Examining the Banking Industry Value Chain

In this second lesson, we will explore:

• The business models of the various types of Banking and Capital Markets firms introduced in lesson one.
• The ecosystem and the interconnected nature of the industry.

Despite the complexity of some services offered by Banking and Capital Markets firms, their underlying business models share a relatively straightforward foundation.

• Institutions such as retail or corporate banks offer deposit services, including checking or savings accounts.
• To attract customers, these banks provide interest payments as an incentive to deposit money with them.
• Deposits are then used by the banks to issue loans, for which customers are charged a higher interest rate.

• The interest earned on loans exceeds the interest paid on deposits, resulting in a net profit for the bank.

By understanding these fundamental principles, we gain insights into how Banking and Capital Markets firms balance costs and revenues to achieve profitability.

Organizations such as investment managers, investment banks, transactional banks, and capital markets firms typically operate on a fee-based structure.

• These firms charge fees for specific products or services, which may include:
  • Per transaction fees (for example, trade executions).
  • Activity-based fees (for example, facilitating mergers or raising capital through an IPO).

• While infrequent and highly competitive, these activities can generate significant revenue for financial institutions.

• During tight economic conditions, demand for services like saving, mergers and acquisitions, or large-scale capital development declines, make these business models highly sensitive to economic fluctuations.

The term financial institution broadly refers to any company or organization that provides financial services to industry customers.

Financial institutions have a diverse structure such as:

Small firms: Serve local community needs.

Specialized companies: Focus on specific market niches.

Global institutions: Cater to customers worldwide.

To have this diversity they require a range of business models to achieve the profitability and shareholder objectives, whilst managing risk and meeting their regulatory obligations.

Financial institutions are generally categorized into three broad types:

• Banks
• Capital Markets Firms
• Other Financial Institutions

To expand their business activities, many institutions often serve multiple roles within the industry.

For example, JP Morgan Chase includes a retail bank, an investment bank, a brokerage firm and as an investment management firm, which in itself serves institutions as an asset manager and individuals as a wealth manager. The organizations are often referred to as Universal Banks, and support customers in different geographies with different financial services based on the Bank’s expertise and the local customer and regulatory environments.

Even comprehensive organizations like JP Morgan Chase cannot operate entirely independently. Both universal banks and firms who specialize in a single area of financial services depend on a network of relationships to other financial providers, service providers, technology providers and even legal specialists.

Financial institutions operate under diverse business models depending on their specific roles within the industry. The following is a structured breakdown of these business models.

Banks' business models typically begin with customer deposits, which serve as the primary source of funds.

To receive deposits, firms need tobe licensed with their local regulator. This means they need to satisfy the minimum requirements set out by one or more regulators needed to provide financial services. These requirements will include a satisfactory business model, consumer protection, technical stability and ethical operations amongst other things.

Banks are the most highly regulated of all financial institutions because protecting customer deposits is one of the primary objectives of industry regulators.

Once firms have their licenses and are able to accept customer deposits, they use these deposits to lend money to other customers and invest in securities.

Investment Managers attract capital by creating structured investment funds or portfolios targeting specific investment goals, such as ESG-focused funds or real estate in developing markets.

This principal is the same for Asset Managers with their focus on institutional capital and wealth management with the exception that wealth managers have a more specific focus on support the individual for different life events such as buying a house, putting a child through university or retirement.

These institutions support corporations to raise capital in the form of equity or debt products that are brought to the market through an Initial Public Offering, or supporting corporate deals such as mergers and acquisitions (M&A).

To do this, they need extensive knowledge of multiple industries, corporate valuations, future trends and also an extensive network of contacts who serve as the initial buyers of an IPO.

Transactional banks focus on services critical to corporate and institutional operations, facilitating the secure flow of funds and financial instruments. Key services include the transfer of money from one country to another (also known as cross-border payment transactions), trade financial deals, mitigation of risks, cash flow management services, and even offering security services for improving relationships between banking institutions, clients and partners.

