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The New Economic Performance Equation

Updated: Dec 4, 2023


The aim of this article is to concisely present the new economic performance equation for modern financial institutions in the dynamic new world, based on the idea of Leo M. Tilman in his book “Financial Darwinism”. We’ll attempt to provide a comprehensive picture starting from the so-called static business model of financial institutions, then moving to the forces that led those institutions to adjust their value creation model, and finally touching all the ingredients composing the new economic performance equation.

Static business model

Starting from the mid-1980s, financial institutions experienced a period of prosperity and tranquility relative to the Great Depression of the 1930s and Great inflation of the 1970s. This era, referred to as the Great Moderation, was characterized by reduction in volatility of output growth and inflation, which helped to appease the macroeconomic landscape after the rally of the 70s, with inflation touching 12% at the end of the decade. Decades of tranquility of economic conjunction coupled with high net interest margin for banks lead CEO of financial institutions to be persuaded with the idea of endless prosperity, high return and low risk, marking a new era for financial intermediation. Out of this long-lasting framework banks adopted plain and unsophisticated business strategies backed only by corporate finance decisions, in which underlying risks were either not understood or simply disregarded. The canonical static business model of financial institutions in the old regime was based on the maximization of the economic performance equation, based on the differentials between assets and liabilities plus fees exceeding expenses minus costs of capital. More formally:

Where R and R represent return on assets and liabilities, F and E are total fees and expenses and Cᶜ is total cost of capital. Everything is presented as a percentage of total assets value. In the Golden age of financial intermediation funding sources were almost limited to standard retail and wholesale deposits as opposed to the vast realm of financial instruments employed by modern financial institutions falling in the scope of liability management. The absence of any oversight over the right-hand side of the balance sheet is iconic for explaining the easiness of managers and CEOs in managing corporate affairs due the high buffer in differential returns between assets and liabilities. During the old regime fees and A/L spreads were relatively generous, affording the luxury of static behavior. In fact, the implication of the banker joke, “borrow at 2 percent, lend at 6 percent, be on the golf course at 3 pm”, is that what an institution earns on its assets is so much larger than its cost of its liabilities that it is more than enough to cover expenses and produce a handsome return on capital (Tilman 2008).

Therefore, the economic performance equation for static business models in the old regime had to do with accounting related performance, which of course, are inaccurate in periods of high differentials between rate of return on asset and liabilities and completely useless in periods of margin pressure. In this context, the term static refers to the financial institutions’ adherence to the traditional ways in which their balance sheets were deployed to fulfill chartered intermediation roles. Of particular importance in this discussion, static also emphasizes the absence of dynamic and explicit risk-taking behavior and business model transformations.

In the dynamic new world, financial institutions that fail to recognize the permanence of changes in the macroeconomic scenario and instead decide to cling to past business strategies will inevitably face extinction.

The end of the Great Moderation

The period of prosperity that led financial institutions to dominate in terms of compensations and low volatility of returns over all other sectors came to an alt and ultimately reversed course after the financial crisis. The forces exerting pressure over financial institution’s business models were neither sudden nor resounding, on the contrary, those powerful global forces exerted pressure upon bank’s income statements little by little, causing subtle but constant flaws in the financial stability of those institutions. We can classify those powerful global forces in three different categories: secular, period-specific, and cyclical. The forces falling into the category of secular refer to those forces expected to influence the financial system over the long-haul, they are best summarized by these four trends:

  • Inflation targeting and control by central banks around the world contributed to the decline in both levels and variability of inflation and, in turn, was an important driver of the low return environment across financial markets.

  • Disintermediation—the process of “cutting out the middleman” whereby corporations, investors, and consumers deal with each other directly and gain more direct access to capital markets—has removed some financial institutions from the traditional flows of funds.

  • Financial deregulation has contributed to the reduction of price controls, portfolio requirements, product restrictions and barriers to entry within a financial system.

  • The convergence between different traditional financial businesses—a direct consequence of deregulation, disintermediation, and earnings pressures—became pervasive.

We refer to the second group of forces that affected financial institution during the Great Moderation as period-specific, these forces can be summarized by:

  • Disinflation exporting—the abundance of low-cost labor in developing countries combined with the liberalization of trade—has limited inflation in developed countries and impacted the market environment.

