Investment Banking Business Model and Financial Stability (Essay Sample)

Retail Banking and Investment Banking Models
Deng et al. (2007, p.2455) postulate that to understand the business models under retail and investment banking, there is a need to under the difference between the two. The type of services each of the bank offers and the target market defines the fundamental difference between the two types of banks. Retail banking offers deposit accounts and loan advancements to individual customers and other related services such as saving and checking, payment services and safe deposit boxes. Retail banks offer their services to individuals, families, or small business through various bank branches or automated tellers. Jonghe (2009, p.7) explains that banks generate income by charging interest on loans and service charge towards their customers. On their part, investment banks offer advisory as well as underwriting services to their clients. The services provided by these banks include corporate finance, sale and purchase of securities and other financial instruments, provision of detailed industry reports, asset management services, and consulting regarding conditions and movements of capital markets as well as providing mergers and acquisition information. These banks make money by charging a fee negotiated by the bank and its clients.
Hryckiewicz (2014, p.10) expounds that the type of banking model adopted by each type of the bank is largely influenced by the banks overall objective of generating income and the ability of the model to withstand financial crises. The models also need to consider the organizational structure, exposure to risk, and the legal environmental under which the bank is operating.
The following diagram shows the various banking models each bank can adopt depending on the factors highlighted.
Source; businessmodelgeneratio.com
In understanding the features that influence a banking model, inferences about retail banking model and investment banking model can be drawn. In his research, (Lavinio 2000) found out that these models are both characterized by borrowers and depositors. Deposits for retail banking mainly come from individuals and small business enterprise. The retail bank model is branded as ‘’Retail Funded’’ as customer deposits make up the largest percentage of these funds. The model is characterized by high dependence on stable funding sources and a greater proportion of loans on their balance sheet. On the other hand, investment banking has large businesses and corporations as their borrowers and depositors. The banks are more capital market oriented, and mostly they hold almost half of their assets in the form of trade securities. These banks are predominantly funded by wholesale markets. The business model is labeled ‘’Trading Bank’’ with its assets and liabilities accounting for almost one-fifth of its balance sheet.
In a study carried out by (Paulet 2012) established that the popularity of either model is influenced by geographical region. For instance, in 2013, the study found out North American banks had a mixture of banks with the two models while banks in emerging market economies largely preferred retail-funded model
Table 1
Distribution of business models around the world

Retail-funded

Whole-sale funded

Trading

North America

16

-

6

Europe

36

22

9

Advanced Asia-pacific economies

11

3

3

Emerging market economies

45

2

3

G-SIOBS

14

2

12

SOURCE BIS Quarterly Review, December 20-14
More so, Lovett (2009) points out that the two banking models embrace technology to be at par with the changing technological world. Banks have employed innovative ideas such as mobile banking as well as internet banking for their clients. Retail banks are heavily investing in ATMs to serve their customers better. These banks collaborate with IT experts to fulfill their needs. The experts on their part provide IT solutions to cover areas such as customer service experience, business process improvement, multi-channel integration, business intelligence, risk management, predictive analysis among others. Automation is helping banks to reduce channel costs.
Additionally, the two banking models identify two fundamental sources of revenue. Interest income from lenders and fee charges comprise the two primary sources of revenue. Banks have introduced credit cards that are serving as an alternative source of income. In a study involving the Bank of China (BOC) and Deutsche Bank (DB) Lepetit, et al. (2008) noted trends taken by the two banks concerning interest and non-interest income. The two banks have different business models and operate under different conditions. By considering the two streams of income for the two banks, symmetrically opposing movement are observed. Although DB strongly depends on non-interest income revenue generating activities, it is moving towards less volatile interest-related income instruments. It is also noted that the bank is reducing its dependence on fee income, commissions, and capital market operations. On the other side, BOC is moving from its high dependence on interest income towards the increase in fee revenue and commission income.
The two business models recognize the impact of government regulations (Manchester 2012). Since banks are the lifeline of an economy, regulatory agencies need to maintain control. The control protects depositors from possible fraud and maintains sanity with the banks especially regarding competition. For instance, Retail banks face with minimum reserves that must be retained by the central bank.
Q2.
Rosenbaum & Pearl (2013, p. 567) notes that to understand the relationship between investment business bank models and financial stability, it is essential to comprehend the role investment bank and its linkage to the financial system. The primary role of investment banks is to provide clients with services such as helping them to acquire or raise equity by acting as the underwriter for the initial public offers. They also facilitate private share placements, aiding in mergers and acquisitions, raising debt capital and managing investments. These banks also provide supplementary services including propriety trading, development, investing, and sale of debt and equity to their clients.
Schutter et al. (2013, p.347) acknowledged that investment banks play a critical part in capital markets by facilitating the efficient operation of financial markets. Their recent financial crisis exposed risk posed to the economy by these banks, owing to their link with the financial markets. This arises from the fact that investment banks have well interconnected and complex as well as a large-scale level of their operations (Green et al. (2011, p.462). The relationship between these banks and the financial system are analysed by the nature of their activities as follows.
First, investment banks assist business organizations such as government agencies and companies to raise funds through the capital markets. When these parties want to raise money by issuing shares, investment banks link the parties with the investors. They also act as underwriters during the issue of shares or bonds- this means that they guarantee to deliver funds at a pre-determined price once the bonds or shares are issued. Meester (2014) warns that this kind of a relationship has enormous consequences to the economy in case of crises.
Second, according to (Meester 2014) investment banks apply various financial instruments, which include shares, corporate and government bonds, foreign exchange and precious possessions such as gold and associated derivatives on behalf of their customers. Trading involving financial instruments enable companies to manage risks. These banks also offer services to retail banks, insurance firms and other financial institutions that deal with operating savings of their clients. Such funds include hedge funds and pension funds. These trading activities help in maintaining efficient functioning of the monetary markets. Thus, they serve the needs of end-investors in the economy. However (Diamond& Rajan 2002, p. 276) notes that these companies undertake some activities such as propriety trading for themselves instead of their clients may not yield clear benefits to market functioning.
Paulet (2012) clarifies that investments banks bring risks to financial systems. Trading assets of ten largest banks amount to more than £5 trillion, which implies that liquidity conditions in financial markets are vulnerable in case a single firm fails. Additionally, the interconnection between these banks and other financial institutions may act as the avenue for transmitting losses throughout the financial system. Sironi & Resti (2007, p.784) further explains that the complexity of some of their activities also adds significantly to risks experienced in the international financial system.
Table 2
Investment banks and their activities
Investment Bank Activity

Clients

Underwriting and book building

Non – financial companies(usually large ones)
Government agencies
Retail banks and other financial institutions

Trading in securities

Insurance companies
Pension funds
Asset managers such as hedge funds

Derivative tradin...