Transaction banking has gained a lot of significance in recent times, and it will continue to do so in the future. The most important function it offers is treasury solutions, and allows a safer, secured, and effective flow of cash and financial securities across the international financial system.

The Capital market business model is to generate profit both through transaction fees and achieving favorable price differences between buying and selling assets. This applies to both the capital markets participants on the buy- and sell-side. Stock exchanges and broker / dealers typically use transaction fees to generate income. Over the last 20 years as competition has become fiercer, they’ve had to look at new ways of generating revenue such as monetizing the data generated within their business, which is extremely valuable. These data businesses are often known as Information Services, and have recently increased in scope again with Deutsche Borse acquiring a portfolio management software company called Simcorp, and NASDAQ acquiring a trading and regulatory reporting platform known as Adenza.

Therefore, financial institutions must continuously adapt their business models to remain competitive.

• Market Awareness: Firms must monitor changing market dynamics and customer needs.
• Technology Adoption: Strong technology foundations are critical for agility.
• Consequences of Inaction: Institutions that fail to adapt risk significant losses in profitability or reputation, which can result in failure or acquisition by competitors.

Financial institutions play a critical role in addressing the diverse financial needs of their customers, which include individuals, businesses, public sector entities, and other financial institutions. Here’s a structured overview of how they achieve this:

Financial institutions provide a range of products and services to meet the financial needs of individuals.

• Transferring Money:
  • Offering safe, reliable, and convenient methods for receiving and making payments.
• Storing and Growing Money:
  • Providing secure ways to save money for both short-term needs (For example paying bills) and long-term goals (for example retirement).
• Borrowing Money:
  • Allowing individuals to finance significant purchases like homes or cars through loans, with interest paid to lenders.
• Financial Advice:
  • Helping individuals navigate options such as investment strategies and retirement planning to achieve their financial goals.

Like services for individual customers, financial institutions offer thousands of different products and services to business customers to help meet one, or more of five basic financial needs. Businesses served by financial institutions range from small local businesses to the largest global corporations.

• Small and Medium Enterprises (SMEs): Privately owned businesses, partnerships, or sole proprietorship, primarily served by local commercial banks, savings banks, or cooperative banks.
• Middle Market Companies: Firms smaller than large multinationals, served by commercial banks, finance companies, private equity firms, and smaller investment banks.
• Large Corporations: Multinational firms with complex structures and global operations, requiring services from large commercial and investment banks with expertise in multiple markets.

• Transferring Money: Safe, efficient payment systems for receiving customer payments, paying suppliers, or managing payroll.
• Storing and Growing Money: Maximizing returns on cash reserves through investment in low-risk, short-term securities.
• Borrowing Money:
  • Access to loans for:
    • One-time acquisitions (for example acquiring a company).
    • Short-term needs (for example inventory purchases).
    • Long-term investments (for example launching a new division or building headquarters).
• Insurance Against Financial Loss: Protection against risks like fluctuating interest rates, currency volatility, or economic downturns.
• Advice: Expert guidance on raising capital, managing cash flow, and optimizing financial strategies.

• Industry-specific financial needs.
• Complex structures with subsidiaries and international operations.
• Multiple financial relationships with different providers for expertise or better pricing.
• Competition between providers, requiring businesses to balance cost and service quality.

Financial institutions also work with public sector customers, including:

• Federal or national governments.
• Regional or state governments and agencies.
• Local governments or municipalities.
• Foreign governments and public pension funds.

Similar to businesses, public sector entities require services like transferring money, borrowing, and managing cash flow, but often evaluate providers based on additional criteria like transparency and adherence to public policies.

In the US, for foreign governments and public pension funds, many of the needs and evaluation criteria used by public sector customers are similar to those of business customers.

Banks and capital markets firms also provide services to each other for mutual benefit.

The reasons for the interdependences between financial institutions are due to service gaps such as a financial institution not wanting to provide a particular service to their customer, or they legally can’t provide a service.

Some examples include:

Payments - In most countries banks can be members of payment systems. As a result, non-bank financial institutions (such as investment management firms) need to use banks to send and receive payments.

