Banking on Creative Destruction

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Jason Clemens and Patrick Basham

According to the eminent Austrian economist Joseph Schumpeter, one of capitalism's distinctive advantages is the process of "creative destruction."1 By this term, Schumpeter referred to the dynamic entrepreneurial spirit present in capitalist societies whereby the pursuit of profit provides the incentive for both individuals and companies to innovate, experiment, and create. It is the process by which outdated products and production methods employed by inefficient companies are destroyed, i.e., replaced, by cutting-edge products designed by newer, more efficient companies with their innovative production techniques.

The history of the twentieth century proved Schumpeter correct in terms of the value and importance of the creative destruction process. For example, rather than horse-drawn carriages, we currently use motorized vehicles which, inevitably, will be replaced by some new mode of transport. Rather than listening to records, we currently listen to compact discs, which, like 8-tracks and cassettes before them, will be replaced by an even more efficient and less expensive product. Further examples abound illustrating how technology has improved our daily lives and made better off those societies that embrace technological change.

However, a century of technological innovation - revolution, even - has not convinced everyone of the long-term benefits of creative destruction. While many of us embrace new technology and its accompanying benefits, many others feel uncomfortable about the human displacement that new technologies cause. In other words, we accept the creative side of the equation but are deeply anxious about the destructive side, without realizing that creation and destruction are two sides of the same economic coin.

The financial services sector offers a prime example of partial public resistance to such change. The process of creative destruction has been revolutionizing the banking industry for some 15 years. Due to technological innovation and improvement, the so-called "bricks and mortar" of banking, i.e., the physical branches that have traditionally constituted the banking system, have been rapidly replaced by automated banking machines (ABMs), telephone banking, and the Internet.

Since peaking in 1991, the number of domestic branches operated by the so-called "Big Five"2 Canadian banks has fallen from 6,354 to 5,509, a 13 percent reduction. Equally telling is the increase in the number of Canadians per branch, which rose from 4,344 in 1988 to 5,570 in 1999, an increase of 28 percent.

During the same period, the number of Big Five ABMs increased by 253 percent, from 4,373 to 15,438. More telling, though, is that the number of Canadians per ABM decreased from 6,150 in 1988 to 1,988 in 1999, a decrease of 68 percent. Such technological advancement has meant more convenience, less waiting time, and more choice for customers.

New technology has also stimulated the development of telephone and Internet banking. By the end of 1999, the Big Five banks had 8.4 million registered telephone banking customers and 2 million registered Internet customers. This represents a 44 percent increase in telephone customers and a 25 percent increase in Internet customers in just two years. Again, these services offer more convenience, less waiting, and more choice for customers.

Embracing creative destruction, therefore, means welcoming such change because it means the old and the outdated are being replaced by the new and the superior.

Unfortunately, rather than recognizing the importance of - and the myriad benefits that accrue from - permitting and, indeed, encouraging such dynamic change, Finance Minister Paul Martin remains unmoved. Like so many Canadians, Mr. Martin's reflexive reaction is to fear change. For example, with his late 1998 decision to preclude bank mergers he attempted to use regulatory constraints to slow down change and, consequently, he adversely affected the competitiveness of Canada's domestic banks.

What is the result? Predictably, technology continues to change both the nature and the structure of banking. At the same time, however, unlike their international competitors, Canadian banks have been prevented from re-organizing themselves to meet future challenges. Headline after headline details how American and European banks have merged, or are in the process of merging and restructuring, to meet the new technological demands of banking, and thereby provide their customers with the best service.

Rather than permit the rational consolidation of contemporary Canadian banking through mergers, Mr. Martin's ill-considered decision has hindered the long-term viability of our banks. Now, the Big Five must pursue second-best policies, such as branch closures and staff reductions, in order to remain internationally competitive.

In the short term, Mr. Martin placed political considerations before economic ones. Hopefully, before his tenure as Finance Minister comes to an end, he will learn the value of the advice proffered by former US President Ronald Reagan: in the long term, good economics is always good politics.

Notes

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Last Modified: Wednesday June 9, 1999.