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DNB Working Paper

Follow the money: what does the

literature on banking tell prudential

supervisors on bank business models?

Paul Cavelaars and Joost Passenier

No. 336 / February 2012

Working Paper No. 336

February 2012

De Nederlandsche Bank NV P.O. Box 98 1000 AB AMSTERDAM The Netherlands

Follow the money: what does the literature on banking tell prudential supervisors on bank business models? Paul Cavelaars and Joost Passenier * * Views expressed are those of the authors and do not necessarily reflect official positions of De Nederlandsche Bank.

Follow the money: what does the literature onbanking tell prudential supervisors on bank

business models?

Paul Cavelaars and Joost Passenier∗

February 3, 2012

Abstract

This paper gives an overview of the recent literature on bank busi-ness models, structured along what we deem to be the three centralquestions when analysing business models. By doing so, we endeav-our to provide the recent shift in prudential supervision towards theanalysis of bank business models with a sound economic basis. Thebottom-line for supervisors — in our view — is that it is essential tounderstand where the profit comes from and what risks the bank orthe banking sector is exposed to in generating those profits.

JEL codes: G21, G28,Key words: banking, business model.

∗De Nederlandsche Bank, Supervisory Strategy Department. Comments by MaartenGelderman, Marco Hoeberichts, Iman van Lelyveld, Mark Mink, Armand Schouten aregratefully acknowledged. Any errors are ours. This article does not necessarily representthe opinion of DNB. Correspondence: De Nederlandsche Bank, P.O. Box 98, 1000 ABAmsterdam, the Netherlands, e-mail: paul.cavelaars@dnb.nl.

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1 Introduction

The financial crisis has led to a re-thinking of financial regulation and su-pervision. Bank capital and liquidity requirements are strengthened as aresult of the so-called Basel-III agreement, government authorities obtaingreater powers in the area of crisis management, international coordinationamong national supervisors is enhanced (with the creation of the EuropeanBanking Authority for instance) and financial supervisors and others arecritically reviewing the approach to supervision (Vinals and Fiechter, 2010).

One major lesson of the crisis is that supervisors should be ‘asking thebig questions’(FSA, 2009). This refers to questions in the area of businessmodels, corporate strategies and culture. The crisis has shown that bankfailures can often be related to fundamental problems in these areas. At thesame time, these are typically questions that are more diffi cult to address,as they require a deep understanding of the business and the courage toquestion the functioning of a bank’s board. We focus on bank businessmodels in this paper.

Analysing bank business models goes beyond the traditional approach toprudential supervision, which mainly focuses on the adequacy of bank capi-tal, liquidity and risk management. The analysis of business models impliesa different approach to risk, starting from understanding a bank’s activi-ties, customer groups, distribution channels and sources of profits. Whatproducts and customer groups are most profitable and why? What risks areinvolved? Do there appear to be any ‘free lunches’? Are any cross-subsidiesinvolved? What is the rationale for that? What distribution channels areused? What vulnerabilities may arise from these choices? How sustainableare the current business models? These questions illustrate that the analysisof bank business models is about the story behind the balance sheet. Thishelps to identify risks, some of which may be ‘soft’, in the sense of diffi cultto quantify. Early identification of these ‘soft’risks (i.e. before they affectthe balance sheet in an untenable way) will help to make supervision moreforward-looking. See DNB (2010) and BoE and FSA (2011).1

This paper contributes to bridging the gap between the economic litera-ture on banking and the needs of bank supervisors. By giving an overviewof the recent literature on banking that is relevant for understanding bankbusiness models it helps to provide supervisors with a sound economic ba-

1Also Fallenbrach et al. (2011) show that a bank’s poor performance during a crisisforecasts poor performance during another crisis and attribute this to persistent aspects ofthe business model, in particular reliance on short-term financing, the degree of leverageand the growth rate in the run-up to the crisis.

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sis for assessing banks’business models. By framing this (non-exhaustive)survey of the literature in terms of the questions we see as relevant for banksupervisors it may also assist in guiding future academic research.

