# **3. Drivers of Performance by Market Segment**

22. **Several explanatory factors may account for the significantly different financial performance of retail and corporate banking.** First, the difference in performance might be apparent rather than real because the estimated stand-alone results do not capture the complex inter-linkages and cross-sales/subsidies between business lines. For example, as was indicated in several bank interviews, corporate banking sometimes represents a ‘loss leader’ for generating additional business booked in Retail (e.g., payroll loans) or Treasury (e.g., foreign exchange trading). This is a valid argument in the case of Brazil, although it likely cannot explain by itself the large difference in performance across business lines. Second, and consistent with traditional finance theory, the discrepancy in performance might be a temporary phenomenon related to the stage in the business cycle that will eventually sort itself out. While there might be some merit to this argument<sup>21</sup> , one would need to show that retail banking was less profitable on a riskadjusted basis than corporate banking at other points in the cycle – an unlikely result given the even higher interest spreads that existed for retail loans in previous years. Finally, as described below, distinct market drivers might affect business lines in different ways, and their combined effect would therefore help explain the differences in performance across bank business lines.

23. **A host of factors that influence revenues, costs, and risks explains the structure and financial performance of different market segments** . These factors can be common across business lines (although they might have different effects), but they can also differ substantially by – and even within a – business line. They include, among others, inherent client and transaction features, regulation (including the type and degree of government involvement in the financial system)<sup>22</sup> , and the state of the financial infrastructure. All these factors are relevant in determining the degree of effective competition and contestability<sup>23</sup> in particular market segments and, by implication, on market structure and profitability (see Table 3.1 for a summary).

## **3.1 Retail Banking**

24. **Retail banking shows many aspects of a network business in which physical presence is very important** . It is characterized by significant fixed costs of operation, including branches, ATMs and information and communications technology (ICT) infrastructure. Yet, as the study indicates, margins and fees of this business more than compensate the higher inherent fixed and overhead costs. Not surprisingly, efficiency is a key driver of this business and the cost-to-income ratio is the traditional control variable.

> 21 For example, Clark et al (December 2007) speculate that there is a cyclical element at play in explaining the higher returns on retail activities for large US bank holding companies, while Hirtle and Stiroh (2005) analyze a sample of 700 US bank holding companies for 1997-2004 and conclude that in the US “ _while retail banking may be a relatively stable activity, it is also a relatively low-return one_ ”.

> 22 For example, McKinsey (1998 and 2006) stresses the importance of regulation as a key barrier to increased productivity growth for Brazil’s capital-intensive retail banking sector.

> 23 A contestable market has low entry and exit barriers, thereby restraining incumbent firms from exercising monopoly power because of the credible threat of new entrants.

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