Banking Business Models and Financial Stability - Case Study Example

Part I

Introduction

A business model can simply be described as the plot a company or industry takes up with an intention of creating revenue and being profitable from its achievements. It’s basically an abstract representation of the functions and components of the business, the financial arrangements, the core products, and services offered by the organization and the preparations set up to allow achievement of the organization’s tactical objectives. The business model that banks adopt tends to be different depending on the objective and sector of operation they are dealing in. However, the current set up of the different banks business models is attributable to the imposition of new rules and regulations and past events that have taken place in the economic environment. Different banks types have different ways of operation and distinct features. This paper will focus on the comparison between Retail and investing banking.

Retail banking, a banking mass market, has large commercial banks which are used by individual customers to offer services like mortgages, debit/ credit card, savings and checking accounts, certificates of deposits and personal loans. Retail banks aim at serving the retail clients with as many financial services, therefore, act like a one stop shop. Basically, retail banking involves commercial banks that deal with consumer- oriented services. For a better understanding of the retail banking business model, it’s prudent that first an analysis on the origin and the different events that took place over time to establish the current retail banking status (KOSLOWSKI, 2011 pp 33-45).

The revolution of retail banking began in the 1950s when commercial banks changed their attitudes in regard to the personal sector. The 1945 period was an era of prosperity for the banking sector which saw new players entering the financial system. This prosperity was linked to the personal sector which was a major contributor to the economy through the provision of surplus funds. Providers of retail banking services are several since they range from small ones that only concentrate on retail services to the big ones that take on a collection of banking activities. What has made retail banking attractive is its ability to facilitate for the availability of cheap and stable funds for banks thus leading to commercial banks entering the traditional marketplace (MEYER, & BACK, 2014 pp 27-31). Commercial banks in Sweden, Netherlands and Germany entered retail banking and ended up giving postal organizations and saving banks competition despite their previous domination in this market segment.

Retail banking was considered to be supply-led for periods before the 1950s but was later transformed to customer-driven. This meant that the strategies the banks were using had to adapt to this drift. Many banks in this period used this marketing strategy due to the competition that had emerged for retail deposits. Retail banking had been revolutionized to a model that focused on customers and even went to the extent of classifying their products to cater for the needs of the different customer segments in the market.

On the other hand, investment banking is a banking division that mainly focuses on capital creation for the government, companies, and entities. Investment banks aid in the sale of securities, assist corporations in underwriting new debts and equity securities, and assist institutions and private investors in reorganization, broker trades and mergers and acquisitions. They also provide direction in regard to the allotting and placement of stock.

A point to note is, unlike Retail bank who take deposits from individuals, investment banks don’t take deposits. Investment banks way of earning most revenues is through the buying and selling of products in the market with an objective of making profits from every trade. Majorly, investment banks operate under double key lines; the buy side and the sell side. The buy side is basically the giving of counsel to organizations that purchase investment services. While the sell side is basically the business of security transactions; either for cash or exchange for other securities.

After a series of changes that investment banks have gone through the years, in present day they usually deal with asset management, trading and principal management and investment banking. Major scrutiny has been undertaken on banks of an investment and commercial nature (WENDT, 2015 pp 45-51). Additionally, discussion held on if it’s best that they separate and not operate under one roof, therefore, leading to countries like the United States deciding that they should remain separated through the repeal of the Glass-Steagall Act

An important point to note is the major deregulation that Investment banks business models underwent after the 2008 financial crisis that almost led to the collapse of the banking sector. This made investment banks to shift their goals from seeking long-term gain and underwriting established companies to short-term gains and low standards.

A deep analysis shows that Investment banks operate more freely than retail banks due to the different regulation of the two models. Retail banks are more highly regulated by regulatory bodies and must always show they have the ability to provide a certain level of security and be able to protect the consumer accounts at all times. Some of the regulatory bodies that oversee retail banks include the Federal Reserve and the Federal Deposit Insurance Corporation. On the contrary, Securities and Exchange Commission regulate investment banks which offers less protection to customers. Therefore, due to the weak regulations accorded to investment banks, they are riskier than retail banks.

Therefore, in conclusion, it’s clear from the analysis that retail banking operates using the traditional business model. This means that most retail banks business models are characterized by a lower capital ratio and return. Also, from the analysis, it’s seen that most banks in the sector operate in retail banking. This is because retail banks business model are not prone to systematic risk. Investment banks, on the other hand, are associated with the originator and trader model. This means that they exhibit features like higher capitalization and high profitability. However due to this structure, they tend to be highly prone to systematic risk. The reason for the high risk is the high correlation investment banks have with the capital market performance.

Part II

It’s imperative to note that the banking sector remains very vital in ensuring there is stability in financial systems. The validation of the huge effect the banking sector has on financial system was clearly expressed during the crisis period. This has led to the placement of massive investments by financial supervisors and central bankers in coming up with ways to build up the financial system and avoid another fiscal catastrophe from ever happening. In this analysis, an assessment on Investment banks business model will be undertaken with regard to their relationship to financial stability (EVANOFF, et al., 2013 pp 23-33).

