Introduction
Today, retail banks offer little distinction between fundamental products and services. As a consequence, product and service packaging & branding will be the main distinguishing factor between banks.
In order to maintain their product and service offers consistent with evolving client requirements, banks have to make considerable investments in research, innovation and product design. They must process the enormous quantity of customer information that is produced from daily operations, and create products that align with client preferences, derived through analytics. In this sense, banks also have to constantly engage with their customers to gauge their needs and capture their opinions and requirements.
As competition progressively reduces spreads and profits, banks must continually improve their productivity and effectiveness in order to preserve their RoE. To that end, technology will be the most important facilitator. While technology has been accessible for more than two centuries and used in the banking sector, it has still not been optimally utilised. Technology can help in every area of banking: planning, strategy, Management Information Systems, processing, distribution, monitoring and follow-up. The ultimate winner in the long term will be banks that can rapidly develop technology-based, cost-efficient distribution models for their products and services.
Globally, there have been dramatic innovations in retail lending in the commercial banking sector. In emerging economies, the development of retail lending has been enabled by fast progress in information technology, changing macroeconomic climate, reforms in financial markets, and various factors on the side of demand and supply at the micro level. The use of scoring models can minimise a subjective component in the context of retail loans and thus quickly monitor the decision-making process.
Another main differentiator will be the quality of services provided by the banks. Ultimately, improved customer service is the key to creating a sustainable business that consistently generates higher revenues.
Several quantitative measures are in place for measuring the performance of individual banks and for the industry as a whole. These are usually the market share of a bank and the share of risk capital allocated to those business units. Both measures are holistic in that they condense the full range of retail activities — both those that generate balance-sheet positions and those that do not — into a single measure that is comparable across business lines in a bank. Unfortunately, not all banks include in their annual reports and other public financial statements the figures on revenue, profits, and risk capital for identifiable retail business lines. To generate consistent measures of retail banking activity, data from regulatory reports and central banks are more useful. Broadly speaking, there are three primary indicators of retail banking activity: retail lending (mortgages, home equity lending, credit cards, automobile loans, personal loans and other consumer loans), retail deposits (current accounts, savings accounts, and fixed deposits), and the channels like bank branches, internet banking and mobile banking.
Generally, on lending, technological changes have enabled retail banks to realise massive economies of scale, particularly in credit cards and other personal loans.
In addition, the growth and consolidation of bank branches illustrates the leading role of major bank organisations in retail banking. The number of bank branches has grown steadily over the last 50 years with the focus now moving to digital channels rather than branch networks.
Enabling regulations and laws have stimulated a wave of industrial consolidation allowing banks to build larger branch networks and higher penetration rates that are crucial for attracting new retail customers. In addition, it allowed banks to reap the benefits of technology-driven economies of scale. For example, in the US, deregulation in the 1990s significantly increased the size of branch networks, both in terms of the network’s density in a given local market and in terms of the coverage over larger geographic areas. Combined with advances such as new credit-scoring technology, these large networks have allowed large banks to compete with small community banks in the retail sector more effectively. It is also a fact that large, multi-market banks were better able to compete with small banks in the 1990s compared to the 1980s, presumably as a result of technological advances leading to higher economies of scale in the management of larger organisations compared to smaller ones, and new lending technologies for small businesses. The giant global retail banks adopted new technologies for small business lending earlier than smaller banks did, using technologies to expand their lending to relatively opaque small businesses, a segment that had been traditionally dominated by small banks.
From the bank’s standpoint, building a branch network can be especially valuable as a means of marketing to attract customers and a source of funding for secure deposits. This assumption suggests that when opportunities for profit emerge in a market such as those generated by new customer inflows, large banks are likely to establish new branches to meet additional demand and stem competition. Banking industry observers and banks themselves consistently point to revenue and profit stability as retail banking’s most important feature and a primary reason for the recent interest. In general, the stability of retail is considered valuable for large banks trying to mitigate the uncertainty of riskier business lines such as trading and other capital market operations. Recent discussions of retail operations in annual reports, analyst conferences, and press releases from large banks highlight retail as a key source of stable, reliable earnings when other sources of revenue are relatively weak. For example, Standard and Poor’s (2004) describes retail banking as “an island of last-cycle stability,” while Moody’s (2003) stresses the “low correlation to lending sector, allowing flexibility of earnings” as a key benefit from retail activities. Usually, several reasons attribute this stability to retail operations. The main thing is that retail banking is basically a customer business. The consumer industry’s resilience has almost certainly contributed to retail banking sustainability in recent years.[RL|L1] [S2] Retail banking is relatively more stable as compared to corporate and investment banking, which are more prone to sudden events in the market. However, retail banking is also affected by macroeconomic events like unemployment, bankruptcies and – as currently – a pandemic. But retail business is more resilient and can withstand systemic shocks better as the trickle down effect of economic events takes more time, which gives ample time to banks to manage unforeseen events.
A second important factor in the stability of retail banking is that it serves a large number of small customers. The granular nature of the retail lending portfolio — which contains a large number of small, often collateralised loans — means that the lending income may be less volatile over time because of diversification across customers. In essence, the retail lending portfolio is exposed primarily to cyclical or macroeconomic risk, rather than to borrower-specific exposures (concentration risk). This is one particular example of how sustainability in retail banking depends on the consumer sector’s continued stability.
Finally, some part of the stability in retail banking revenues may reflect natural hedges within retail banking, in other words, products or services within the business that respond differently as market conditions change. The low or negative correlation between mortgage originations and margins of deposits is one example cited by bankers. Deposit margins — the difference between rates paid on retail deposits and alternative market funding rates such as the central bank funding rate — are an important source of income in retail banking. Deposit margins tend to be low in periods of low interest rates, reducing the implicit revenue earned on deposit balance. Nevertheless, low rates promote loan refinancing, which raises the revenue from charges. Changes in income flows from the two activities thus tend to offset one another over the interest rate cycle, giving greater stability to overall retail banking revenues. This view of retail banking is relatively aligned with academic and analytical studies.
Despite substantial evidence supporting retail sustainability, there is other conflicting data on retail banking returns that describes retail banking as the “Cinderella” of financial services, offering “high margins, stable income, and modest capital consumption”. Recent data from a group of major banks holding firms show that retail operations offer high risk-adjusted returns compared to other business lines. The ratio of return on risk-adjusted equity (ROE) in retail business lines to ROE on non-retail activities is almost twice, for a small set of banks that report business-line-level returns in public financial statements. [RL|L3] [S4]
Returns on retail activities consistently exceed those on non-retail activities, often by a margin of two-to-one or three-to-one, a finding consistent with claims that retail banking offers high returns relative to risk. Significantly, however, there also appears to be a cyclical element at play. The retail-to-non-retail ratio has declined since 2002 as returns in non-retail business lines recovered from relatively low levels during and just following the 2001 (dot com) recession and subsequent capital market slowdown. This result indicates that when assessing how large changes in business strategy impact risks and returns, it is important to use a comparatively long-term view.
[RL|L1]This is a bit confusing. Does it mean that retail will only be stable as long as there is a strong consumer market? On page 19 it says ” Retail banking is dependent on economic factors like unemployment, inflation and other indicators.” Please make this more clear.
[S2]I agree. I have changed the statement here
[RL|L3]This is only a partial sentence.
[S4]Updated.