The crisis has killed the standalone i-bank model with all the big names gone. Lehman is no more, Merril takeover by Bank of America, Morgan Stanley and Goldman converted into banks. This has led to the belief that Universal banks (all services under one bank) is the way to go.
I cam across this interesting paperby Asli Demirguc-Kunt of World Bank and Harry Huizinga of Tilburg University. The authors say:
The main contribution of this paper is to provide evidence on what bank income and funding strategies perform well in terms of producing profitable and stable banks. In particular, we examine how a bank’s income and funding mixes affect the rate of return on its assets and Z-score or distance to default. Our basic regressions suggest that at low levels of non-interest income and non-deposit funding, there may be some risk diversification benefits of increasing these shares, although at higher levels of non-interest income and non-deposit funding shares, further increases result in higher bank risk.
Traditionally a bank funds itself via deposits from public and earns by giving those deposits as loans at a higher interest rate than deposits. In this crisis we saw banks using repo market for funding (non-deposit) and earned via investment in other financial instruments (non-interest income). This paper uses a sample of 1334 banks in 101 countries to show that this strategy leads to higher return on assets but the risk also rises.
They says the collapse of i-bank model is an example of this strategy (non deposit / non income) going wrong:
The collapse of the U.S. investment banking sector shows that the market can weed out banks that have chosen an apparently unviable business model. All the same, there is an important role for policy as well, as bank collapses, such as in the U.S. investment banking case, can have important real side effects and impose high costs on the taxpayers through the financial safety net. The observed variation in policies regarding banking powers and restrictions over time and across countries, also suggests that policy makers are experimenting with different banking models, searching for an optimal model for banks. The evidence presented in paper suggests that traditional banks – with a heavy reliance on interest-income generating and deposit funding – are safer than banks that go very far in the direction of non-interest income generation and funding through the wholesale capital market.
The question is what is the threshold level non deposit / non income where you say – this is enough. This paper also suggest that one needs to look at the financial system holistically once again. The same strategies – non deposit / non income- were considered to be the strategies for banks a while ago. Especially non deposit or wholesale market funding was considered to be very safe.
Finally for U-banking:
However, our results do not suggest that banks with systemic importance should completely eschew non-interest income generating and non-deposit funding, suggesting that universal banking can be beneficial. Nevertheless, evidence of diversification benefits is weak. Hence, while the universal banking model may be the best way to conduct investment banking business in a safe and sound manner, our results also suggest that there may limits to how far banks can steer away from the traditional model of interest income generation and deposit taking.
So, if C-Banks start doing I-banking under its Universal bank umbrella it should ensure that it does not allow non deposit / non income to grow. This is interesting bit and one can see the implications already. There are quite a few U-banks bleeding right now – Citi, UBS etc. All of them seem to have gone too far allowing i-banks within them to get real big on non deposit / non income. This inturn has led all their businesses to bleed. When BoA took over Merill similar thing happened. They underestimated (it is BoA’s fault) the losses from Merrill’s i-banking division.
Interesting paper with lots of insights. How does a policymaker organise its banking systems? What all should it allow banks to do? These are very important questions especially for emerging markets which still are developing their financial markets.