Published October 1, 1999 | October 1999 issue
This is the first of a two-part series on noninterest income; the next issue of the fedgazette will include an analysis of noninterest income and Ninth District banks.
Analysts regularly attribute record bank profitability in recent years to the significant growth of noninterest income, the revenue that banks earn from areas outside their lending operations. In addition to its growth, noninterest income over the last decade has been characterized by a shift in sources from charges on deposit accounts, for example, to fees for mortgage servicing or sales of mutual funds.
These trends are partly explained by new technologies and opportunities available to banks, but the "unique features" of noninterest income also explain them. Most importantly, banks that increase noninterest income could reduce risk; the increased noninterest income could lead to more diversification. Of course, noninterest income is no panacea and claims about its stability may be exaggerated.
Any income that banks earn from activities other than their core intermediation business (taking deposits and making loans) or from their investments is classified as noninterest income. This type of income is often referred to as "fee income" since fees constitute the majority of noninterest income. Banks report this income to regulators in five broadly defined categories summarized in the accompanying table.
Over the last 20 years noninterest income has transformed from a supportive role into a major contributor of bank revenue. The growth of noninterest income has been accompanied by a significant change in the sources of such income.
Noninterest income and interest income grew at similar rates from the 1950s through the 1970s. From the beginning of the 1980s, the growth rates diverged and for the past 20 years noninterest income has grown on the national level at roughly twice the rate of net interest income. As a result, the share of net revenue attributable to noninterest income has increased from 20 percent in 1980 to over 40 percent today.
The rapid growth in noninterest income shows no signs of slowing. Noninterest income has grown at double-digit rates for the last three years and surged ahead almost 19 percent last year, compared to only a 5 percent increase for interest income. Both large banks (those with assets greater than $100 million) and small banks have experienced the shift toward more fee-oriented businesses, although small banks have registered consistently lower levels of noninterest income. (Noninterest income accounted for 43 percent of large banks' revenue in 1998 and 23 percent of small banks' revenue, compared to 27 percent and 15 percent in 1984.)
The composition of noninterest income has also changed markedly during the last five years. Fee income has become the dominant source of noninterest income received by banks, replacing the traditional mainstays of service charges and income from trust activities. Fee income has accounted for most of the growth in noninterest income since it was first measured in 1991. Almost 50 percent of the increase in noninterest income nationally is due to heightened levels of fee income.
The change in composition is not limited to large institutions. Small banks have also focused more of their efforts on generating fee income over the past eight years, which currently accounts for over 40 percent of their noninterest income, the same percentage as large banks. Small banks still earn more from service charges than they do from generating fees, and the gap between fee income (the largest source of noninterest income) and revenue from service charges and trust activities at large banks has been narrowing recently.
Fee income at large banks reached its highest level in 1995, when it was responsible for over 50 percent of noninterest revenue. Since then it has grown around 7 percent per year, while service charges and trust income have grown at over 20 percent.
There are at least two explanations for the recent trends in noninterest income. First, technological and regulatory changes opened up new sources of noninterest income. Second, noninterest income was believed to provide favorable attributes to a bank's revenue stream.
All the examples under fee income in the table reflect technological changes over the last decade and a half. Asset-backed securitization, for example, has been in existence for 15 years and only took off within the decade. Likewise, the explosion of ATMs is a relatively recent phenomenon made possible by advances in communication and computing power. Even the massive size of modern-day mortgage lending and servicing operations at banks reflects significant advances in financial technologies. Most generally, the advances made in computing and telecommunications make it possible for banks to directly market fee-related services in a manner not previously possible.
Other of these revenue possibilities for banks reflect a relaxation of regulatory constraints. Banks have more freedom to offer nontraditional products today than they did a decade ago. Moreover, government deregulation has opened up the banking industry to previously unfelt market forces. As a result, banks face fierce competition from nonbank companies and other banks who can enter their territory. With increased pressure, banks have a greater incentive to exploit new sources of revenue. The record level of profits that banks earned at the start of the decade have been maintained in recent years, in significant part, because of this emphasis on noninterest income (for more details see "Record bank profitability: How, who and what does it mean?" in the April 1998 fedgazette.
Banks also seek to increase noninterest income because it is considered to have traits that make it different from interest income and thus desirable. In particular, noninterest income could lead a bank to be less risky if it leads to greater diversification. In addition, noninterest income is typically described as more steady or stable than interest income.
Adding noninterest income to a bank's revenue stream could reduce risk by giving the bank a more diversified portfolio of revenue producing activities. This diversification would only be achieved, however, if changes in interest income are not associated with changes in the same direction and of the same magnitude for noninterest income. The degree to which two quantities are related to one another can be determined by measuring the correlation between them. Such a measurement shows that, over the last 15 years, movements in net interest and noninterest income sources are essentially uncorrelated (that is, the correlation statistics are very close to zero). As a result, banks that add noninterest income could be diversifying and hence becoming less risky.
It is important to note that these aggregate measures do not indicate precisely how a given bank uses noninterest income. It is possible that in any individual case, a bank is not decreasing its risk through its noninterest income activities. For example, the bank could choose a particular fee income activity where the income moves in the same direction and by the same magnitude as its income from loans.
There have been other claims made about the uniqueness of noninterest income beyond its risk-reducing abilities. In particular, noninterest sources are often described as providing a more stable source of income than net interest sources. Stable can mean several things in this context. First, in a statistical sense, stability relates to how a quantity (whether it is the temperature or stock prices) varies around its average value. But, under this measurecalled the standard deviationnoninterest income is more variable than net interest income. Specifically, the standard deviation of the growth rate of noninterest income between 1984 -1999 was significantly larger than that of interest income.
Second, stable could mean that noninterest income will be less likely to move in synch with economic variables such as interest rates or gross domestic product. We find that when interest rates are increasing, noninterest income falls and vice versa. At the same time, the correlation between interest income and the same interest rates turned out to be almost 0, implying that there is no linear relationship between the two. In contrast, changes in GDP are positively correlated with changes in interest income and a negative correlation exists between noninterest income and GDP. So when the economy slows, and with it interest income, noninterest income actually increases and acts as a revenue buffer.
Finally, observers could also use stability to mean that noninterest income compensates for declines in banking conditions. We try to measure that by examining how these two sources of income move in relation to loan losses. For instance, if noninterest income grows at faster rates when losses are increasing, the heightened levels of noninterest income would steady banks' revenue stream and help the industry better weather the uptick in losses. Both the growth rates of interest income and noninterest income had a correlation close to 0 with respect to changes in total loan losses. This implies that both types of income are similar and do not have a clear relation to loan losses.
The growth of noninterest income, in particular from fee sources, has altered the revenue sources for banks. These trends have been associated with record profits and represent the exploitation of new technologies and legal regimes. Moreover, there is the potential that adding fee income into the mix will reduce the risk of the bank by enhancing its diversification (although other claims about noninterest income merit more skepticism).
|Definitions of Noninterest Income|
|Source of Noninterest Income||Examples|
|Income from Fiduciary Activities||Income from trust department transactions and services|
|Trading Revenue||Income from exposure to financial instruments relating to commodities, foreign exchange, interest rates, and equity securities and indices|
|Service Charges on Deposit Accounts||Charges for account maintenance, failure to maintain minimum balances and processing of "insufficient funds" checks|
|Fee Income||Fees from credit cards, securitizing loans, mortgage refinancing and servicing, sales of mutual funds and annuities, and ATM surcharges|
|Other Nonfee Income||Income received from data processing services, sales of miscellaneous assets and other income not included above|