The remainder of this paper is organised as follows. Section 2 gives ourdefinition of a business model and provides an overview of the economicfunctions that banks perform. Sections 3 to 5 analyse the different aspectsof banks’business models, taking due account of what the economic litera-ture has to say about this. Section 6 discusses the relevance for prudentialsupervisors. Section 7 concludes.

2 Business model: what do we mean?

The literature on business economics and management provides several def-initions of a business model: This is illustrated by the following quotations:

• ‘We define a business model as consisting of two elements: a) whatthe business does and b) how the business makes money doing those things’(Weill et al, 2004).

• ‘A good business model answers Peter Drucker’s age-old questions:Who is the customer? And what does the customer value? It also answersthe fundamental questions every manager must ask: How do we make moneyin this business? What is the underlying economic logic that explains hoe wecan deliver value to customers at an appropriate cost?’ (Margretta, 2002).

• ‘The business model is a structural template that describes theorganization of a focal firm’s transactions with all of its external constituentsin factor and product markets’(Zott et al, 2007).

These definitions of business model serve to illustrate that there is nouniversally accepted definition, even though people seem to mean roughlythe same.

We will define a business model as a simplified representation of theactivities that a bank performs to make money. A description of a businessmodel will have to answer (at least) the following questions:

1. What products and services does the bank offer and to what cus-tomer groups?

2. How will the bank approach its (potential) customers and distrib-ute its products and services?

3. What is driving the profitability of the bank and are those profitssustainable?

As the potential answers to these questions are numerous, we can expectto see a wide diversity of business models in practice. Furthermore, large

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banks (bank holding companies) may combine several business models atthe same time.

Although the economic literature on banking provides useful insightsinto these questions, it does not address these questions directly. Mostof the academic literature approaches banks on an abstract level, in thatit tends to focus on their economic function. Understanding the economicfunction of bank products is in our view essential for understanding a bank’sbusiness model. It is the economic function that explains why banks existat all, while it is the bank’s business model that explains why some banksare more successful then others. The academic literature recognises at leastfive functions.

A first economic function provided by banks is brokerage / intermedia-tion. Banks solve the problem of borrowers and lenders to find each other.There is no direct connection between the final borrowers and lenders; theycommunicate only with the bank (Temin, 2004). Banks allow borrowers andlenders (more generally, anyone searching for a counterparty to engage intoa financial transaction) to economise on search costs. In this respect, bankscan be regarded as close substitutes for public markets.

A second function of banks is financial asset transformation. Individuallenders may offer assets in other quantities (transaction size) or qualities(e.g. currency denomination, credit risk profile, duration) than required byborrowers. Maturity transformation is an example of asset transformationthat is particularly important for banks. Individuals usually want to insurethemselves against illiquidity by having long-term liabilities (that cannot becalled upon in the short term) and short-term assets (that can be disposedof quickly in case of unforeseen contingencies). Banks effectively insuretheir clients against illiquidity risk by providing long-term loans and offeringshort-term deposits. By pooling liquidity risk, banks can economize onliquid assets and thereby offer a higher return. The reason is simple: theliquidity need of an individual is less predictable than the liquidity needof the coalition of individuals that forms a bank (Diamond, 1997). Thisnot only applies to explicit liabilities such as deposits, but also to implicitliabilities such as credit lines.2 More generally, banks circumvent the needfor a coincidence of wants of individual customers (Temin, 2004). By poolingassets and accepting risk, banks effectively transform assets.

Third, banks are screening potential borrowers. Individual lenders do notknow the true characteristics of borrowers and verification of these charac-

2A credit line (or loan commitment) is a call option on a loan, written by the bank inreturn for a commitment fee.

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teristics is costly. When verification is subject to economies of scale, onewould expect firms to specialise in verification activities. However, the saleof this information may be inhibited by the fact that potential buyers cannotassess the value of the information ex ante. This problem in capturing theproceeds of verifying the true characteristics can be overcome by combiningscreening and lending activities in a single firm. The firms’willingness toinvest serves as a signal about the quality of these borrowers (Leland andPyle, 1977).

