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.
- 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.