  • The global savings glut—a confluence of forces behind a significant increase in the global supply of savings—has facilitated the transition of many developing countries from net borrowers to net lenders and changed the global flow of funds.

  • The end of Bretton Woods—an allusion to the international monetary system with fixed exchange rates between 1945 and 1971—has represented the adoption by several countries, mostly in Asia and the Middle East, of currency exchange rates that were pegged to the U.S. dollar. The break of the Bretton Woods system forced financial institutions to adapt to a new environment of greater exchange rate risk and uncertainty.

The third group of cyclical forces (e.g., economic expansions, favorable corporate and consumer credit fundamentals, flat yield curves, low volatilities) had at times exacerbated the pressure of the other two categories over financial institutions by further stressing and targeting the areas where they were most vulnerable.

The need for a new dynamic performance equation

The pressure of disintermediation, which opened up competition to non-bank companies like fintech and financial firms; more efficient financial markets, reducing free-lunch opportunities by means of arbitrageurs and introduction of more complex financial instruments; and wider availability of financial information, through mandatory disclosure and corporate committees, among other secular forces, have led to a more hostile and less profit-friendly environment for financial institutions. It is important to note that ongoing margin pressure, which in the past had stifled brokers' greediness, low refacing rates, and the increasing complexity of (misunderstood) financial instruments, have led to a leverage spiral, providing all the necessary ingredients for a crisis to erupt.

Financial institutions that overcame the financial crisis were forced to revise the process of economic value creation in terms of conceptually different risk-taking and fee-generating activities, which we refer to as risk-based business models.

These conclusions led to the new economic performance equation for dynamic business models, composed of balance sheet arbitrage, principal investment activities, exposures to systematic risks, fee-based businesses, cost control, and minimisation of the cost of capital. We’ll continue our discussion by opening up the equation and analyzing individually all components.

Balance sheet arbitrage

By using the term balance sheet arbitrage, we mean being able to create profit on the liability side of the balance sheet, which allows firms to generate value without putting significant capital at risk. This strategy tends to take advantage of businesses-specific characteristics, one such example are GSEs enjoying submarket refinancing rates. Another case for balance sheet arbitrage is given by the differential between liabilities on retail deposits and wholesale funding rates, where the former are both relatively inelastic in change in interest rates and have, in normal times, lower refinancing rate compared to wholesale funding sources.

Wachovia bank, a real world example

Banks have also been exploiting their liabilities to generate profits, by expanding in fields of their business that are more stable, and therefore less risky. It is the case of Wachovia bank, which was acquired by Wells Fargo in 2008. The institution started concentrating on the growth of retail deposits and improvement in customer service standards, as many of the banking institutions did at the beginning of 2000s. The reasons behind this choice are different and were deeply analyzed, as explained in a paper titled “The Role of Retail Banking in the U.S. Banking Industry: Risk, Return, and Industry Structure” by Timothy Clark et al. Here, the phenomenon is thoroughly explained as a product of favorable regulations that enabled mergers and branching activities, which, in turn, allowed banks to deliver better services to customers, while exploiting the spread of new technologies.

Moreover, microeconomic factors were critical in this shift. In fact, the retail market for banks has always been subject to lower volatility compared to trading and other activities related to the capital market, which has made it a safe and reliable profit opportunity. The reasons for such a belief are primarily found in the consumer sector that, especially during the years analyzed, had proven to be very resilient, and, therefore, subject to very low volatility. Another factor that contributed to the stability of the retail market is associated with the large number of small customers that retailing serves; this makes the lending income less volatile thanks to the very fact that diversification reduces the exposure to risk. A third reason for focusing on the retail market is represented by deposit margins (difference between interest rates paid on deposits and alternative funding rates). These are in fact an important source of profit, which, during times in which rates are lower, obviously represent a less remarkable source of income. On the other hand, though, lower rates boost mortgage refinancing, which leads to higher fee income. This natural and automatic adjustment of profits, depending on the conditions of the market, represents an appealing characteristic of the retail market, which encouraged Wachovia and other banks to exploit retail deposits, and, hence, develop balance sheet arbitrage.

Principal investment activities

With principal investments being one of the most frequent responses to margin constraints, active risk taking is becoming more and more significant in contemporary financial institutions. The risk-taking activities that make up the economic performance equation's principal investment component have returns that are unrelated to systematic hazards. According to financial theory, diversification can help to lower nonsystematic hazards, and risk management is used to set risk ceilings, measure exposures, and control them.