Previous events in the financial market indicate that investment banks carry risk to the financial system. An in-depth analysis of ten of the largest investment banks shows that the trading assets that these banks operate with exceeds to more than 5 trillion pounds meaning that the failure of a single firm can cause liquidity problems in the economy and generally affect financial stability. During the global financial crisis, largest investment banks had to be bailed out by government and taxpayers, others were taken over and others declared bankrupt after the distress. The financial distress that most large banks faced during the financial crisis crystallized some of the risks investment bank have on financial stability. Investment banking is mostly relevant in regard to the United Kingdom since most of the largest banks operate in London.

However, global regulations have been set up after lessons learned from the crisis, with an objective to correct the failures that led to the crisis and the economy being affected due to financial instability. The bank of England is at the forefront in collaboration with the global regulatory to ensure that the acts of investment banking don’t pose a risk to financial stability again.

For there to be a regain to public confidence and financial health, it’s imperative that investment banks choose welfare enhancing and sustainable business models to ensure there is no repeat to the risk of financial stability that was brought by the global crisis. In fact, the emergence of the financial crisis can be partly blamed on the business models of investment banks due to the high risk and high leverage features these banks are attributable to. The originating, distributing and trading business models that investment banks have while dealing with complex securities bring excess risk to the financial system. It’s notable that this systematic risk had a major contribution to the emergence of the 2008 crisis. These shows the close linkage investment banks business models have on the real economy and how this affects financial stability.

In pursuit of the root to the vulnerability, economies face with regard to investment banks and their connection to financial stability; it’s reasonable to state that the risks that arise are due to the fact that banks changed their business models from the traditional commercial banking. Attempts to mitigate these risks led to the introduction of reforms like the Basel III rules which help in the reduction of the volatility of profitability (De Jonghe, 2010 pp 10-21). This is a model that was adopted in the financial market to ensure that the public is not put under financial risk and forced to pay for bank mistakes like before. It proposes the divorce of investment and commercial bank. The banking sector is currently adapting to a specialized approach than a universal one in their business models. This is to ensure that the macroeconomic duty of banks to supply credit to the real economy is protected while being shielded from the inherent risks associated with investment banks.

Present day regulations have been set up to ensure that taxpayers don’t suffer losses. This is through distressed banks having their shareholders and creditors bearing losses instead, therefore not putting the real economies financial stability at risk. However, there should be more discussions and analytical reviews on the structure of investment banks. Hard questions should be asked on whether these banks business models are too complex to ensure credibility and facilitate realistic market exit.

Actions like the imposition of ring-fencing have been introduced with intentions to mitigate liquidation risk. It attempts to protect the financial stability of normal people in that they will not be affected by investment banks failures and also investment banks will establish separate departments like HR, legal and risk operations which would ensure that they are not so reliant on investment activities revenues. But scholars must also not be blind and assume that ring-fencing investment banks from the principal trade of banks will be enough to ensure financial stability and avoid a crisis (Hryckiewicz, 2014 pp 41-45). This is because the model is yet to be tested and can only be proved workable when financial markets are in panic.

Therefore, to ensure financial stability, the focus should be on the systematic risks attached to investment banks business model and the ways to mitigate them. As much as investment banks solvency is important in ensuring financial stability, it’s still not enough. Besides asset portfolio quality, what is important and key to restoring confidence is the amount of capital. Having capital adequacy is not the ultimate solution but without it, all efforts to bring stability count to nothing.

In the case of financial stress, capital acts like an internal buffer to cushion the strains. And to be able to ring-fence, banks will need to set up tens of millions aside to act as capital buffers.

Conclusion

The analysis basically indicates that lack of stability and the inherent risks attributable to investment banks contributes to financial crisis leading to the rise in social cost. Therefore, in the assessment of investment banks business models, it’s impossible to not consider the effect they have on financial stability. The study indicates that failure of investment banks contributed hugely to the financial crisis of 2008, therefore, making the economy unstable financially. However, that doesn't mean that the crisis was unavoidable. With more disclosure, proper regulations and transparency of investment banks business models, financial stability can be maintained and the rise of financial crisis avoided.

Reference

De Jonghe, O., 2010. Back to the basics in banking? a micro-analysis of banking system stability. Journal of financial intermediation, 19(3), pp.387-417.

EVANOFF, D. D., HOLTHAUSEN, C., & KAUFMAN, G. G. (2013). The Role of Central Banks in Financial Stability How Has it Changed? Singapore, World Scientific Publishing Company.

Hryckiewicz, A., 2014. Originators, Traders, Neutrals, and Traditioners–Various Banking Business Models Across the Globe: Does the Business Model Matter for Financial Stability?. Available at SSRN 2412171.

KOSLOWSKI, P. (2011). The Ethics of Banking: Conclusions from the Financial Crisis. Berlin, Springer Netherland.

MEYER, N., & BACK, A. (2014). Business Model Innovation in the Retail Banking Industry the Strategic Impact of Mobile Banking Loyalty Programs.

WENDT, K. (2015). Responsible investment banking: risk management frameworks, sustainable financial innovation and softlaw standards.