A fourth function performed by banks is monitoring of borrowers. Whena loan is made, individual lenders will have to monitor borrowers, in order tobe able to act in a timely manner when interest and principle payment areat risk. Banks operate as a delegated monitor on behalf of the depositors(Diamond 1984). Banks have a cost advantage in monitoring individualborrowers as the alternatives are either multiplication of monitoring costs(each lender monitors individually) or too little monitoring (each lender triesto free ride on the monitoring of other lenders).

A fifth, and final, economic function provided by banks is value transfer.Individual customers desire to transfer value to other customers. Banks cantransfer funds more effi ciently, by offering (electronic) payment services, bywhich customers (borrowers and lenders, or buyers and sellers) do not haveto physically meet each other.

There is no one-to-one correspondence between bank products and theeconomic functions discussed in the literature. One product may serve sev-eral economic functions. For example, by making a loan a bank 1) intermedi-ates between the person in need of a loan and people with a financial surplus,2) may transform the savings of several persons into one loan, 3) providesliquidity to the person in need of a loan, 4) has evaluated the borrower’screditworthiness.

Although the distinction in economic functions is useful to understandwhy banks add value, it does not help in understanding why some banks aremore risky then others. To that end, a more in-depth knowledge is neededof bank business models, which is the subject of the rest of this paper. Wewill discuss each of the three main questions related to business modelsidentified above in sections 3 to 5 (with a separate section devoted to eachmain question).

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3 Products and customers

Our first main question about the bank’s business model was: ‘what prod-ucts and services does the bank offer and to what customer groups?’Whendescribing bank products and customers, a common distinction is betweencommercial and investment banking. See for example Benston (1994) orBoot and Marinc (2008). Commercial banking products are mainly pro-vided to retails clients (households and small and medium-sized enterprises),although payment services and asset management are offered to retail con-sumers and multinational companies alike. Investment banking productsare mainly provided to wholesale clients, that usually have direct access tofinancial markets, such as large multinational companies and financial in-stitutions. But as with many classifications, there are grey areas and otherclassifications are possible (Table 1).

Table 1

Products and services Target customersCommercialbanking

Loans, deposits, paymentservices, asset manage-ment, custodian services,letters of credit.

Households, small andmedium sized enterprises(SME’s), large firms

Investmentbanking

Equity/bond issuance,structured finance, M&A,asset management, pro-prietary trading.

Large firms, other finan-cial institutions

Non-banking Insurance, real estatedevelopment, operationalcar lease

Consumers, SME’s andlarge firms

In deciding on its business model, a bank must determine the range ofproducts and services it offers, the types of customers it serves and the geo-graphic locations in which it chooses to be active. The academic literatureon banking addresses these questions in terms of diversification.3 We firstdiscuss three types of functional diversification (combining commercial andinvestment banking, combining banking and insurance and combining bank-ing and non-banking activities) and subsequently we focus on geographicaldiversification (the combination of locations).

3The choice of product range etc. is primarily a matter of where a bank expects tohave a competitive edge, but the economic literature has little to say on that.

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One form of functional diversification is the combination of commercialand investment banking. Although this combination is fairly common today,it has long been forbidden in the US (Glass-Steagall act). One reason for theGlass-Steagall act was the fear that the combination of commercial bankingand investment banking created conflicts of interest. For example, a bankmay be more inclined to underwrite an equity or bond issue of inferior qualityif it increases the likelihood of repaying a bank loan. However, it has beenshown that the quality of securities underwritten by securities affi liates ofcommercial banks was higher than of securities underwritten by investmentbanks (see for example Ang and Richardson, 1994 or Kroszner and Rajan,1994). Another reason for the Glass Steagall act was the argument thatallowing commercial banks to conduct securities business would increase theriskiness of banks and the financial system. This argument has recently beenraised again. See for example the ‘Vickers report’in the UK (IndependentCommission on Banking, 2011).

