Chapter 4
Managing Non-Interest Income and Non-Interest Expense
Chapter Objectives
Introduce financial ratios that characterize a bank’s ability to generate non-interest income and control non-interest expense.
Document the sources of bank non-interest income.
Explain the significance of the efficiency ratio and operating risk ratio.
Explain the importance of knowing which customers are profitable.
Describe the link between business mix and fee income.
Describe various strategies to manage non-interest expense.
Key Concepts
Because banks face strong competition in pricing loans and deposits, their net interest income and NIMs are likely to remain stable or decline over time. To grow earnings, banks must increasingly rely on non-interest income and expense controls.
The bulk of a bank’s non-interest income comes from deposit service charges and fees from services such as trust management, securitization, mortgage banking, asset management, and investment banking and trading for the largest banks.
Bankers and analysts typically measure performance over time and versus peer banks via their burden, which is equal to non-interest expense minus non-interest income; net overhead expense, which is equal to the burden as a fraction of total assets; and the efficiency ratio, which is equal to non-interest expense divided by the sum of net interest income and non-interest income. In each case, better performance is indicated by a smaller figure or percentage.
Productivity ratios help indicate how efficiently banks are using their employees relative to capital assets. Two commonly cited ratios are assets per employee and average personnel expense. The more productive bank typically has fewer employees per dollar of assets held and often controls personnel expense per employee better. Still, this latter ratio is often high for high performance banks because they operate with fewer people but pay them more.
Typical analyses of customer profitability profiles suggest that banks make most of their profit from a relatively small fraction of customers. The traditional view is that up to 80 percent of a bank’s customers are unprofitable when all services are fully accounted for. Such figures support the increase in fees assessed by most banks over the past few years.
Banks pursue a variety of cost management strategies to control non‑interest expense. Four different strategies are: 1) expense reduction, 2) increase operating efficiency, 3) changing product pricing, and 4) pursuing contribution growth whereby non‑interest revenues rise by more than non‑interest expense.
Teaching Suggestions
One of the most significant trends in bank performance over the past 15 years is the increasing reliance on non-interest income versus net interest income. It is important to motivate the discussion of non-interest income and non-interest expense by documenting the flat or declining net interest margins at most banks during the latter 1990s and 2000s, and emphasizing the fact that banks’ future earnings growth will depend strongly on how much a bank can charge fees and control costs. Note that the types of non-interest income available to community banks are substantially different from that available to the largest banks. In fact, large banks’ interest in investment banking and insurance is driven primarily by the motivation to diversify activities and enter businesses that generate fee income.
Start by visiting the FDIC web site at www.fdic.gov and view the graph book data which shows the sources of a bank’s non-interest income. Similarly, look at data related to the sources of non-interest expense (operating costs) and aggregate efficiency ratios.
Spend time discussing the key financial ratios that measure a bank’s ability to generate non-interest income and control expenses. Examine changes in bank’s burden over time and versus peers. Use the UBPR data for Citibank at the end of Chapter 3 as an example. Discuss analysts’ and management’s focus on the efficiency ratio in recent years. Obtain a copy of virtually any large bank’s most recent annual report, and have students document trends in the bank’s efficiency ratio. Most large banks discuss the efficiency ratio in the first 10 pages of the financial report because it reflects a key part of their current strategy. Discuss the operational risk ratio and why it might provide different insights than the efficiency ratio, and the two productivity ratios related to assets per employee and average personnel expense. Again look at Citibank’s UBPR data as an example.
Describe in general how a bank might measure how profitable a customer’s account is. Have students discuss why many banks believe that only 20 percent of the bank’s customers are profitable. Why are so many unprofitable. Have students suggest fees that could be charged to improve profitability.
Finally, while the text emphasizes recent efforts to reduce non-interest expense at banks, it is important to demonstrate that costs should be managed, and it is acceptable to pursue strategies that raise costs if significant revenues are similarly generated.
Special Project
Many analysts and bankers believe that there is over capacity in banking and that mergers can be motivated by cost cutting opportunities to realize economies of scale and scope with greater volumes of business. Have students review current and recent issues of The Wall Street Journal, American Banker, Business Week, etc. to document the pace of bank mergers and to evaluate the rationales provided. Ask them to obtain estimates of the amount and nature of cost savings projected by management of the merged institutions.