What Does the Financial Crisis Teach Us about the Feasibility of Different Banking Models?

The recent financial crisis has seen the demise of large investment banks in the U.S.  This major change in the financial landscape has also rekindled interest in discussion of optimal banking models.  All over the world, perceived costs and benefits of combining bank activities of various kinds have given rise to a wide variation in allowed bank activities.  Should banks operate as universal banks, a model which allows banks to combine a wide range of financial activities, including commercial banking, investment banking and insurance; or should their activities be restricted?

To some policymakers the universal banking model may appear to be a more desirable structure for a financial institution due to its resilience to adverse shocks, particularly after the crisis.  However, others have called for the separation of commercial and investment activities (along the lines of the Glass-Steagall Act of 1933 in U.S. which was repealed by Gramm-Leach-Bliley Act in 1999) to minimize the crisis-related costs imposed on taxpayers through the financial safety net.  So which model is more desirable?

Theory, as usual, provides conflicting predictions about the optimal asset and liability mix of an institution.  On the one hand, banks gain information on their customers in the provision of one financial service that may prove useful in the provision of other financial services to these same customers.  Hence, combining different types of activities – non-interesting earning, as well as interest-earning assets – may increase return as well as diversify risks, therefore boosting performance.  This argues for the merits of universal banks.

On the other hand, if a bank becomes too complex, bank managers may actually start taking advantage of this complexity for their own private benefit (what are sometimes known as “agency costs”) at the expense of the bank.  So, too much diversification may actually not be optimal, increasing bank fragility and reducing overall performance.  This tends to support the separation of commercial and investment activities. 

In a recent paper, my co-author Harry Huizinga and I examine the implications of banks’ activity mix and funding strategy for their risk and return, using an international sample of 1334 banks in 101 countries leading up to the 2007 financial crisis.  On the funding side, the crisis has clearly exposed the dangers of a bank’s excessive reliance on wholesale funding.  Similarly, asset side weaknesses were exposed when large U.S. investment banks completely disappeared from the banking scene when faced with the crisis. To understand differences in banks asset and funding strategies or business models, we constructed bank-level indices of (1) the share of non-interest (fee) income in total income, and of; (2) non-deposit funding in total short-term funding.  Indeed, we see substantial cross-bank variation in business models employed by our sample of international banks for the 1995-2007 period.

On average, we see that financial institutions substantially combine interest generating and other income generating activities, with fees typically accounting for 35% of total income.  But this figure masks large differences across different types of institutions – while commercial banks, which make up the bulk of the sample, obtain around one third of their income from fee-generating activities, for investment banks this figure is over 75 percent (Figure 1).  Moreover, the fee income share has been rising for all institutions over the sample period, with particularly steep increases in 2007 for investment banks, non-bank credit institutions and other financial institutions such as real estate mortgage banks and savings banks.

Trend of the fee income share by categories of bank type.  The fee income share is the share of non-interest income in total operating income. This plot shows the trend of the fee income share by bank categories from 1999 to 2007. Bank categories are commercial banks, investment bank or securities house, non-banking credit institution and other. Subcategories of commercial banks are bank holdings and holding companies, and commercial banks. Subcategories of other are cooperative banks, Islamic banks, medium and long term credit banks, real estate mortgage banks and savings banks. The data are from Bankscope.  Source: Demirguc-Kunt and Huizinga, forthcoming. 

On the funding side, most banks attract only a small share of their short-term funding in the form of non-deposits, with an average non-deposit funding share of 8%. The distribution of the non-deposit funding share, however, has a fat tail of banks that raise more than half of their short-term funding in the form of non-deposits (Figure 2).  And just as with the share of fees in total income, the reliance on non-deposit funding increased significantly for investment banks, non-bank credit institutions and other financial institutions such as real estate mortgage banks and savings banks, and markedly so in 2007 (the last year covered by our dataset). 

Trend of non-deposit funding share by categories of bank type. This plot shows the trend of non-deposit funding share by bank categories from 1999 to 2007. Bank categories are commercial banks, investment banks or securities houses, non-banking credit institutions and other. Subcategories of commercial banks include bank holdings and holding companies, and commercial banks. Subcategories of other are cooperative banks, Islamic banks, medium and long term credit banks, real estate mortgage banks and savings banks. The data are from Bankscope.  Source: Demirguc-Kunt and Huizinga, forthcoming. 

So how do these two strategies impact a bank’s risk and return? (Risk is defined here as the distance that the return on assets would have to fall for a bank to become insolvent – see the paper for a more precise definition.) 

1. Fee Income: Both a bank’s rate of return and risk increase with its fee income share, suggesting trade-offs. Our results suggest that increasing the fee income share can yield some risk diversification benefits, albeit when starting from very low levels.
2. Wholesale Funding: In contrast, non-deposit, wholesale funding lowers the rate of return on assets, while it can also offer some risk reduction benefits again at low levels.
    

Hence overall, our results provide a strong indication that banking strategies that rely preponderantly on non-interest income or non-deposit funding are indeed very risky. This does not necessarily mean that banks should completely eschew non-interest income generating activities and non-deposit funding, suggesting that universal banking can be beneficial.  But evidence of diversification benefits is weak.  Hence, while the universal banking model may still be the best way to conduct investment banking in a safe and sound manner, our results also suggest that there may be limits to how far banks can steer away from the traditional model of interest income generation and deposit taking.

Further reading:

Demirgüç-Kunt, Asli and Harry Huizinga, “Bank Activity and Funding Strategies: The Impact on Risk and Returns,” Journal of Financial Economics, Forthcoming. (See the Policy Research Working Paper version.)