As concerns the combination of banking and insurance, three argumentsare often mentioned to underline the potential benefits (see Boot and Mar-inc, 2008). First, using the branch network of the bank to sell insuranceproducts, in order to create economies of scale and scope. Second, the factthat the maturity mismatch on the bank’s balance sheet tends to be oppositeto the maturity mismatch on the insurer’s balance sheet. Third, the reali-sation of economies of scale in asset management. However, the experienceof countries differs widely with respect to the extent that the potential syn-ergies have materialised. Creating commercial synergy, achieving integralcorporate risk management and overcoming differences in corporate culturebetween the banking and the insurance part often turn out to be importanthurdles. The success of the bancassurance model in the Netherlands hasbeen mixed at best.

Another type of functional diversification is the combination of bank andnon-bank activities. This may be attractive from the banks’perspective, asgovernment arrangements that have been set up in relation to the specialfunction of banks (deposit-guarantee, lender of last resort) provide bankswith the possibility to fund themselves more cheaply. By becoming activein non-bank activities, the implicit government subsidies on attracting de-posits can be used to gain a competitive edge in those markets (Barth etal, 2000). From the bank’s point of view, this is most effective in capital-intensive business, such as operational car leasing and real estate develop-ment. Naturally, this generates a welfare-reducing competitive distortion inthe ‘other’markets, as the implicit government subsidy may give the banka competitive advantage over more effi cient producers who cannot make use

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of the subsidy, but this is outside the scope of the current paper.Geographical diversification is another manner to reduce risk or reap

more benefits from a successful business model. Although Berger and Dey-oung (2001) do not find that geographical diversification makes banks moreeffi cient, geographical diversification may reduce bank’s vulnerability tochanges in the local economy, which may be an important explanation forthe severity of banking crises. For example, Bernanke (1983) attributes theseverity of the banking diffi culties in the US during the great depressionto the fact that the US banking system was made up of small independentbanks. More recently, Van Lelyveld (2011) finds that geographical diversifi-cation reduces risk in internationally active banks by some 20% on average.However, the benefits of diversification are not necessarily used to make thebank safer. Instead, diversified banks have used their advantage to operatewith greater leverage and to pursue riskier lending (Demsetz and Strahan,1997).

Overall, functional and geographical diversification may lead to cost sav-ings or revenue improvements due to spreading of fixed costs, economies ofscope from using the same information and customer cost economies (Bergeret al, 1987).Diversification may also lead to risk reduction.4 However, in-creasing the size and scope of a bank’s activities introduces the ‘cost ofcomplexity’, which at some point may dominate the benefits that can beachieved (Rajan et al, 2000). This may even give rise to a diversificationdiscount. See for instance Laeven and Levine (2007) or Lelyveld and Knot(2009).

4 Customer approach and distribution channels

Our second main question about a bank business model was ‘How does thebank approach its (potential) customers and distribute its products andservices?’ Banks may use different customer approaches. The academicliterature usually distinguishes between two such technologies: relationshipand transaction banking.

Relationship banking involves building relationships with borrowers overtime and/or across products (Petersen and Rajan, 1994 or Boot and Thakor,2000). Banks may obtain ‘soft’information about the borrower and her in-vestment projects by making a relation-specific investment before the deci-sion to lend (‘screening’) and by observing the borrower’s behaviour after the

4This form of risk reduction however does not create value as shareholders can do thatthemselves.

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decision to lend (‘monitoring’). Similarly, banks may generate private client-specific information by selling more than one product to the same client. Forexample, banks may use the information gathered from transaction accountsto monitor borrowers (Mester et al, 2007). Screening and monitoring gen-erates valuable information, that is not available to the bank’s competitors.Given that the customer cannot credibly communicate this information tocompeting banks, the relation-specific investment provides the bank withsome monopoly power that can be used to extract profits. See for exam-ple Sharpe (1990) or Rajan (1992). Note that relationship banking maybe valuable for the client as well, by economising on search and switchingcosts. Relationship banking may be more diffi cult for large banks. As ‘soft’information is diffi cult to quantify, verify and communicate through the for-mal internal channels of a banking organisation, agency problems may arisewithin banks. Small banks may be better able than others to resolve theseagency problems (Berger and Udell, 2002). Of course, banks do not havea relationship with every potential borrower. In a banking system purelybased on relationship banking, borrowers without a prior relationship withbanks would have a hard time finding a bank willing to provide them a loan.

