advantage over large banks will likely decrease and their interest margin will

Advantage over large banks will likely decrease and

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advantage over large banks will likely decrease, and their interest margin will shrink. A more diversified income stream is also beneficial because it makes them less dependent on the level of interest rates. This should also reduce their incentive to increase credit risks during periods of low interest rates in search of yield [Delis and Kourtas (2011)]. Banks may also be less likely to engage in maturity transformation in order to offset declining interest margins, thus possibly reducing interest rate risk. Overall, therefore, small banks have to restructure their business models in a manner different from that which is beneficial to large banks. The discussion on the inherent riskiness of investment banking activities and the reform proposals of the Liikanen Group (2012) that aim to reduce these risks should, therefore, not distract small banks from the fact that a higher share of non- interest income may help them better diversify their income and to become more stable. It is important to note that this does not mean that small banks should expand into investment banking, as many large banks did over the past decades. Owing to their small size and their lack of expertise and experience in investment banking, they are at a disadvantage compared to large banks in this business and might become less stable [Mercieca et al. (2007) and Goddard et al. (2008)]. A better strategy for these banks to expand the share of their non-interest income would be to build on their close relationships with their customers and to cross-sell additional financial services demanded by retail customers.
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13 The Journal of Financial Perspectives Cross-selling may be the most practicable way to increase profits in stagnating or shrinking markets, in which lending volumes can only be extended if interest rates are reduced below the level of their competitors or if loans are granted to borrowers that have not received a loan from other banks because they asked for loan rates that are too low or provided insufficient collateral relative to their credit quality. Cross- selling may thus represent a strategy with which banks can increase their profits without incurring greater risks from lending activities. Increasing the rate of cross-selling and the share of non-interest income may, however, not be enough to ensure sufficient long-term profitability. Small banks also have to become more cost-efficient. So far, they can compensate for their cost disadvantages over large banks through higher net interest margins. The market power of small banks will, however, likely decrease if customers become more price- sensitive and less loyal to their banks. Furthermore, although proximity to a bank is still important, other distribution channels, such as online or mobile banking, have become more important over time. Because of the variety of different distribution channels, nowadays it is the customer that decides how to interact and not the bank. Banks have to react to these changes and to rethink the role of their branches. It is likely that this will change their function and reduce the number and the size of their branches.
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