There are five broad groups into which expert commentators categorise the current banking models. There isn’t a single right way to make profits running a bank. Successful banking means doing many different things right, like providing good customer service, bundling the products correctly, having effective marketing, a solid finance base, proper underwriting, and active management. These are the common features that separate top performing banks from average banks.
The way that banks generate revenue largely divides into two areas – service fees and lending. Each of these again divides into two broad categories. Service fees can come from general activity where small individual charges occur in extremely high volume – this is what is generally known as trading banking. In the other type, banks are highly specialized in a few areas, and earn substantial fees from their exclusive clients. A typical example of these would be investment banks. Lending also breaks down into two sections. The Traditional Banking Business Model has built a large portfolio of deposits from individual customers, and lends this out in short and medium-term financing. More dynamic banks work by leveraging a small capital base to provide a large range of financing for business customers.
In terms of current banking models, generally they fall into one of five categories, each with their strength and challenges. However, many banks do not actively choose a model, but their categorization is determined by the market.
Five Banking Models
These banks drive profit by having higher than average ratios of individual customer accounts to assets. Such a bank works to attract deposits, although not always at the lowest cost, and are effective in lending. This model works best in a period of rising interest rates, where loan growth is strong. However, credit shocks such as occurred in 2008, and sharp declines in general interest rates which followed the flooding of markets with cheap government money in response to the crisis, and now again in the face of the Coronavirus pandemic, tend to hit this type of bank hard.
High Leverage Activity
Some banks drive profit by leveraging their capital to the highest level possible within regulations. This type of bank focuses on a niche customer base, to gather a stable portfolio from which it can then leverage maximum return. This model is generally accompanied by high fees, as seen in banks specializing in leasing, financing receivables, etc, and works best in a low rate, low volatility and abundant credit environment like the one that we are in now. Although this model has had more volatility of earnings, they more usually produce above-average performance.
The business model here attracts cheap short-term deposits with which it finances its essential financial services. Retail banking, vehicle and home equity financing, credit card financing, insurance premium financing, leasing, and other similar customer actions are the main ways that trading banks operate in this model. This model usually excels in a stable or falling rate environment.
Trust, retail and payment-related banks fall into this category that is characterized by higher fees generated throughout their operations. The downside of this model can be that there are higher fixed costs as well as high initial setup costs, which means the scale of both assets and customers is important. Other than following the crisis in 2008, this business model has consistently exhibited the lowest degree of volatility in earnings, which means slower growth in dynamic economic periods but stability in difficult climates.
Unlike banks that rely on a diversified range of activities to drive profits, these banks usually choose to specialize in a single loan category such as credit cards, student loans or equipment financing to drive profits through higher margins. Banks using this model are usually carrying a higher than average cost of funds, lower leverage, but in the end achieve higher net margins. These banks usually outperform the other models in all markets, and they excel particularly well in middle rate markets that are stable as to credit and interest rate movement. Since the crisis of 2008, interest rates have been close to zero which has worked in favor of this model, giving them low borrowing costs against their higher lending rates
Most banks are hybrids and don’t have a business model that focuses all of its resources in a particular area. However, banks with a highly specialized model tend to outperform hybrid banks. Looking at the top 100 banks in the advanced economies, you will find that banks with one of the above business models combine to make up almost 70% of the total.