Differences between a retail bank and an investment bank
According to Investorpedia, retail banks are banks devoted to provide services to particular savers and investors and small and medium sized enterprises. On the other hand, wholesale banks specialize in the provision of services in large operations, generally with large companies and organizations.
Although financial institutions today specialize in a certain type of activity, this has not always been the case. In fact, it was not until after the crash of 1929 that these two types of banking began to operate separately.
This took place in 1933 through the Glass-Steagal Law, which was promoted by Roosevelt as part of a package to stimulate the economy (The New Deal). This law was abolished by Bill Clinton in 1999, which allowed both models of banking to be housed under the same institution once again. However, after the financial crisis that devastated banks in 2008, these activities currently operate separately in most cases.
The main difference between both banking sectors is that they each specialize in different types of customers, but this is not the only difference, Let's take a look at other things that distinguish them.
The business model describes the rationale of how an organization creates, delivers and captures value in different contexts, such as social, cultural… The business model development process is part of the business strategy.
Originate to keep
In retail banking, financial institutions, manage the risks generated in their relationship with customers, which some shareholders and investors are willing to take. In other words, they make loans that stay in their balance sheet through maturity. Therefore, the growth of a retail bank’s business is limited by its capacity to take risks.
Originate to distribute
Thanks to financial innovation, banks can now manage credit risk more efficiently by transferring risk from the originators to third parties more willing to take higher risks. In investment banking, institutions that originate the financing operation are not the same that provide the financing or that take the risk. Now it is possible to originate, bundle and distribute risks among investors and markets, and to cross frontiers.
Taking into account the initial distinction among customer types, the products and services they demand are also different.
Traditional bank products
Retail financing is granted through simple bank products, loans or lines of credit, aimed at individuals or SMEs. The amount is usually not very high. Price competition is usually fierce.
Complex instruments other than simple bank loans
Corporations and large enterprises usually have more complex financing needs, and resort to instruments other than simple bank loans. In long-term financing we can find products such as loans (syndicated or bilateral) or bonds, underwritten by investors. Another format used in wholesale banking is project finance, used to finance large projects. Financial institutions compete in terms of price, but also in terms of capabilities and expertise.
All companies need to finance themselves to carry out their activity, even if their main activity is offering financing to third parties
Deposits
A significant percentage of the funds in retail banking come from balance sheet products, mainly deposits made by customers, which can entail up to two thirds of an institution’s interest-bearing liabilities. It is worth mentioning that more complex disintermediation products are increasingly gaining traction (investment funds, pension plans…).
Capital Markets
Wholesale banks also take customer deposits, but these are usually not enough to cover their third party funding operations. That is why investment banks turn to capital markets, and develop a particularly high activity in the interbank market, an essential tool that allows them to manage their liquidity
Policies to identify, measure and cover potential risks in the banking business have a different approach in each banking model
Balance risk assessment and monitoring processes
As we said above, the business model of retail banks is to “originate to keep” and therefore the originated risk stays in the balance sheet of the originating institution. This is the reason why risk policies are highly developed and include risk, assessment and monitoring processes. The principles of prudence, foresight and diversification are essential in risk management.
Highly sophisticated risk management systems
Investment banks need to observe similar risk management standards. In fact, this task will be performed both for the bank originating the operation and by the investors among which the risk is distributed. Product complexity has led these institutions to develop highly sophisticated risk management systems, capable of identifying and quantifying underlying risks. Also, rating agencies play a key role as qualifiers of risk in the wholesale banking sector.
The differences between both banks models in terms of results have to do with the source of their revenues.
Net Interest Income
Traditionally, net interest income has been the main source of income for retail financial institutions. It can be defined as the difference between the interest charged on loans made less interest paid to depositors. Performance is tightly linked to the interest rate trends and the size of portfolios. This results in fierce price competition that is detrimental to margins.
Fees
In wholesale banking, the percentage of profits coming from the fees charged is virtually twice as high as in the case of a retail bank. It is also worth noting that this is a business where margins are high, as the product offering is usually specialized and, in many cases, tailored to meet the specific characteristics of each customer.