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Going with the Flow: Changes in Banks’ Business Model and Performance Implications

Summary:
Nicola Cetorelli, Michael G. Jacobides, and Samuel Stern Does the performance of banks improve or worsen when banks enter into new business activities? And does it matter which activities a bank expands into, or retreats from, and when that decision is made? These important questions have remained unaddressed due to a lack of data. In a recent publication, we used a unique data set detailing the organizational structure of the entire population of U.S. bank holding companies (BHCs). In this post, we draw on that research to show that while scope expansion on average hurts performance, entering into activities that are highly synergistic with core banking at a given point in time yields net performance benefits. Transformation in U.S. Banks’ Organizational Structure In the

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Does the performance of banks improve or worsen when banks enter into new business activities? And does it matter which activities a bank expands into, or retreats from, and when that decision is made? These important questions have remained unaddressed due to a lack of data. In a recent publication, we used a unique data set detailing the organizational structure of the entire population of U.S. bank holding companies (BHCs). In this post, we draw on that research to show that while scope expansion on average hurts performance, entering into activities that are highly synergistic with core banking at a given point in time yields net performance benefits.

Transformation in U.S. Banks’ Organizational Structure

In the past two to three decades, U.S. banking institutions have gone through the largest and deepest process of scope transformation in history. Throughout the 1990s and early 2000s, more than half of the population of BHCs (accounting for about 97 percent of total industry assets) either created or took control of tens of thousands of subsidiaries, spanning virtually every activity within the financial industry and even beyond. For example, between 1990 and 2006, more than 230 distinct U.S. BHCs incorporated securities-dealer or broker subsidiaries, about 500 took control of insurance agencies, and over 1,000 added one or more special purpose vehicle legal entities to their organizations.

Costs and Benefits of Adding Subsidiaries

The so-called “agency view” predicts that adding new operational units, especially those engaged in activities that the organization has not previously focused on, will impose a variety of costs (misallocation of resources, for example) associated with agency frictions within the organizational hierarchy. And yet, scope expansion is widely observed through time and across industries, suggesting that adding subsidiaries may promise underlying economic gains. An influential strand of research in the strategy literature, known as the “resource-based view,” has emphasized that a firm may benefit from expanding scope into business activities where its current resources can be efficiently redeployed. This, in turn, rests on the premise that certain activity types are more likely than others to share similar processes, knowledge bases, human capital, and so on. Such relatedness across activities should translate into relatively larger efficiency gains and/or the attainment of return synergies associated with their joint operation.

A challenge in trying to capture relatedness across activities is that sectors are not static. As Teece et al. have observed, industries evolve, and so should the opportunities for synergies across activities. This suggests that relatedness has a life cycle, so that certain additions may confer different performance benefits at different points in time. The observation rings particularly true for U.S. banking, where the mode of financial intermediation changed so dramatically during the 1990s and 2000s.

The banking sector shifted from a model where commercial banks brokered supply and demand of intermediated funds, to a decentralized system where matching increasingly took place through much longer credit intermediation chains, with nonbank entities emerging as providers of specialized inputs along the way. This evolution created new opportunities for potential synergies across a variety of businesses—but the value of those synergies also varied depending on regulatory, technological, and market conditions. For example, the newfound benefits from combining commercial banking with securities dealing and underwriting, following the institution of Section 20 subsidiaries in the late 1980s/early 1990s, appear to have increased firm-level value, and probably especially so in the run-up to the 90s technology boom. Likewise, the surge in asset securitization throughout the 1990s likely created the conditions for banking institutions to add specialty lenders, special purpose vehicles, and servicers, among others.

Empirical Study of Relatedness

The empirical analysis of an evolving relatedness has represented a major challenge in applied studies because of the demanding data needs. However, we are able to address these needs in our study. Following the strategy literature, we capture relatedness by looking at how many BHCs choose to hold a given activity at a given time, under the plausible assumption that the more popular activities are those closer to the current core of intermediation. Such a metric could only be computed by having full information on scope of the entire population of BHCs, which is what our database provides.

We can offer a simple visualization of this concept of evolving relatedness. The chart below shows, for a sample of alternative business activities, the proportion of BHCs in any quarter/year reporting at least one entity that both is part of their organization and was engaged in that activity. So, for instance, special purpose vehicles (included in “Other financial vehicles”) were hardly found in BHCs’ organizational structures in the early 1990s, but they indeed became a staple for BHCs in later years, as the asset securitization boom prompted banks to move into that business area, and new synergies emerged as a result.

Waxing and Waning of Banks’ Business Scope

Going with the Flow: Changes in Banks’ Business Model and Performance Implications

Sources: Board of Governors of the Federal Reserve System, Report of Changes in Organizational Structure (Y-10); authors’ calculations.

Conversely, entities managing residential dwellings (included in “Lessors of residential buildings and dwellings”) were relatively very popular in the cross section of BHCs in the early 1990s. These were indeed times when balance-sheet assets such as mortgages and their collateral defined the predominant scope of a commercial bank—but later they declined into obscurity, probably mirroring the subsequent evolution toward the originate-and-distribute model of intermediation. At the same time, securities brokerage entities and insurance brokerage firms start at similar levels of popularity but diverge later on.

How Should Relatedness Contribute to Performance?

Using the chart above as an illustration, we conjecture that a BHC entering the insurance business for the first time when this activity is at the nadir of its popularity should yield a smaller performance boost than if entry is done at a time when the insurance business is more integrated with banking, as reflected by insurance subsidiaries being found more frequently across BHCs. We find that this is indeed the case. According to our estimates, BHCs that expanded into this activity in the early 1990s were more likely to experience a net negative impact on their return on equity. Conversely, for BHCs that expanded instead when the activity was at its maximum popularity (around the mid-2000s), the return on equity increased.  

We brought this intuition to the data and sought more systematic evidence, and our overall findings confirm this example: BHCs pursuing scope transformation strategies on averagedo not do as well as their peers. However, it matters a lot whichactivities a BHC expand into, but even more importantly whensuch entry occurs: entry into activities when those activities are highly related to core bankingtranslates into significant net performance gains.

Summing Up

We find that expansion into activities when they are highly related to core banking seems to be beneficial for BHCs. However, we should also clarify that benefits for BHCs that transform their scope do not necessarily imply concomitant benefits for society as a whole, nor do they rule out the possibility of associated negative systemic externalities (see, for example, Rajan 2011 and Jacobides et al 2014). This in an important issue, and one deserving of a separate undertaking.

Going with the Flow: Changes in Banks’ Business Model and Performance Implications

Nicola Cetorelli is a vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Michael G. Jacobides is the Sir Donald Gordon Professor of entrepreneurship and innovation and Professor of strategy and entrepreneurship at London Business School.

Samuel Stern is a Ph.D. student at the University of Michigan and a former senior research analyst in the Federal Reserve Bank of New York’s Research and Statistics Group.

How to cite this post:
Nicola Cetorelli, Michael G. Jacobides, and Samuel Stern, “Going with the Flow: Changes in Banks’ Business Model and Performance Implications,” Federal Reserve Bank of New York Liberty Street Economics, September 1, 2021, https://libertystreeteconomics.newyorkfed.org/2021/09/going-with-the-flow-changes-in-banks-business-model-and-performance-implications.

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Were Banks ‘Boring’ before the Repeal of Glass-Steagall?


Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

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