Retail-funded bank model is top performer – Part 2

Dr Abdul Rahman

In my last post, I presented evidence from a recent study by the Bank of International Settlements (BIS) which concluded that “regardless of the profitability metric, the retail-funded model is the top performer.”

I now consider a key explanation for this significant finding.

Actually, the BIS study of 222 international banks found that retail-funded banks earned higher levels of profitability by achieving lower efficiency ratios (also called ‘cost-income ratios’) compared to banks which are heavily capital-markets dependent.

This is a key point since cost-income ratios are negatively correlated with gross profit.

The managerial imperative is clear — take actions to increase operational efficiency and/or increase sources of stable income.  Note that I did not recommend aggressive cost-cutting measures since this could lead to a perverse effect of actually increasing cost-income ratios by reducing income as well as a higher level of operational risk.

We also note that while the sources of funding matter, the structure of the bank’s asset portfolio is just as important.

The important lesson is:

Keep the proportion of investments in capital markets of total assets below 10%.  This will minimise the volatility of the bank’s profitability level that arises from the volatility of capital markets.

Conclusion:

  • Retail banks should stay close to their proven business model – seek stable sources of funding (mainly consumer deposits) and invest in stable assets (mainly consumer and SME loans).
  • Decouple as much as possible from capital markets on the asset side and money markets on the liability side.

Manage cost-income ratios to lower stable levels by seeking operational efficiency and stable sources of income.

Dr Abdul Rahman - RBA Academic Director
About Dr Abdul Rahman - RBA Academic Director 23 Articles
Dr. Abdul H. Rahman is a former full professor of economics and finance and Telfer teaching Fellow at the Telfer School of Management, University of Ottawa. He was previously associate dean at what is now the John Molson School of Business, Concordia University in Montreal. He has been published in several academic journals including the Journal of Banking and Finance, Journal of Asset Management, Journal of International Financial Markets, Institutions and Money, and Journal of Financial and Quantitative Analysis. He has consulted for global financial institutions in retail banking, commercial banking, asset management and life insurance. Abdul is the academic director of the Retail Banking Academy.

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