Investment banking business model and financial stability

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Investment Banking




Assignment: Investment banking business model and financial stability


Question: The high risk and high leverage business model applied by investment banks is described as the major contributor of the recent financial crisis. Due to the capital-intensive nature of business, investment banks are more vulnerable to exogenous shocks on money market funding conditions. In the post-Basel III era, hitting by high capital requirements and the imposition of ring-fencing in several European countries, investment banks tend to increase revenue streams from less capital intensive businesses to slash costs and improve profits.

Go through the relevant literature on bank business model and financial stability and answer the following two questions:


  1. Compare the business models of retail banking and investment banking.
  2. Discuss the relationship between investment banking business model and financial stability.



Please limit your answer of the question to 2000 words or less. You can use charts and tables to illustrate your analysis. The text of an accepted assignment should be plain formatted, e.g., 1.5 line spaced, one column, 12 point font, A4 paper with proper margins in top/bottom and left/right-hand sides.




Investment and Retail Banking

Over the past few decades, globalization of the banking sector has intensified in terms cross-border entry and capital flows. The process of globalization and the intensified activities within economies have exposed banks to stiff competition hence the need for banks to use varying approaches to counter the competition. Deng et al. (2007, p.2440) explain that investment and retail banks have engaged different interventions to be different from one another by employing productive models to leverage their strengths. However, the two models still have similarities. This paper seeks to compare retail banking and investment banking. Moreover, the paper provides an exploration of how investment banking relates with financial stability.

Retail Banking and Investment Banking Models

Deng et al. (2007, p.2455) hypothesize that understanding retail and investment business models necessitate knowledge of the difference between the two models. The type of services each of the bank offers and the target market defines the fundamental difference between the two categories of banks. Retail banking offers deposit accounts and loan advancements to individual customers and other related services such as saving and checking, payment services and safe deposit boxes. Retail banks offer their services to individuals, families, or small business through various bank branches or automated tellers. Jonghe (2009, p.7) explains that retail banks generate income by charging interest on loans and service charge towards their customers.

Investment banks offer advisory as well as underwriting services to their clients. The services provided by these banks include corporate finance, sale and purchase of securities and other financial instruments, provision of detailed industry reports, asset management services, and consulting regarding conditions and movements of capital markets as well as providing mergers and acquisition information. These banks make money by charging a fee negotiated by the bank and its clients.

Hryckiewicz (2014, p.10) expounds that the type of banking model adopted by each type of the bank is largely influenced by the banks overall objective of generating income and the ability of the model to withstand financial crises. The models also need to consider the organizational structure, exposure to risk, and the legal environmental under which the bank is operating.

The following diagram shows the various banking models each bank can adopt depending on the factors highlighted.



Inferences about retail and investment banking model can be drawn from an understanding of the features that influence them. In his research, Lavinio (2000) found out that borrowers and depositors characterize both models. Deposits for retail banking mainly come from individuals and small business enterprise. The retail bank model is branded as ‘’Retail Funded” as customer deposits make up the largest percentage of these funds. The model is characterized by high dependence on stable funding sources and a greater proportion of loans on their balance sheet. On the other hand, investment banking has large businesses and corporations as their borrowers and depositors. The banks are more capital market oriented, and mostly they hold almost half of their assets in the form of trade securities. Wholesale markets predominantly fund these banks. The business model is labeled ‘’Trading Bank’’ with its assets and liabilities accounting for almost one-fifth of its balance sheet.

In a study carried out by Paulet (2012) established that geographical region influences the popularity of either model. For instance, in 2013, the study found out North American banks had a mixture of banks with the two models while banks in emerging market economies mostly prefer retail-funded model

Table 1: Distribution of business models around the world

Region Retail-funded Whole-sale funded Trading
North America 16 6
Europe 36 22 9
Advanced Asia-pacific economies 11 3 3
Emerging  market economies 45 2 3
G-SIOBS 14 2 12


Source: BIS Quarterly Review, December 20-14

More so, Lovett (2009) points out that the two banking models embrace technology to be at par with the changing technological world. Banks have employed innovative ideas such as mobile banking as well as internet banking for their clients. Retail banks are heavily investing in ATMs to serve their customers better. These banks collaborate with IT experts to fulfill their needs. The experts on their part provide IT solutions to cover areas such as customer service experience, business process improvement, multi-channel integration, business intelligence, risk management, predictive analysis among others. Automation is helping banks to reduce channel costs.