Trade Finance - Many small banks have business customers with trade finance needs related to international trade. These small banks often hire large banks to provide these services in the background.

Institutional Investors - These are an important segment within other financial institutions. Institutional Investors are financial institutions, companies or other organizations with large investment portfolios to manage such as pension funds, mutual funds, hedge funds, life insurance companies, and sovereign wealth funds who manage investments on behalf of a sovereign country or state.

Overall, that makes for a complex web of interactions between individuals, businesses and state institutions with financial services. It is this complexity and desire to protect basic financial principles that leads to the heavy regulatory burden.

The gap between a customer and a financial institution has inherently been quite distant in the past. This was predominantly due to the nature of the services provided. These were often branch based or at arms length, using forms and even physical delivery of cash into the banking systems. Even for investment banks, transactional banks and investment managers, their businesses relied heavily on relationships and customer initiated interactions.

In the last 20 years, the role of the regulator has become increasingly close to the financial institution as society as a whole demands more transparency into business activities and state or regulatory bodies need to understand the current position of a financial institution and its ability to deal with a shock event.

The technological advancements over the same period are immense. Where processes used to rely on paper forms, the same can now be achieved automatically and digitally. As a result, Banking and Capital Markets firms are juggling a myriad of legacy systems, many of which are either tied to significant revenue generating or regulatory activities, and the need to create more modern, customer centric solutions. For the latter, firms are leveraging Cloud technology to provide fast time to production and lower cost development, whilst benefiting from the range of ‘edge’ services offered by cloud and related providers. At the same time, they are having to maintain and reduce the cost of their legacy systems.

The ultimate goal for Banking and Capital Markets firms, along with their technology and service partners, is to minimize the gap between customer requirements and the delivery of financial products.

• Firms aim to embed financial services seamlessly into their customers’ processes and activities.
• Financial services should become invisible yet effective, supporting daily operations without disrupting workflows, while remaining compliant and auditable.

Recent advancements, particularly in Artificial Intelligence (AI), have enabled firms to take a more proactive role:

• Predictive Services: Banks and capital markets firms are offering suggestions such as cash management and investment advice based on authenticated access to customer data.
• Seamless Integration: Financial services now strive to meet customer needs in real-time, delivering value through smart, data-driven tools.

To achieve seamless service delivery, firms need to focus on partnerships and trust:

• Close Collaboration: Working closely with partners, suppliers, and customers is essential to embed services into broader ecosystems.
• Transparency and Compliance: Regulators need confidence in the financial system's operations, which demands clear, auditable practices.
• Customer Clarity: Customers must clearly understand their needs and the available solutions, often requiring education and guidance.

As the industry transitions to higher-value, seamless products, it is crucial to:

• Simplify Communication: Ensure customer interactions are transparent and free from jargon or complexities stemming from legacy systems.
• Provide Education: Empower customers to understand their options and make informed decisions without encountering unnecessary barriers.

FinTechs are pivotal in transforming the Banking and Capital Markets landscape:

• Customer-Centric Focus: FinTech firms are laser-focused on meeting customer requirements, offering agile and innovative solutions.
• Partnerships and Acquisitions: Traditional banks and capital markets firms are increasingly partnering with or acquiring FinTechs to accelerate their transformation.
• Technology Integration: To achieve meaningful progress, firms must understand their existing technology landscape and effectively bridge legacy systems with newer FinTech capabilities.

• Foundational Business Models: Banks operate on deposit-based models, profiting from interest rate differentials, while capital markets firms rely on fees and trading margins. Despite varied operations, all financial institutions focus on balancing revenue, costs, and risk for profitability.
• Ecosystem Interconnectivity: The industry is a dynamic network of institutions, regulators, and technology providers, with firms often serving multiple roles and collaborating to meet regulatory and market demands. Emerging technologies like cloud computing and AI enhance integration and customer-centric innovations.
• Adapting to Customer Needs: Financial institutions address diverse customer needs by providing payments, savings, loans, and advice. They leverage AI and FinTech partnerships to bridge gaps in service delivery, while maintaining transparency and simplifying