Transaction banking, in its archetypical form, has no special role forrelationships. Screening of potential borrowers is typically based on ‘hard’information that is relatively easily available at the time of loan origination.The availability of this information reduces the need to invest in buildingrelations with customers. This may be public information, such as financialaccounts and ratings (‘financial statement lending’) or information that canbe purchased (‘credit scoring’) (Berger and Udell, 2002). For example, bankscan purchase historical data from credit bureaus and combine these withinformation on borrowers derived from their loan applications to predictthe probability that a loan applicant or existing borrower will default orbecome delinquent (Mester, 1997). The reliance on ‘hard’data facilitatesthe standardisation and automation of information processing, leading toeconomies of scale than can be exploited by large banks (Elyasiani andGoldberg, 2004).

Relationship banking and transaction banking are stylised descriptionsof customer approaches. In reality, the distinction is not so sharp. One maybe inclined to think that a relationship-orientation is more prominent inretail banking and a transaction-orientation more common in investmentbanking. However, many retail banks largely rely on the processing ofstandard information, whereas the marketing of an equity issue requiresan extensive network of relations. The acceptance of placement risk by theunderwriting bank is facilitated by proprietary information and multiple in-

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teractions (Boot, 2000). Moreover, the choice between relationship bankingand transaction banking is not a binary one. Although the decision to lendmay be based on a transaction banking technology, the bank will acquirespecific information on the characteristics of the borrower after the loanis made. This information is not available to other banks, giving rise to asimilar information-based monopoly rent as arises with relationship banking(Sharpe, 1990).

During the past decades we have seen a shift from relationship to trans-action banking. This shift may be best illustrated by the evolution of con-sumer credit, as described in White (2007). Until the 1960’s, obtaining aloan required a face-to-face application procedure with a bank employee inwhich one had to explain the purpose of the loan and demonstrate one’screditworthiness. Over time, the development of credit bureaus and creditscoring models enabled banks to obtain information about individual con-sumer’s credit records even though they had no prior relationship with them.Computer systems enable the effi cient processing and use of this information.These innovations reduced the cost of credit by eliminating the face-to-faceapplication procedure and by increasing competition in local credit marketsas banks could now easily expand nationally. It is not obvious whether thisshift is good or bad per se. The increase in competition has likely led to adecline in monopoly rents for banks, to the benefit of the bank’s customersand society as a whole. On the other side, the shift away from relationshipbanking may have led to a loss of information that may be costly in welfareterms. Indeed, Kotlikoff (2010) argues that ‘Jimmy Stewart is dead’, mean-ing that the traditional banker who knows his clients no longer exists andarguing that the financial crisis may be at least partly attributable to thedemise of the traditional banking business model. At the same time, lendingbased on hard-information may outperform lending based on relationship-based soft-information, especially in long-distance situations (DeYoung etal, 2008).

The shift from relationship banking to transaction banking may also af-fect the way banks distribute their products and services to customers. Inretail, relationship banks need a physical presence in the form of a branchin the borrower’s neighbourhood.5 It is the local branch that gives the banka good knowledge of the area and which enables him to acquire the ‘soft’information he uses to screen and monitor borrowers. However, the dis-

5Although the need for local presence probably diminishes with the size of transactionsand the expertise of the bank’s clients, local presence may still be important even inwholesale banking.

