The Benefits of Disentangling Servicing and Holding

September 6, 2022 | Wholesale Funding Update

In recent updates, we’ve discussed the diversity of business models among US banks, and how fintech partnerships have helped foster greater specialization. We’ve also noted that specialization requires financial innovation — namely, the existence of marketplaces in which banks can exchange their assets and liabilities. A core financial innovation, which permeates the entire banking system, is the separation of servicing and holding.

The separation of servicing and holding is already invaluable for bank lending. In the textbook model of banking, a bank originates a loan to a customer — be it a mortgage, personal loan, or credit card — and holds this loan on their books for its lifetime. However, all loans held by a bank must be backed by sufficient liquidity, which can constrain the bank’s balance sheet. In addition, banks may suffer from a serious lack of diversification if they extend credit mostly in localized regions or in specific industries.

Over the past few decades, banks began selling their loans to each other and investors in capital markets. In many cases, the bank continues to service the loan, retaining the customer relationship, while also earning a return on sold assets and removing pressure from their balance sheet. The result has been more abundant and lower cost credit, promoting greater liquidity across the financial system in general (provided that the parties involved properly understand the risk profile of the assets).

The benefits of disentangling servicing and holding also extend to bank deposits. Bank account relationships are valuable for institutions because strong customer relationships provide cross-selling opportunities, and interchange fees provide a meaningful revenue stream for many banks. However, a large number of institutions are flush with liquidity and do not need additional deposits. By sweeping deposits off balance sheet using interbank markets, a bank can retain the customer relationship and all of its associated revenue, while removing deposit pressure from its balance sheet. This model is especially valuable for institutions that want to remain under $10B in assets and Durbin exempt, as mentioned in our last update.

The separation of servicing and holding is part of the natural evolution of financial markets. It has proven invaluable for lending and credit, and is more and more common in other asset classes as well. Bank deposits would benefit immensely from the same approach, allowing for a more efficient allocation of funding across the banking system.