Additionally, the two banking models identify two fundamental sources of revenue. Interest income from lenders and fee charges comprise the two primary sources of revenue. In a study involving the Bank of China (BOC) and Deutsche Bank (DB) Lepetit et al. (2008) noted trends taken by the two banks concerning interest and non-interest income. By considering the two streams of income for the two banks, symmetrically opposing movement are observed. Although DB strongly depends on non-interest income revenue generating activities, it is moving towards less volatile interest-related income instruments. It is also noted that the bank is reducing its dependence on fee income, commissions, and capital market operations. On the other side, BOC is moving from its high dependence on interest income towards the increase in fee revenue and commission income.

The two business models recognize the impact of government regulations (Manchester 2012). Since banks are the lifeline of an economy, regulatory agencies need to maintain control. The control protects depositors from possible fraud and maintains sanity with the banks especially regarding competition. For instance, Retail banks face with minimum reserves that must be retained by the central bank.

Relationship between investment banking business model and financial stability

Rosenbaum and Pearl (2013, p.567) notes that understanding the relationship between investment business bank models and financial stability requires comprehension of the role of the investment bank and its linkage to the financial system. The primary role of investment banks is to provide clients with services such as helping them to acquire or raise equity by acting as the underwriter for the initial public offers. They also facilitate private share placements, aiding in mergers and acquisitions, raising debt capital and managing investments. These banks also provide supplementary services including propriety trading, development, investing, and sale of debt and equity to their clients.

Schutter et al. (2013, p.347) acknowledged that investment banks play a critical part in capital markets by facilitating the efficient operation of financial markets. Their recent financial crisis exposed risk posed to the economy by these banks, owing to their link with the financial markets. This linkage arises from the fact that investment banks have well interconnected and complex as well as a large-scale level of their operations (Green et al., 2011, p.462). The relationship between these banks and the financial system are analysed by the nature of their activities as follows.

First, investment banks assist business organizations such as government agencies and companies to raise funds through the capital markets. When these parties want to increase money by issuing shares, investment banks link the parties with the investors. They also act as underwriters during the issue of shares or bonds- this means that they guarantee to deliver funds at a pre-determined price once the bonds or shares are issued. Meester (2014) warns that this kind of a relationship has enormous consequences to the economy in case of crises.

Moreover, according to Meester (2014) investment banks apply various financial instruments, which include shares, corporate and government bonds, foreign exchange and precious possessions such as gold and associated derivatives on behalf of their customers. Trading involving financial instruments enable companies to manage risks. These banks also offer services to retail banks, insurance firms and other financial institutions that deal with operating savings of their clients. Such funds include hedge funds and pension funds. These trading activities help in maintaining efficient functioning of the monetary markets. Thus, they serve the needs of end-investors in the economy. However, Diamond and Rajan (2002, p. 276) notes that these companies undertake some activities such as propriety trading for themselves instead of their clients may not yield clear benefits to market functioning.

Paulet (2012) clarifies that investments banks bring risks to financial systems. Trading assets of ten largest banks amount to more than £5 trillion implying vulnerability of liquidity conditions in financial markets in case a single firm fails. Additionally, the interconnection between these banks and other financial institutions may act as the avenue for transmitting losses throughout the financial system. Sironi and Resti (2007, p.784) further explains that some activities complexities also adds notably to risks experienced in the international financial system.

