retail banks should expand into investment banking and other areas in which

Retail banks should expand into investment banking

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retail banks should expand into investment-banking and other areas in which they have little experience or comparative advantage, since this result might in fact make them more, and not less, risky [Stiroh (2004a), Mercieca et al. (2007) and Goddard et al. (2008)]. Instead, they should increase their share of fee-based non-interest income. The effect of income diversification on a bank’s risk and return, therefore, crucially depends on that bank’s overall business model.
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11 The Journal of Financial Perspectives 5. Restructuring business models in the post-crisis period Business models have significantly changed over the past decades, as banks have become increasingly more active in non-traditional activities. While this has allowed banks to offset declining net interest margins, it has also exposed them to greater income volatility. Driven by an increase in demand, rising stock prices and a low stock market volatility many investment- oriented banks increased their capacities in the pre-crisis period. Due to cyclical reasons, such as the weak economy, low interest rates and less trading activity, many of these banks now have to cut costs and reduce their staff to adjust their capacities to the post-crisis reduction in demand for their products. According to a recent survey by EY (2013), for example, almost 50% of all European banks are planning to cut jobs over the next six months. Reducing costs and cutting jobs alone may, however, not be sufficient. For structural reasons, investment-oriented banks need to rethink their business models in general. An important structural reason is the implementation of the Basel III banking regulations, which will significantly raise capital requirements. This will make business more costly and reduce the extent to which banks can raise their profitability by increasing their leverage. Growth will also be limited by higher liquidity requirements, which reduce the extent to which banks can fund their activities by wholesale funds and make customer deposits a more important source of funding. Banks also have to rethink their business models, because the recommendations of the Liikanen Group (2012), if implemented, will force them to move their trading activities into a separate legal entity. This will particularly affect banks with a large trading exposure. 14 Overall, the recent regulatory reforms will particularly affect large, investment-oriented banks, since they are more active in trading, more dependent on wholesale funding and more highly leveraged. This, however, does not imply that small, retail- oriented banks do not need to change their business models. Because the lending and deposit markets will likely become more competitive, these banks are under pressure to rethink their business models as well. The important difference between those types of banks, however, will lie in how they have to change 14 The Liikanen Group recommends that if a bank’s assets held for trading and available for sale exceed a threshold of 15% to 25% or €100bn then the bank would be referred to a supervisor to decide whether it needs to ring-fence its trading activities from its deposit-taking side.
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