How Do Banks Make Money? A Variety of Business Strategies

By DeYoung, Robert; Rice, Tara | Economic Perspectives, Winter 2004 | Go to article overview

How Do Banks Make Money? A Variety of Business Strategies


DeYoung, Robert, Rice, Tara, Economic Perspectives


Introduction and summary

Banks make money many different ways. Some banks employ traditional banking strategies, attracting household deposits in exchange for interest payments and transaction services and earning a profit by lending those funds to business customers at higher interest rates. Other banks employ nontraditional strategies, such as credit card banks or mortgage banks that offer few depositor services, sell off most of their loans soon after making them, and earn profits from the fees they charge for originating, securitizing, and servicing these loans. In between these two extremes lies a continuum of traditional and nontraditional approaches to banking--focusing on local markets or serving customers nationwide; catering to household customers or business clients; using a brick-and-mortar delivery system or an internet delivery system; and so on.

This panoply of business strategies is a relatively new development in the U.S. banking industry, made possible by deregulation, advances in information technology, and new financial processes. To date, academic economists have performed very little systematic analysis of the relative profitability, riskiness, or long-run viability of these different banking business models. Academic studies of bank performance tend to focus on issues of regulatory concern (for example, capital adequacy, bank insolvency) or investor concern (for example, the reaction of bank stock prices to bank mergers) rather than broader questions of competitive strategy. Moreover, many so-called studies of banking business strategies focus myopically on banking company size. Although banks of different sizes often do different things in different ways, size is a poor proxy for strategy: It assumes that the banking strategy space has only one dimension; it assumes that a bank's size always constrains its choice of a business model; and it assumes that two banks of the same size always use the same strategy. As we demonstrate in this article, none of these assumptions are accurate. Moreover, failing to recognize this can result in a misleading analysis of bank performance.

This is the second of two companion pieces on "How do banks make money?" appearing in this issue of Economic Perspectives. In the first article, we focus on the remarkable increase in noninterest income at U.S. commercial banks during the past two decades, the regulatory and technological catalysts for this historic change, and how this newfound reliance on noninterest income can affect bank performance. In this article, we explain how deregulation and technological change have encouraged U.S. commercial banks to become less like each other in virtually all aspects of their operations--including the generation of noninterest income--and how the resulting divergence in banking strategies has affected the financial performance of these companies. We define a variety of banking business strategies based on differences in product mix, funding sources, geographic focus, production techniques, and other dimensions, and examine the financial performance of established U.S. banking companies that used these strategies from 1993 through 2003. While we recognize that bank size can have implications for strategic choice and financial performance, we do not use bank size to define any of the strategy groups.

We draw a number of conclusions about "how banks make money" and how this may matter for the future of the banking industry. First, we find substantial differences in profitability and risk across the various banking strategy groups. Importantly, low profitability does not necessarily doom a banking strategy. High average return strategies like corporate banking tend to generate high amounts of risk, while low average return strategies like community banking tend to generate less risk; thus, on a risk-adjusted basis, both high-return and low-return strategies may be financially viable. Second, we find that very small banks operate at a financial disadvantage regardless of their competitive strategy. …

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