1. 1 Chapter 4: Managing Noninterest Income and Noninterest Expense

2. Issues in Interest Income and Interest Expense Sharp increase in net interest margins (NIM) from 1945 to 1992 with a reversal of the trend since then. NIMs increased sharply again from the beginning of the financial crisis in 2008 until 2010 due primarily to the Federal Reserve’s extraordinarily low interest rate policy. Competition again heated up and the temporary increase in NIM fell again. 2

3. Issues in Interest Income and Interest Expense 3

4. NIM have been decreasing since 1992 due to a reversal of factors that led to the sharp increase. Where there are profits, competition follows. Popularity of mutual funds and stocks led to funds being moved out of FDIC- insured deposits. Deregulation and innovation put pressure on loan rates and deposit costs. Refinancing of loans at lower rates reduced yields. Increased number of competitors, financial sector combinations and regulatory changes. 4

5. Issues in Interest Income and Interest Expense Larger institutions have de-emphasized lending in favor of fees from loan securitization and offering a variety of fee-based products and services. Smaller banks have continued to be much more dependent on lending and their NIM. 5

6. Issues in Interest Income and Interest Expense 6

7. Noninterest Income Sources of Noninterest Income Deposit service charges Fiduciary activities Trading, venture capital and securitization income Investment banking, advisory, brokerage and underwriting fees and commissions Insurance commissions Net servicing fees Net gains/losses on loan sales Other net gains/losses and other noninterest income 7

8. Noninterest Income 8

9. Biggest contributors are deposit service charges and other noninterest income. Stable sources of revenue but difficult to increase over time due to visibility and unpopularity with customers. Larger banks rely more on noninterest income than their smaller counterparts. Large institutions have greater amounts and wider variety of sources of noninterest income. Nondeposit fees and trading revenue are highly cyclical because they depend on capital market activity. 9

10. Noninterest Income 10

11. Deposit Service Fees Deregulation encouraged “unbundling” of products and charging for individual services rather than offering them for free. Intense competition through the mid-2000’s led to bundling, “free checking” and no-fee debit and credit cards. Regulatory burden from Dodd-Frank Act has reversed this trend and banks are again beginning to charge for non-interest bearing checking accounts. 11

12. Deposit Service Fees 12

13. Deposit Service Fees 13

14. Deposit Service Fees 14

15. Deposit Service Fees Critical decision is to determine the appropriate fee-based business mix. Many institutions offer mortgage banking services. When rates are low firms earn substantial origination fees from new loans and mortgage refinancing. When rates are high, origination fees decrease but serving revenues increase. Many large banks prefer the huge potential fee income from nonmortgage businesses which can also be volatile due to economic changes. 15

16. Noninterest Expense Five components: Personnel expense Occupancy expense Goodwill impairment Other intangible amortization Other operating expense The sum of these five components is called overhead. 16

17. Key Ratios Burden (Net Overhead Expense) Burden = Noninterest Expense – Noninterest Income Net noninterest margin = Burden/Average Total Assets The smaller these measures, the better the bank has performed. Efficiency ratio = Noninterest Expense/(Net Interest Income + Noninterest Income) Larger banks tend to have lower (better) efficiency ratios because they generate more noninterest income. Low efficiency ratios do not always lead to higher ROEs. 17

18. Key Ratios 18

19. Key Ratios 19

20. Key Ratios Operating Risk Ratio = (Noninterest Expense - Noninterest Income)/Net Interest Margin Lower is better because proportionally more income comes from fees. Productivity Ratios: Asset per employee = Average Assets/Number of Full-time Employees Average personnel expense = Personnel Expense/Number of Full-time Employees 20

21. Key Ratios 21

22. Key Ratios For community banks, two related ratios provide useful information about productivity. Dollar amount of loans per employee = Average Loans / Number of Full-Time Employees Net income per employee = Net Income / Number of Full-time Employees 22