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tance between the bank and its borrowers has increased over time, whileboth parties are communicating less and less in person. Petersen and Ra-jan (2002) explain these findings by arguing that banks can now use hardinformation about the creditworthiness of borrowers, enabling them to lendover a distance even if they lack the soft information they could obtain fromclose contact with the borrower. This is not to say that personal contacthas become useless to banks. Agarwal and Hauswald (2010) find that in thecase of small business lending, borrower proximity facilitates the collectionof soft information. Banks may also use agents/intermediaries, for instancein order to sell mortgages. In this case, they still rely on personal contacts indistribution but they have outsourced these contacts to a third party. Usingintermediaries is a way to economise on the cost of setting up a networkof branches. The drawback is that the use of intermediaries gives rise toagency problems, in the sense that the interests of the intermediary maynot correspond to the interests of the bank. This may lead to inadequatescreening of (potential) borrowers.

Newer technologies such as ATMs and online banking co-exist with thetraditional channels and can thus be seen as a distribution channel com-plementary to existing channels. Most banks nowadays use both a branchnetwork, ATMs and e-banking. However, clearly some substitution takesplace. Banks have reduced their physical presence giving rise to cost sav-ings. Both ATMs and e-banking have also reduced the costs (in terms oftime) and increased the value-added (e.g. 24/7 access) of bank transac-tions from the customer’s perspective. The importance of e-banking as adistribution channel has increased tremendously over the past 15 years. In1995, the first internet-only bank was created in the US and around thesame time the first traditional bank established its online presence. By theend of 2003, more than half the commercial banks in the US offered on-line banking services and this share had increased to more than 80% bythe end of 2006. See Hernandez-Murillo et al (2008), who also discuss themain mechanisms driving the decision to adopt e-banking in a competitiveenvironment. Arnold and Van Ewijk (2011) point to weaknesses of internetbanks. They argue that while it is easy to capture market share in the sav-ings market, it is not that easy to find good investments. Furthermore, lowdepositor loyalty makes the business model vulnerable for bank runs. Newtechnologies and new applications of existing technologies may threaten thebusiness models of banks. For instance, telecom providers or such companiesas Google (Google Wallet) and Ebay (PayPal) could become challengers inthe market of payment services, or financial services more generally.

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5 Sources of profit

The third and final main question about the bank business model put for-ward in Section 2 was ‘what is driving the profitability of the bank?’ Thethree main revenue sources of banks are interest income, fee income andtrading income. The interest margin essentially derives from three sources.One part is the information-based monopoly rent that the bank may earnfrom investing in borrower relationships. This revenue source is possibleeven without maturity transformation. The second part is the mismatchmargin that the bank earns from maturity transformation. Borrowing shortand lending long enables banks to earn the term spread, which is positive onaverage over time. The maturity mismatch makes banks inherently vulner-able to bank runs (Diamond and Dybvig, 1983). The third part is the riskpremium that a bank charges to compensate for the credit risks it acceptswhen making loans. The second revenue source is fee income. Fee incomeis generated through a wide range of activities, such as payment services,asset management services, advisory roles in mergers and acquisitions, un-derwriting of equity and bond issuance, structured finance and brokerage.These activities as such typically do not lead to balance sheet exposure,although they are often combined with activities that do. Trading incomeis the third main revenue source. Trading income accrues from proprietarytrading, from positions resulting from client transactions and as a result ofunderwriting equity and bond issuance.

Allen and Santomero (2001) document a fairly steady decline in net in-terest income and a simultaneous increase in fee and trading income for USbanks between the late 1970s and the late 1990s. This trend is confirmedfor European banks by ECB (2000) and for more recent years by Stiroh(2006) and Brunnermeier, Dong and Palia (2011). There are different ideasabout the underlying mechanisms. Petersen and Rajan (1995) argue that thedecline in interest income is caused by increased competition in traditionalbanking segments, leading banks to search for new areas of profitability. Incontrast, Deyoung and Rice (2004) argue that the observed shift from inter-est income to non-interest income is only partly related to the observed shiftaway from relationship banking. In their view, the decrease of interest in-come is mainly a reflection of changes in the way banks fund their operations.Interest margins were relatively large in the traditional ‘originate to hold’model, but they have declined as the ‘originate to distribute’model gainedpopularity. This explanation is confirmed by Stiroh (2004) who also findsthat the increased importance of non-interest income has not contributedto more stable bank profits, due to the volatility of trading income and due

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to the fact that fees and service charges are strongly correlated to interestincome. As the popularity of the ‘originate to distribute’model has declinedsince the financial crisis of 2007, one may expect interest income to becomea more important income source again.