The distinction between these activities, however, can be difficult to make because certain ostensibly market-neutral activities, such as investing in hedge funds, may produce profits that are unconnected to systematic risks. We can identify conceptually distinct activities and organizational structures within contemporary financial institutions on the basis of the presumption that a portfolio of principal assets does not over time contain structural systematic risk exposures.

Diversification can change the nature of how hedge funds and proprietary trading desks create economic value and can become ineffective as a risk-management technique in particular market settings where rewards from systematic risks are beginning to make up an increasing portion of returns. Firms that provide funding to proprietary trading desks and organizations that invest in hedge funds must address this circumstance. It is extremely risky, difficult, and lacks transparency and predictability to integrate market-neutral principal investments into an institution's business model without major organizational adjustments.

Exposures to systematic risks

Financial institutions should take into consideration another crucial factor while allocating resources on the market: the exposure to systematic risks, the risk that is inherent to the entire market or market sector. Being also referred to as "undiversifiable risk," "volatility," or "market risk," has an impact on the entire market as a whole rather than just a certain stock or sector. Systematic danger is both unforeseeable and utterly unavoidable. Diversification cannot reduce it; only hedging or the appropriate asset allocation strategy does.

Some investment hazards, including industry risk, are driven by systematic risk. It is possible to diversify by investing in a number of stocks in different industries, such as healthcare and infrastructure, if an investor, for instance, has placed an excessive amount of attention on cybersecurity firms. But, among other significant changes, systematic risk includes fluctuations in interest rates, inflation, recessions, and wars.

Unsystematic risk, which impacts a very particular group of securities or a single investment, is the opposite of systematic risk. Diversification can be used to reduce unsystematic risk. Unsystematic risk relates to the possibility of a loss inside a particular industry or securities, whereas systematic risk can be thought of as the probability of a loss connected with the entire market or a segment thereof.

You can check a securities, fund, or portfolio's beta, which gauges how volatile an investment is in relation to the market as a whole, to find out how much systematic risk it carries.

A beta of greater than one means the investment has more systematic risk (i.e., higher volatility) than the market, while less than one means less systematic risk (i.e., lower volatility) than the market. A beta equal to one means the investment carries the same systematic risk as the market.

A good illustration of systematic risk is the Great Recession. Everybody who had assets in the market in 2008 witnessed the dramatic changes this economic crisis caused to the prices of their holdings. Several asset classes were impacted by the Great Recession in different ways. While simpler, less risky assets, like U.S. Treasury bonds, increased in value, riskier securities (including those that were more leveraged) were sold off in significant quantities.

Fee-based businesses

Fee-based businesses are based on commissions, which means that the financial institution's profit is made up of both the fees paid by the client for the provision of services and the additional sales commissions charged on the product. On the other hand, fee-only services compensate advisors solely through direct fees paid by the client. Therefore, they differ from fee-based services since there are no commissions involved.

To sum up the difference between the two, consider working with a financial advisor. If the advisor is fee-only, they will be paid the same flat fee for their service. However, if the advisor is fee-based, their remuneration can be based on a mix of flat fee and commissions.

As the first graphic shows,The top 10 global banks earned a total of 82,142.40 million dollars in fees in 2022, a reduction from the 2021 amount (-32%), due to a reduction in deals. To understand these figures better, let's look at the second graphic, which compares financial institution earnings by fees with other industries. In numerical terms, banks' profits are three times larger than those of their counterparts in other sectors.

Therefore a question worth asking might be: Why do financial institutions focus on fee-based businesses? The fact is that these services can generate steady earnings. The increase in volatility of financial markets following the start of the new century brought a decline in differentials between assets and liabilities. In this landscape, institutions couldn’t help but pay attention to these businesses. Moreover, in the 80s, the banking industry underwent deregulation, which led banks to new opportunities to invest in fee-based services. In those years, fee-income dramatically increased, more specifically because of the GLB Act (1999), which eliminated the Glass-Steagall Act that prohibited investment activities to commercial banks.

A simple example of a fee-based service is credit cards, where the card issuer earns money when the client uses the credit instrument. Moreover, these cards have annual fees. American Express, for example, charges 3.5% for a simple withdrawal.