23. Key Ratios 23

24. Which Lines of Business and Customers are Profitable? Line-of-Business Profitability Analysis Risk-Adjusted Return on Capital (RAROC): Risk-adjusted income / Capital Return on Risk Adjusted Capital (RORAC): Income / Allocated-risk Capital Concept is to identify some measure of return generated by a line of business and compare that return with the allocated capital. Either the income may be adjusted for risk or the capital measure may be adjusted for risk. 24

25. Which Lines of Business and Customers are Profitable? Customer Profitability Analysis Used to evaluate whether net revenue from an account meets a bank’s profit objective. General rule is that 20% of a firm’s customers contribute about 80% of profits. Objective is to identify the 20% (high value customers) and determine their needs in order to protect and promote revenue. Next level (value and average customers) represent the second biggest strategic opportunity for the firm. With low-value and high-maintenance customers the goal is to increase profitability to encourage them to find services elsewhere. 25

26. 26 Customer Profitability Analysis

27. Appropriate comparison is: If revenues exceeds expenses + target profit, account generates a return in excess of minimum required return. If revenues equals expenses + target profit, account just meets the minimum required return. If revenues exceed expenses but are less than expenses + target profits, account is profitable but does not meet the minimum required rate of return. If revenues are less than expenses, account is unprofitable. 27

28. Customer Profitability Analysis Expense Components: Noncredit services expense are obtained by multiplying cost x activity. Credit services costs include interest cost of financing loans and loan administration expenses. Business expense risk represents actual cash expenses and noncash expenses and provisions for losses. Transaction risk is the risk inherent from fraud, theft, error, computing system integrity, internal controls and delays in processing, clearing and settling payment transactions. Default is the greatest risk with respect to credit services. 28

29. Customer Profitability Analysis Revenue Components Investment Income from Deposit Balances Noninterest (Fee) Income Loan Interest 29

30. Aggregate Profitability Results From Customer Profitability Analysis Profitable customers maintain multiple relationships with the bank such as substantial loans and investment business. Unprofitable customers tend to “shop” for the lowest price or do not use multiple products. Should encourage banks to offer product bundles based on the size of the bank’s relationships. Banks who want to increase revenues should identify perceived value of services by customers and price them accordingly. 30

31. What Is The Appropriate Business Mix? Some fee income comes from relatively stable services and lines of business, while other fees are highly volatile. Deposit service charges should be balanced with fess from other lines of business or products with higher growth potential. Potential fees is the motivation behind banks’ acquiring or merging with insurance companies. Community banks do not have the same opportunities to enter investment banking and specialty intermediation. 31

32. What Is The Appropriate Business Mix? Community banks do not have the same opportunities to enter investment banking and specialty intermediation. Many work with bankers’ banks in the same area to offer services they could not offer independently. Many depository institutions offer mortgage products. Many commercial banks are offering new services such as remote deposit service and mobile banking. 32

33. What Is The Appropriate Business Mix? Some managers view volatile fees as permanent sources of income although they are not. Demonstrated by reduction in mortgage activity when interest rates increased and the stock market crash. Some banks view fee business on a transaction basis. They originate loans to distribute or sell which leads to reduced interest rates and even reduced loan standards. 33

34. What Is The Appropriate Business Mix? 34

35. Strategies for Managing Noninterest Expense Depository institutions are high-cost producers relative to money market funds and commercial paper and bond markets. Noninterest expense is too high and earnings are too low. Are there too many banks, credit unions and other financial institutions in the U.S.? If banks combined operations, expense would decrease. This has motivated much of the bank merger activity. Manage costs in line with strategic objectives. 35

36. Cost Management Strategies Expense Reduction Employee reduction, temporary workers and outsourcing Operating Efficiencies Reduce costs while maintaining the existing level of products and services Increase output but maintain current expenses Improve workflow Economies of scale exist when average costs decrease as output increases. 36

37. Revenue Enhancement Involves changing the pricing of specific products and services but maintaining a sufficiently high volume of business so that total revenue increases. Closely linked to the concept of price elasticity. Identify products with price-inelastic demand. Price increase lowers demand but the decrease in demand is less than the increase in price. Contribution growth allocates resources to best improve overall long- term profitability. 37