6 Discussion: challenges for supervisors

Bank supervisors need to identify and understand risks in banks. In manycases, it is fairly straightforward to relate the type of risks to the type ofproducts (e.g. demand deposits and mortgages on the balance sheet leadingto interest rate risk), customers (e.g. corporate lending giving rise to highercredit risk than government lending), distribution channels (e.g. e-bankingmaking an institution more vulnerable to IT risk), and the source of profits(e.g. trading income being related to market risk), although reality is ofcourse somewhat more complicated than this.

In order to get a better grip on risks (and in particular those that areless straightforward to identify), the simplest and best advice is probably to‘follow the money’.6 Banks make money by accepting risk. This means thatit is important for bank supervisors to understand why specific activities areprofitable (and especially so if they are highly profitable).7

Following the money is not always easy. Sources of bank profits cannotalways be attributed to a single product or service. For instance, banksmay offer bundles of products and services, which complicates the calcu-lation of the profitability of individual products. Individual products andservices need not be profitable on a standalone basis, as they may serve thegoal of attracting new customers or making existing customers more likelyto stay (i.e. reduce the price-elasticity of their demand, effectively creatingsome market power for the bank). Cross-subsidies may be paid for by (i)the same customer over time (examples are the pricing of credit cards orthe use of teaser rates for mortgages), (ii) the same customer, when buyingother products (for example, the bank offers payment services free of charge

6 In the movie ‘All the president’s men’(1976), ‘deep throat’Mark Felt advises jour-nalists Woodward and Bernstein to ‘follow the money’. This finally leads them to revealthe Watergate scandal.

7The reverse is also true: activities that are structurally loss-making may indicate thatmanagement finds it diffi cult, for whatever reason, to downsize these particular activities.It is often seen that management continues to make new plans with bright financial out-looks. Such activities may also endanger the health of a bank, by reducing its financialbuffers and possibly causing a loss of market confidence. In any case, activities that arean outlier in terms of profitability deserve further attention.

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and pays below-market interest rates on deposits to recover those costs),or (iii) other customers (price discrimination based on whether customersare better-/less-informed and more/less prepared to spend time and effortto compare banks). Decisions to combine activities or to bundle productsand services are not necessarily in the interest of customers. Bundling mayalso be done to exploit consumer misperception (Bar-Gill, 2006). Think ofuseless or very expensive insurance products coupled to home mortgages.Furthermore, banks may combine different activities in order to reap eco-nomics of scale and scope (as discussed in Section 3). This enables thesharing of overhead costs among different business lines, but also makes thecalculated profitability of individual activities sensitive to the allocation ofoverhead costs.8 For instance, centralising the treasury function may giverise to internal transfer pricing at non-market rates, such as a single fundingrate for all business units without regard of their risk profiles.

Bank balance sheet strategies are another reason why bank profits cannotalways be attributed to individual products. Examples of balance sheetstrategies are: i) ‘long balance sheet’: combining low-risk assets with highleverage in order to enhance return on equity, ii) ‘carry trade’: systematicand sizeable exposure to currency mismatch and/or country risk, usuallyby borrowing (attracting deposits) in a low-interest country and lending ina high-interest country, iii) ‘originate to distribute’: originating loans andselling them reduces the length of bank balance sheets, but may result inoff-balance sheet risks and effectively higher leverage. These balance sheetstrategies need to be well-understood by supervisors.

