroachments mainly by merging with each other. Though that allowed them to consolidate functions, cut costs, and keep profits growing, it was still a stopgap measure. But there have been some notable efforts to buck the tide. One came in 1982, when BankAmerica bought Charles Schwab, the discount broker. A decade later, Mellon Bank bought Dreyfus, the venerable fund company. Alas, Schwab soon bolted from BofA, while Dreyfus proved a difficult turnaround for Mellon.

Although the Travelers-Citi merger has its share of naysayers, it says here that the deal is going to work. Citi has the brand, the global reach, and the distribution network. Travelers has the array of products, in insurance and investments, the people demand. It makes too much sense to fail.

Far more than just about any other bank in the country, Citicorp has long understood that the survival of banking depended on its ability to offer other, nonbank financial services, such as mutual funds and insurance. Wriston saw that 20 years ago, and John Reed, his successor, has been similarly clear-eyed. While other banks huddled behind the regulatory barriers, hoping they would offer protection, Citicorp eagerly sought to break them down, knowing that was the only way banking could be saved. Now Reed has done it: The Travelers-Citi deal completes the revolution. "This deal," says Furash, "makes banking relevant again."