Threat to the Traditional Banking

Threat to the traditional banking

Traditional Banking refers to the business model with main feature of accepting the deposits and using those funds to provide loans. Over the years it has been noticed that profitability of traditional banking activities of banks have declined especially in United States (Franklin Edwards, 1995). Declining profitability encourage the managers of the institute to take more risks. Over the period new financial products developed and it is these activities that made over for the lower profits in traditional banking.

The rise of off-balance sheet activities and use of complex derivatives instruments for hedging and speculation gave rise to a new era in banking – ‘Investment Banking’. Though the term is much wider but derivatives contribute significantly in operations of an investment bank. Most profitable financial institutes like Goldman Sachs and JP Morgan didn’t bother to get into traditional banking until very recently when they were forced to, by the US government.

The reason can be attributed to three main aspects –

Firstly, banks reliance on deposits is decreasing substantially for the given fact that they have to be compensated with interest and operating costs for maintaining deposits are high and this eventually results in lower margins for the bank.

Secondly, the purpose of accepting deposits is to give out loans at a higher interest rate but with the development of new markets like money market, interbank market and new products for that matter like the rise of commercial papers has led the availability of funds easy and at a lower cost.

Finally, the development of investment banking, off-balance sheet activities and the use of derivatives have led to very high returns for the financial institutes. Thus given a choice of deciding the separation (as in they want to operate as a traditional bank or an investment bank) the decision for a majority would be the latter. It’s a risk-return trade off. Higher the...