Noninterest Income and Financial Performance at U.S. Commercial Banks
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P Noninterest Income and Financial Performance at U.S. Commercial Banks Robert DeYoung Tara Rice Emerging Issues Series Supervision and Regulation Department Federal Reserve Bank of Chicago August 2003 (S&R-2003-2) Noninterest Income and Financial Performance at U.S. Commercial Banks Robert DeYoung Federal Reserve Bank of Chicago Tara Rice Federal Reserve Bank of Chicago Forthcoming in The Financial Review. Abstract: Noninterest income now accounts for over 40 percent of operating income in the U.S. commercial banking industry. This paper demonstrates a number of empirical links between bank noninterest income, business strategies, market conditions, technological change, and financial performance between 1989 and 2001. The results indicate that well-managed banks expand more slowly into noninterest activities, and that marginal increases in noninterest income are associated with poorer risk-return tradeoffs on average. These findings suggest that noninterest income is co-existing with, rather than replacing, interest income from the intermediation activities that remain banks’ core financial services function. JEL codes: G21, G28 Key words: Banks, Noninterest Income, Deregulation. ______________________________________________________________________________ DeYoung is Senior Economist and Economic Advisor, Economic Research Department, Federal Reserve Bank of Chicago, 230 South LaSalle Street, Chicago, IL 60604. Email: [email protected]. Phone: 312-322-5396. Rice is Economist, Department of Bank Supervision and Regulation, Federal Reserve Bank of Chicago, 230 South LaSalle Street, Chicago, IL 60604. Email: [email protected]. Phone: 312-322-5274. The views expressed herein are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System. The authors thank Phil Bartholomew, Steven Dennis, Gerry Hanweck, Iftekhar Hasan, Cathy Lemieux, Tom Lutton, Larry Wall and an anonymous reviewer for their help, comments, and encouragement, and Jennifer Blair for expert research assistance. 1 Introduction A number of theories have been advanced to explain why banks, and more generally financial intermediaries, exist. In most of these theories, banks exist because they mitigate a host of problems that otherwise prevent liquidity from flowing directly from agents with excess liquidity (depositors) to agents in need of liquidity (borrowers). These problems arise because of informational asymmetries, contracting costs, and scale mismatches between liquidity suppliers and liquidity demanders. Intermediation-based theories of financial institutions see banks as the solution to these problems because: banks have a comparative advantage at gathering information on borrower creditworthiness; banks are better able than individual lenders to monitor borrowers; banks provide increased liquidity by pooling funds from many households and businesses and by issuing demandable deposits in exchange for these funds; and banks diversify away idiosyncratic credit risk by holding portfolios of multiple loans.1 Much of the empirical literature in commercial banking has followed these rich theoretical leads, analyzing the financial flows fundamental to the intermediation process (e.g., interest paid on deposits, interest received from loans and securities, and the resulting net interest margins) and the risks associated with those flows (e.g., liquidity risk associated with deposits, credit risk associated with loans, market risk associated with fixed income securities, and interest-rate risk associated with the relative maturities of deposits, loans, and securities). However, commercial bank business models have evolved over the past two decades, and today banks generate an increased portion of their income from nonintermediation and/or noninterest activities. For example, between 1980 and 2001 noninterest income in the U.S. commercial 1 Seminal theoretical studies in this area include Gurley and Shaw (1960), Pyle (1971), Benston and Smith (1976), Leland and Pyle (1977), Fama (1980), Diamond and Dybvig (1983), Diamond (1984), Boyd and Prescott (1986), 2 banking system increased from 0.77% to 2.39% of aggregate banking industry assets, and increased from 20.31% to 42.20% of aggregate banking industry operating income. The increasing presence of noninterest income at commercial banks has been widely documented and discussed in the industry press and regulatory publications (for example, Feldman and Schmidt 1999), but only a few academic studies have investigated the impact of increased noninterest income on the financial performance of commercial banks. While it is well known that large banks and banks with specialized strategies (e.g., credit card banks, mortgage banks) rely more heavily on noninterest income than do small banks with traditional business strategies, there is little systematic understanding of why noninterest income varies across banks and how noninterest income is associated with bank financial performance. This paper attempts to fill in some of these gaps. In Section 1 we document the long-run trends in the amount and composition of noninterest income at U.S. commercial banks. In Section 2 we discuss the regulatory and technological determinants of noninterest income at commercial banks, and consider why noninterest income has grown more quickly at some banks than at others. In Section 3 we discuss the potential effects of increased noninterest income on the financial performance of commercial banks. We refer to the extant literature on noninterest income at commercial banks throughout each of these first three sections. In Section 4 we specify an econometric model designed to answer two broad questions: Which bank characteristics, market conditions, and technological developments are most closely associated with increased noninterest income? Is noninterest income associated with improvements or declines in bank financial performance? In Section 5 we describe the 1989-2001 panel data set on U.S. commercial banks that we use to estimate the econometric model. James (1987), and Gorton and Pennacchi (1990). See Saunders (2000, chapter 6) and Freixas and Rochet (1999, chapter 2) for general discussions of why banks exist and overviews of the theoretical literature. 3 We report the results of our econometric model in Section 6. We find numerous strong statistical associations between noninterest income and bank characteristics, market conditions, technological progress, and bank performance. For example, our results suggest that well- managed banks rely relatively less on noninterest income; that banks which stress customer relationships and service quality tend to generate more noninterest income; and that the development of new financial technologies such as cashless transactions and mutual funds are associated with higher levels of noninterest income in the banking system. We also find that increases in noninterest income tend to be associated with higher profitability, higher variation in profits, and a worsened risk-return tradeoff for the average commercial bank during this time period. These results are consistent with previous research findings, extend our knowledge beyond the small extant literature on this topic, and are robust to changes in estimation technique and data subsampling. In Section 7 we briefly discuss the implications of our results for the future roles of intermediation and nonintermediation activities in bank business models. 1. The changing sources of bank income There are a number of different ways to measure the incidence of noninterest income at commercial banks. Table 1 illustrates how two of those measures – noninterest income as a percentage of bank assets, and noninterest income as a percentage of bank operating income – have increased over time for “large” (assets greater than $1 billion) and “small” (assets less than $1 billion) U.S. commercial banks between 1984 and 2001. Using operating income as the financial benchmark suggests a relatively small increase over time: noninterest income increased by 17 percent on average at large banks (from 25.47% to 29.89% of operating income) and increased by 16 percent on average at small banks (from 14.07% to 16.38% of operating income). Using total assets as the financial benchmark indicates a substantially larger increase 4 over time: noninterest income increased by 79 percent on average at large banks (from 1.20% to 2.15% of assets) and increased by 26 percent on average at small banks (from 0.72% to 0.91% of assets). Finally, using industry aggregates rather than bank averages suggests still larger increases over time: industry noninterest income-to-operating income increased by 72 percent (from 24.60% to 42.20% of aggregate industry operating income) and industry noninterest income-to-assets increased by 125 percent (from 1.06% to 2.39% of aggregate industry assets). These figures illustrate several important points. First, noninterest income comprises a larger portion of commercial bank income today than in 1984. This is not just a U.S. phenomenon: Kaufman and Mote (1994) found that noninterest income ratios increased in the banking sectors of virtually all developed countries between 1982 and 1990. Second, noninterest income ratios are larger, and have grown more quickly over time, at large banks than at small banks. Third, the large industry aggregate ratios indicate that the lion’s share of total noninterest income is being generated by a small number of banks. Indeed, the 1 percent