Supervisors will also have to assess the sustainability of profits. Busi-ness models may be unsustainable for a number of reasons. Business modelsusing large scale cross-subsidies are likely to be unsustainable. If cross-subsidies come from other products, it is likely that competitors will en-ter the market and start to offer those products that are currently pricedabove marginal costs.9 The same logic holds if cross-subsidies come fromother customers, although in this case entrance will focus exclusively onthose customer groups that are currently charged more than marginal costs.

8Therefore, supervisors may want to focus on a breakdown of revenues rather thanprofits, or look at personal salaries to identify what departments stand out as money-makers.

9Remember that there are many non-banks offering similar products as banks. Forinstance, money market funds as close substitutes for deposits, credit card companiesproviding credit and payment services, credit rating agencies providing screening andmonitoring services. These companies have another business model that banks have tocompete with.

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However, it is important to realise that not all cross-subsidies are unsustain-able, especially when banks operate in two-sided markets (Wright, 2004).In such a setting it is not only the price, but also the price structure thatmatters. For example, retail customers in the Netherlands pay no explicittransaction fees for payment services, but only implicitly through lower orno interest on transaction balances, in order to promote cost-effi cient waysof money transfer (Bolt, 2006). Business models based on abuse of con-sumer misperceptions or lack of knowledge (see again credit card markets,Ausubel, 1991) may also be unsustainable. Examples of such behaviour aremis-selling and excessive lending. Over time the public gets informed and bythat time the bank involved may be subject to severe reputational damage.Assessing the sustainability of profits may be particularly diffi cult when thebanking sector as a whole are shifting their business models in the samedirection. See Acharya and Yorulmazer (2007) and Wagner (2010). Forexample, in the run up to the crisis, the banking sector increasingly usedshort term instruments to fund their activities (see Brunnermeier, 2009). Ifsupervisors largely rely on benchmarking and mainly focus on outliers, suchsectorwide shifts may not give rise to alerts in micro-prudential supervision.Newly developing business models may also give rise to new channels bywhich risks are transferred and possibly augmented. Think for instance ofadverse selection in mortgage securitisation. See Agarwal, Chang and Yavas(2010) and references in this paper. Although individual banks may find ithard to resist following these trends as a result of market pressure, such anincreased homogeneity of business models may augment the vulnerabilityof the banking sector as a whole (see also Abreu and Brunnermeier, 2003).This macroprudential perspective adds another dimension to the analysis ofbank business models.

7 Conclusion

This paper has given an overview of the recent literature on bank businessmodels, structured along what we deem to be the three central questionswhen analysing business models. By doing so, we endeavour to provide therecent shift in prudential supervision towards the analysis of bank businessmodels with a sound economic basis. Each model may expose the bank tospecific risks. It is essential for supervisors to understand those risks.

In order to identify those risks, supervisors need to have a thoroughunderstanding of a bank’s business model. This paper has identified someelements that may help supervisors understand these models. We started out

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by outlining the economic functions banks perform. The economic functionsare (or should be) driving the value-added of banks and can thus give a clueon the sustainability of specific business models. We continued by describingseveral trends related to bank business models. These trends include func-tional and geographical diversification. Diversification may generate costsavings but also increases complexity that may in the end outweigh costsavings. Another trend is the shift from relationship banking to transac-tion banking, largely driven by technological progress. Transaction bankingtends to reduce costs, but may also lead to a loss of private informationabout bank clients. A third trend is the shift of interest income to fee andtrading income that is not without consequences for the stability of bankingprofits.

We believe that the advice to ’follow the money’is likely to help identifymajor risks to banks at an early stage. It is essential for supervisors (andbank management!) to understand where the profit comes from and whatrisks the bank is exposed to in generating those profits. This is not an easytask, as an understanding of cross-subsidies and the impact of central func-tions (such as treasury) and balance sheet strategies is required to attributebank profits to different business models.

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Previous DNB Working Papers in 2012 No. 335 Mark Mink and Jakob de Haan, Contagion during the Greek Sovereign Debt Crisis

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Jan Kakes and Cees Ullersma

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