Modelling and measuring business risk and the resiliency of retail banks

Abstract

Non-technical summaryThe recent crisis has revealed the existence of strong resiliency factors in the retail banking business model. Even if retail banking is characterized by a relatively rigid cost structure, most deposit-taking banks focused on retail banking businesses have come through the recent crisis quite well. In fact, the crisis has shown that the specification of business risk sources varies across banks' activities and business models. This paper proposes a new methodology for modelling and measuring banks' exposure to business risk, that is, to situations in which adverse changes resulting from uncertainty surrounding output volumes, margins and costs cause banks' profits to decline.This methodology is based on the efficiency frontier literature. The distance to the efficient frontier provides a profit-inefficiency score at the bank level. Every increase in a bank's distance to its efficiency frontier may be considered to be the consequence of a decline in that bank's profitability. Using this approach, we take the performance of the banks located in the last percentiles of inefficiency scores as illustrating the worst situation a bank will potentially encounter if unfavourable business risk factors materialise. We assume that volatility in banks' profits stems from output uncertainty, and we implement shocks to outputs in the distance function framework representing unexpected changes in output volumes. These shocks produce a decline in profits which corresponds to an increase in the value of the distance. For a given bank, and a given output volume shock, the increase in distance represents the loss in profits attributable to the decline in output volume. Taking extreme values (the 90th and 95th percentiles) of this distribution serves to measure business risk exposure. Indeed, taking extreme values means that we consider the most severe consequences of the shock in terms of declines in profits.This methodology is applied to a large panel of more than 90 French banks -mostly regional banks -running a retail banking model. Data cover the 1993-2011 period. The results verify the resiliency of the retail banking business model. Indeed, business risk, measured in terms of profits at risk, is quite low in the case of severe shocks to main outputs (lending, provision of liquidity services, activities on financial markets and sale of insurance and financial products). Results also show that, regardless of whether costs can be adjusted or not following an output shock, shocks to lending services provoke the highest decrease in profits, which means that retail banks' profits are the most sensitive to the supply of this kind of services. In other words, lending activity is likely to be the most strategic, if not the most profitable, activity for retail banks, protecting banks against business risk. Nichttechnische Zusammenfassung AbstractThe recent banking crisis has revealed the existence of strong resiliency factors in the retail banking business model. On average, retail banks suffered less than other ...

Risk exposures of European cooperative banks: a comparative analysis

“…The literature on the risk exposure of cooperative banks is relatively thin (Groeneveld 2014) and it often involves the reference to retail banking, instead of focusing specifically on mutual institutions. Chaffei and Dietsch (2015) analyze the business risk of French retail banks and find that this is low. The authors focus on business risk as a separate category and claim that this can be more severe than financial risk for some banks.…”

Bank competition and risk-taking in the European Union: Evidence of a non-linear relationship

“…During times of financial turmoil, having a higher share of cooperatives contributes to the stability of the financial sector (Chiaramonte et al, 2015). Retail-oriented business models are the most resilient and are less exposed to financial distress (Chaffai & Dietsch, 2015;Mergaerts & Vennet, 2016). The resilience to risk also depends on internal governance (Martín-Olivera et al, 2017).…”

Assessment of Environmental Sources of Financial Risks on Commercial Banks in Ghana

“…Hypothesis 3: Business risk perceptions of managers of foreign and locally owned banks regarding the financing of the seven selected industrial businesses are the same. Chaffai and Dietsch (2015) defined business risk as the risk of adverse and unexpected changes in banks' profits arising from sudden changes in their activities. It is also the risk that a bank may lose value because its customers sharply curtail their activities during a market down-turn or because a new entrant takes market share away from the bank (Chockalingam et al 2017).…”