Financial institutions aim to reduce costs to increase profits. It’s important for a company to minimize expenses since it makes the firm more competitive. It’s worth noting that a firm's profit-maximizing function is also a cost-minimizing function.

Since the 2008 crisis, bank returns are at their lows because costs have grown faster than revenues, due to three factors: regulations such as Basel III increased the capital that banks must hold and the resources they must allocate to comply with them. Banks had to make improvements to their IT systems to become digital organizations, and many institutions had to face litigation costs related to the crisis. Furthermore, revenues have fallen, also because of low interests on deposits. For example, in January, Goldman Sachs implemented 3000 job cuts and reductions in bonuses.

How can banks reduce their costs? For example, by using new technologies: the pandemic showed an acceleration in the tech process, also due to remote working. Technology reduces both fixed and variable costs and avoids human errors. Furthermore, banks can remove old products and services. A recent PwC study shows that "only 5% of products deliver over 80% of revenues" in bank activities. More products imply more expenses. Therefore, by removing less profitable services, banks can avoid these costs.

Minimization of the cost of capital

All firms have to finance their investments, either through equity or by issuing debt. Obviously, these two options have downsides as well as upsides and this is why most firms decide to engage in both activities. The best financing mix is inherently specific to each company, and it also depends on several other factors, like market conditions and economic situations. Minimizing the cost of capital, meaning the cost of these financing strategies, is anyway the main purpose of companies, in order for them to start creating the greatest possible value.

The weighted average of the cost of capital is defined as:

Where Re represents the cost of equity, and Rd represents the cost of debt, while E/V and D/V respectively represent the weight each financing strategy has on the overall mix. Finally, τ represents the corporate tax rate, as debts are partially deductible as corporate expenses.

As previously said, reducing the cost of financing activities is important, but to have an effective financing strategy, a number of factors must be taken into account. In fact, for example, the conditions of the market in which the firm is operating strongly influence the decisions associated with these strategies. As it has been highlighted in a work on dynamic corporate finance by Michael Michaux, a student at the University of Pennsylvania, in fact, it is possible to see how, in smaller and more uncertain economies, the currency composition of debt issued by companies is designed in such a way to hedge profits from possible exchange rate fluctuations. Contrary to what one would expect, this strategy is not only adopted by exporting firms, that are inevitably influenced by these changes, but also by local firms, operating in flawed markets (i.e. not perfectly competitive). In fact, due to a positive pass-through, changes in the exchange rate also affect the prices of non-tradable goods. By issuing a remarkable amount of dollar denominated debt, these firms manage to hedge their earnings, neutralizing the pass-through effect that they are subject to.

The model elaborated by Michael Michaux, in his dissertation, in fact, starts by analyzing the effects of fluctuations in exchange rate on sales of the exporting firm (firm 1 in the model) and the subsequent consequences of these decisions over the local firm (firm 2 in the model).

Where p1 indicates the price of the product sold in the domestic market,represents the number of products sold in the domestic market, p* represents the price of the product in the foreign market and x1 indicates the maximum capacity of the firm. While, in the second equation, delta(e) represents the exposure to exchange rate fluctuations and it is proportional to i.e., the share of foreign profits over total profits.

The profits and exposure for the second firm (the local one) are, on the other hand given by:

Where p2 indicates the price of the product sold, x2 represents the production capacity of firm 2 and represents its market share.

It is immediate to notice that the exposure to exchange rate fluctuations for the exporting firm is proportional to the share of goods sold in the foreign market. Since the exporting firm is able to substitute domestic sales with foreign ones, its exposure to fluctuations can potentially be very small, while this is not true for the local firm, for which the exposure is proportional to its pass-through (which, in turn, as it is highlighted in the model above, depends on the market share of the firm).

As the exporting firm increases its sales in the domestic or the foreign market, depending on the exchange rate, it creates fluctuations in the sales of the local firm, which will be affected by those decisions, leading to high uncertainty in the amount of sales. This uncertainty, as shown in the model, is higher in case of smaller local firms, producing highly substitutable goods, or lower, in the case of greater firms with a large market share and very differentiated products.

What was just presented constitutes the motive for local firms to also engage in dollar denominated financing activities, although they are not directly part of international markets. In this way, they can hedge their profits as exporting firms do.


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