RETAIL BANKING BUSINESS MODELS

Business models: traditional vs digital

Branchless banking has been around since the launch of First Direct (also known as first direct) in the UK in 1989, which offered 24-hour service through a call centre, followed by internet banks such as Egg Bank in the late 1990s. The arrival of the smartphone, capable of running dedicated mobile apps, opened up new possibilities for mobile-first banking, such as Simple in the US and Monzo, Starling and Revolut in the UK. (Simple was acquired by BBVA in 2018, and was shuttered as a service in 2021.) 

To understand the transformation towards digital banking, we can compare two different business models of retail banking: traditional and digital.

TRADITIONAL BANK	DIGITAL BANK
Branch is centre of the business	App is the centre of the business
Operations and IT hosted on-site	Operations and IT hosted in the cloud
Income derived from lending and fees	Income derived mainly from fees

The business model of traditional banks is to build branches and gather cheap funding through customer deposits. As a result, the bank tends to be limited geographically by the extent of its branch network, unlike digital banks which operate through the mobile phone network and can offer services anywhere inside a regulated territory. We cover bank business models in more detail in the Business Models module.

Traditional banks are often among the finest buildings in a town or city, as banks were originally built to house vaults to keep money and valuables secure, hence the expression ‘as safe as a bank’. Traditional banks also run technology centres based on mainframe computers in order to keep its systems operating smoothly, although some traditional banks are now also moving some elements of operations to cloud computing. 

A traditional bank lends money to earn interest income, while also providing payment and other services that earn fee income for the bank. Established bank JPMorgan earns an almost equal amount from interest income and fee income, as illustrated in its 2019 earnings report (see illustration). The bank earned a total of $115.6 billion, made up of $57.2 billion in net interest income and $58.4 billion of non-interest revenue, principally made up of fee earnings. Here, for example is a ‘Firmwide Overview’ statement from JPMorgan Chase, from its 2019 form 10-K:

JPMorgan Chase reported strong results for 2019, with record revenue, net income and EPS of $115.6 billion, $36.4 billion and $10.72 per share, respectively. The Firm reported ROE of 15% and ROTCE of 19%.

• Net income was $3.4, up 12%.
• Total net revenue increased 6%. Net interest income was $57.2 billion, up 4%, driven by continued balance sheet growth and mix as well as higher average short-term rates, partially offset by higher deposit pay rates. Noninterest revenue was $58.4 billion, up 8%, driven by growth across CCB as well as higher Markets revenue in CIB. Noninterest revenue included approximately $500 million of gains on the sales of certain mortgage loans in Home Lending. JPMorgan Chase & Co./2019 Form 10-K.

Note that the amounts of net interest income and non-interest income are similar.

The digital bank business model

The digital banking business model is also a branchless model where the customer’s interface is the bank app. The digital bank model is largely a self-service model, where customers initiate and confirm payments themselves rather than relying on bank staff. As people carry their phones with them, the mobile-based model offered customers 24/7 access to their services, an advantage over desk-based computers or even laptops. Customer inquiries are typically answered through online chat in an app or on a bank website, and some digital banks also offer a dedicated call centre.

While the digital banking model can include lending, few aspiring digital banks begin by lending, which in many countries requires authorisation from regulators to engage in lending. On launch, Monzo and Revolut offered an app and a prepaid card or debit card, meaning they were initially licenced as e-money businesses rather than as banks. 

The digital bank business model starts by drawing its income from fees rather than interest income. Typically, a digital bank has no branches, though it may offer cash despoits and withdrawals through ATMs, or partners such as the Post Office or a retailer. 

From 2015, several new digital banks launched in the UK including Monzo, Starling and Revolut. Monzo and Revolut started business as prepaid card offerings, while Starling launched later with a full banking licence.

Profit and loss at digital banks

Many new digital banks follow a path closer to a tech business than a banking business, launching for instance a Minimum Viable Product such as a prepaid card, and then acquiring investors through several rounds of fundraising. Almost all of these digital banks are lossmaking in their first few years of operation, and these losses are tolerated if investors see the business as one that can scale up to serving many customers.

This is known as a startup model. Paradoxically, startups often attract great investments despite being lossmaking, because they are gaining market share, while established banks may be profitable but are not gaining customers.

Usually startup businesses are founded by one or more entrepreneurs, and the initial years of operation are focused on seizing as much market share as possible, regardless of losses. Revolut has been in business since 2015 and has rarely been profitable, but continues to attract investors as its customer numbers increase and it enters new markets.    

New retail banking business models

In 2018, the UK’s Financial Conduct Authority undertook a years-long review of the retail banking sector and its business models. It found that incumbent banks continued to rely significantly on cheap funding from customer deposits, and also enjoy income from lending and fee businesses.

“Our Final Report confirms our view that the PCA (Personal Current Account) is an important source of competitive advantage for major banks:

• PCAs bring cheap funding from customer deposits and additional revenues from overdraft fees and other changes
• major Banks with large PCA networks have a net advantage even when the costs of providing the PCA and branch network are taken into account
• FIIC PCAs depend on banks generating funding benefit from balances as well as fees on overdrafts, interchange revenues, and other fees and charges. The majority of FIIC accounts make a positive contribution to bank profits

Major banks also benefit from advantages in lending activities, where they generate higher yields and enjoy relatively low levels of capital requirements.”