The rapid expansion of new forms of off-balance sheet activity means many banks are diversifying, and as a result, non-interest income is an increasingly important source of revenue. The ratios of net interest income and net non-interest income to gross income, for the period 1990–99, are shown in Figures. Looking at the averages for the
Ratio of net interest income to gross income.
Ratio of non-interest income to gross income.
period, for most countries, at least two-thirds of banks’ gross income comes from net interest income. Notable exceptions are Japan, where, on average, 97% of income comes from net interest income, and at the other extreme, Switzerland, where net interest income makes up only 45% of gross income. In all countries except Japan, the ratio fell over the decade, as it had in the 1980s.
As Figure above shows, the opposite is true of non-interest income, except for Japan. Japan’s ratio was highly volatile through the period, reflecting the decline in share values for Japanese banks holding substantial amounts of equity. These dramatic changes explain why non-interest income is such a tiny proportion of gross income. In other countries, about one-third of gross income comes from non-interest income. There are exceptions: in Switzerland it is 55%, and about 19% in Denmark. Thus, there is a slow but steady shift towards non-interest sources of income in most countries, reflecting increased diversification as interest margins on traditional banking products narrow, and banks seek new sources of revenue.
Davis and Touri (2000) look at the changing pattern of banks’ income for EU countries and the USA. They report a decline in the ratio of net interest income to non-interest income for EU states, from 2.9 in 1984–87 to 2.3 in 1992–95. The respective figures for the USA are from 2.6 to 1.8. Italy is the main exception, where the ratio of net interest to non-interest income rises from 2.9 in 1984–87 to 3.7 in 1992–95. However, the source of the non-interest income varies, when it is divided into fees and commissions, profit and loss from financial operations and ‘‘other’’. In the USA and UK, the main source (in 1995) is fees and commission. For France, Italy and Austria, the ‘‘other income’’ source of non-interest income is roughly as important as fees and commissions. Denmark is the only country where profit and loss from financial operations is a key source of non-interest income.
An important question is whether the diversification implied by the growth of noninterest income has made banks’ total income more stable, which it should be if the correlation between the two types of income sources is negative. In a recent paper, Wood and Staikouras (2004) consider this issue for EU banks. They reviewed numerous studies based on US data and concluded that they produce mixed findings. For example, Gallo et al. (1996) found profitability increased in those banks with a high proportion of mutual fund assets managed relative to total assets. Other studies showed diversification increased profit stability.
Sinkey and Nash (1993) showed that specialising in credit card lending (often generating fee income through securitisation) gave rise to higher but more volatile income compared to banks undertaking more conventional activities. According to Demsetz and Strahan (1995), even though bank holding companies tend to diversify as they get larger, this does not necessarily reduce risk because these firms shift into riskier activities and are more highly leveraged. Lower capital ratios, larger loan portfolios (especially in the corporate sector) and the greater use of derivatives offset the potential gains from diversification. De Young and Roland (1999) reported that as banks shift towards more fee-earning activities, the volatility of revenues, earnings and leverage increases.
Staikouras and Wood (2001) looked at a large ‘‘balanced’’ sample of 2655 EU credit institutions for the period 1994–98. It excludes ‘‘births and deaths’’ and any bank that does not report data for the whole period. A larger unbalanced sample includes these other banks, and runs for the period 1992–99, with gaps in some data. Data are from commercial banks, savings banks, coops and mortgage banks (UK building societies).
The authors found the composition of non-interest income to be heterogeneous, consisting of the following.
The authors reported non-interest income has increased in relative importance compared to interest income. With few exceptions, throughout the period 1994–98 there is a decrease in the level of interest income as a percentage of total assets, with a corresponding increase in non-interest income. They found the proportionate increase in non-interest income corresponded with a decline in profitability, suggesting the growth in non-interest income sources did not offset the fall in the net interest margin, and/or operating costs for the new activities were higher.
Using measures of standard deviation, Staikouras and Wood (2001) show that through the 1990s the variability of non-interest income increases. In Germany and France, noninterest income was found to be more volatile (measured by standard deviation, SD) than net interest income, but this did not appear to be the case for the other countries: Austria, Belgium, Denmark, Finland, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden and the UK. However, using the coefficient of variation,20 the variability of non-interest income is almost always larger than that for net interest income.
For several countries, a positive correlation between interest and non-interest income was found, suggesting that income diversification may not result from expanding into non-interest income activities. The combined findings of a higher correlation between the two income sources, the rise in the proportion of non-interest income and the greater volatility of non-interest income suggests the diversification may have increased the overall variability of EU banks’ income.
Overall, the increased emphasis on non-interest income means the operational and strategic risks of the banks will increase. Their findings support the view that there should be specific capital requirements for several categories of risk, not just credit and market risks.
Using return on equity (ROE) as the measure of profitability, Davis and Tuori (2000) show that for the EU, average bank ROE declined between 1984–87 and 1992–97, from 0.15 to 0.08. The UK bucks the EU trend (rising from 0.18 to 0.21) and ROE rises in the USA, from 0.11 to 0.20. Thus, in a period where the ratio of non-interest income to income rose, profitability has declined – the UK and the USA being notable exceptions.
Davis and Touri report a negative correlation between interest and non-interest income for Germany, France, Greece and Luxembourg. For banks in these countries, it appears that diversification into non-interest income sources should help banks in periods when margins are narrow. For example, in a regime of falling interest rates, when margins tend to narrow, banks in these countries could expect to sustain profitability by selling bonds and other assets. French and German banks have substantial shareholdings in non-financial commercial concerns, and falling interest rates (when margins tend to narrow) are often associated with rising equity prices. For the EU as a whole, the correlation is positive (0.08), as it is for the UK (0.45) and USA (0.5). A correlation close to 0.5 is consistent with the Staikouras and Wood finding: diversification may well be associated with an increase in the volatility of banks’ income and profits.
Econometric work by Davis and Tuori showed that for the USA, UK, Germany, Spain, Italy and Denmark, and the EU as a whole, the larger the bank, the more dependent it is on non-interest income. They also find a strong positive relation between non-interest income and the ratio of cost to income. The positive relationship is likely explained by the need for more highly trained, costly staff to generate non-interest income, compared to the traditional core activities.
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