Table 2: Investment banks and their activities

Investment Bank Activity Clients
Underwriting and book building Non – financial companies(usually large ones)

Government agencies

Retail banks and other financial institutions

Trading in securities Insurance companies

Pension funds

Asset managers such as hedge funds

Derivative trading Non-financial companies, Retail banks

Asset managers, Insurance companies


Securitization of loans Retail banks

Finance companies

Providing access to financial market infrastructure Asset managers
Facilitating securities financing transactions Asset managers(some of which act on behalf of pension funds and insurance companies)
Proprietor trading

Source:  Cambridge, National Bureau of Economic Research

Owing to the relationship between investment banks and the financial system (Hu, 2011, p.438) noted that governments and other stakeholders formulated regulations to control functioning these banks. The post-financial crisis has seen the emergence of a number or regulations that influence various aspects of the investment banks. These rules include Dodd-Frank, Basel III, Capital Requirements Regulations (CRR), Capital Requirements Directive (CRD 4), Financial Stability Board, and Foreign Tax Compliance Act among others. The objectives of these regulations aim at increasing consumer protection ensure firms have enough capital and sufficient liquidity, implement early warning signs as well improving corporate governance.


Paulet (2012) notes that investment and retail banks have reaped the benefits of their models as well as mechanisms developed to cope with their deficiencies. The utilization of different models by these banks has enabled them to diversify their services and identify ways of spreading risks. Hu (2011, p.441) also explains that these banks recognize the importance of applying Information Technology to smoothen their operations. The governmental and other regulatory bodies recognize the risks posed by these banks hence the need to regulate them. Retail and investment banking have been shown to have various similarities. For instance, both models have been shown to be influenced by geographical location, technology use, sourced of revenue, customer categories, and government regulation. Moreover, in either case, aversion of risks is a critical issue in ensuring effective operations.

Moreover, the discussion above reveals that investment banking affects financial stability in various ways. For instance, investment banking helps in raising capital market. Moreover, investment banking provides various activities aiming to achieve financial stability. It is also worth noting that investment banking has inherent risks to financial stability. Such areas of influence of the investment banking imply its connection to financial stability.







Deng, S. E., Elyasiani, E., & Mao, C. X. [2007]. Diversification and the cost of debt of bank holding companies. Journal Of Banking &Amp; Finance, 31[8], 2453–2473.

Diamond, D. W., & Rajan, R. [2002]. Liquidity shortages and banking crises. Cambridge, MA.: National Bureau of Economic Research.

Meester, B. D. [2014]., C. J., Pentecost, E. J., & Weyman-Jones, T. G. [2011]. The financial crisis and the regulation of finance. Cheltenham, UK: Edward Elgar.

Hryckiewicz, A. [2014]. Originators, Traders, Neutrals, and Traditioners Various Banking Business Models Across the Globe: Does the Business Model Matter for Financial Stability? SSRN Electronic Journal SSRN Journal, 32, 5–50.

Hu, J. [2011]. Asset securitization: theory and practice. Singapore: John Wiley & Sons [Asia].

Jonghe, O. D. [2009]. Back to the Basics in Banking? A Micro-Analysis of Banking System Stability. SSRN Electronic Journal SSRN Journal, 19[3], 6–48.

Lavinio,S. [2000]. The hedge fund handbook: a definitive guide for analyzing and evaluating alternative investments. New York: McGraw-Hill.

Lepetit, L., Nys, E., Rous, P., & Tarazi, A. [2008]. The expansion of services in European banking: Implications for loan pricing and interest margins. Journal Of Banking &Amp; Finance, 32[11], 2325–2335.

Lovett, W. A. [2009]. Banking and financial institutions law in a nutshell. St. Paul, MN: West.

Manchester, J. [2012]. The 2012 long-term budget outlook. Washington, D.C.: Congressional Budget Office.

Meester, B. D. [2014]. Liberalization of Trade in Banking Services.

Paulet, E. [2012]. The subprime crisis and its impact on financial and managerial environments: An unequal repercussion at European level. Newcastle: Cambridge Scholars.

Rosenbaum, J., & Pearl, J. [2013]. Investment banking. Hoboken, NJ: Wiley.

Schutter, O. de., Swinnen, J. F. M., & Wouters, J. [2013]. Foreign direct investment and human development: the law and economics of international investment agreements. New York: Routledge

Sironi, A., & Resti, A. [2007]. Risk management and shareholders’ value in banking: from risk measurement models to capital allocation policies. Chichester, West Sussex: Wiley.

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