Managing Noninterest Income and Non-interest Expense
1. Introduce financial ratios that characterize a bank’s ability to generate noninterest income and
control noninterest expense.
2. Document the sources of bank noninterest income.
3. Explain the significance of the efficiency ratio and operating risk ratio.
4. Explain the importance of knowing which customers are profitable.
5. Describe the link between business mix and fee income.
6. Describe various strategies to manage noninterest expense.
1. 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 noninterest income and expense controls.
2. The bulk of bank noninterest 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.
3. Bankers and analysts typically measure performance over time and versus peer banks via their burden,
noninterest expense minus noninterest income, the net overhead expense equal to the burden as a
fraction of total assets, and the efficiency ratio, equal to noninterest expense divided by the sum of net
interest income and noninterest income. In each case, better performance is indicated by a smaller
figure or percentage.
4. 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.
5. 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 costed. Such figures support the increase in fees
assessed by most banks over the past few years.
6. 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.
One of the most significant trends in bank performance over the past 10 years is the increasing reliance on noninterest income versus net interest income. It is important to motivate the discussion of noninterest income and noninterest expense by documenting the flat or declining net interest margins at most banks during the latter 1990s and early 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 noninterest 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.
Spend time discussing the key financial ratios that measure a bank’s ability to generate noninterest income
and control expenses. Examine changes in bank’s burden over time and versus peers. Use the UBPR data for PNC Bank 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 5-8 pages of the 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 PNC’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 noninterest 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.
The Contemporary Issues segment on the merger of Chemical Bank and Manufacturers Hanover indicates that 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 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 funds.
Answers to End of Chapter Questions
1. Unmonitored expenses can become excessively high. If a bank has not had a plan to control expenses,
then cost cutting is appropriate and will help the bank be more competitive. Often times cost cutting
simply means letting people go. However, such expense cuts can adversely affect the bank’s ability to
provide service and compete. Managers should approach cost cutting with operating efficiencies in
mind, selecting expenses that will lower the average cost of providing services. In some cases, banks
will have to invest in new technologies to improve productivity as an alternative to simple cost cutting.
2. The primary sources of noninterest income for a community bank are generally deposit fees, trust fees,
mortgage fees, fees and commissions and fees from insurance produces, credit card fees and investment
product fees. The primary sources of noninterest income for large Global, Nationwide, and Super
Regional Banks are deposit fees, investment banking fees, asset management fees, mortgage servicing
fees, and trading profits.
3. Noninterest expense consists of personnel expense, occupancy expense (including rent and
depreciation), and other expense for supplies, deposit insurance, etc.
4. The efficiency ratio is measured as noninterest expense divided by the sum of net interest income and
noninterest income (total operating revenue). As such, it measures how much it costs in overhead to
generate $1 of revenue. A lower figure indicates that a bank is more efficient because it takes less
overhead to produce $1 of revenue. It may not be a meaningful measure because it provided no information regarding whether a specific expenditure is appropriate. Specifically, if an expenditure won’t produce revenue for several years, it may increase the efficiency ratio suggesting that it is not
appropriate, when actual savings or revenue generated is delayed and the expenditure might be an attractive one.
5. The assets per employee ratio suggests that Pacific Rail Bank (PRB) is more productive because it can manage more assets per employee. Of course, this ratio ignores the volume of a bank’s off-balance
sheet activity. The average personnel expense ratio indicates that Pacific Rail Bank pays its employees more, on average, that Tri-Cities Bank. This may indicate high cost – and hence lower productivity –
but it may also reflect the fact that PRB simply pays its people more because they are more productive. Many high performance banks have the profile that PRB has with these ratios.
6. Recommendations: i) identify which accounts are unprofitable and which products or services are most commonly used by these individuals; reprice these accounts to encourage individuals to bundle their products and services to avoid charges; ii) increase minimum deposit balances for customers to avoid service charges, while maintaining access to the most basic banking services at reasonably low cost; iii) offer accounts with minimum fees and balances as long as the customer agrees not to enter the bank or branch and thus conducts all business electronically.
7. Fees/service charges
a. Bank must pay an interchange fee to the owner of the ATM and wants to encourage customers to use
the bank’s ATMs; customer should use ATM of the bank for which he/she is a customer.
b. It costs more to serve a customer with a live teller versus electronically. The pricing is an incentive
for individuals to use electronic delivery systems. Customers should become comfortable banking by
phone or ATM.
c. Banks know that the demand for this is price inelastic. Any increase in price thus increases total
revenue. Customers should avoid these overdrafts to the extent possible.
d. An origination fee covers the cost of making the loan and perhaps the prepayment option that the bank
has sold the customer. Most customers will pay the fee unless competition doesn’t require it.
8. Online brokerage accounts are becoming increasingly popular and represent an alternative delivery vehicle for banking services. Most banks will need to provide access to banking services over the internet to keep many of their customers. Whether banks offer online brokerage accounts depends on the costs and benefits to the bank’s customers. Clearly, markets are headed toward where more customers are demanding this type of access.
9. Expense reduction: strength is the immediate impact as costs decline; weaknesses include the loss of employee and customer morale and making cuts that lower service quality. Revenue enhancement:
strength is that revenues grow without cutting the range of products and services offered; weakness is that it is difficult to implement in the near term and their may not be an immediate improvement in burden or the efficiency ratio. Contribution growth: strength is that this is the best long-term strategy
as service quality improves and employee/customer morale is unchanged; weakness is that it is a long-term strategy with no immediate payoff.
10. Detail Labs and The Right Stuff
a. The bank should sell credit-related services to Detail Labs and its principals. Perhaps credit and
debit cards might serve as the relationship medium. The principals might also want cash management
services for the business to help the firm best use its cash. The bank should sell noncredit services to
The Right Stuff, including cash management services, trust services, etc. because the principals are
likely not in the borrowing stage of their business or personal lives.
b. If profits come from loans, the bank must ensure that the loans are priced at a reasonable spread
over the matched maturity (duration) cost of funds. Additional products and services might be tied to
those required by borrowers. If profits come from the deposit processing side or investment services
side, loans might be used as a way to maintain the account relationship with profits coming from fees.
When bank managers decide to reduce their efficiency ratios, they often implement a combination of strategies designed to control costs and generate additional revenue. One approach is to pare down the list of products and services offered to control costs, choosing the ones that are the most profitable and part of the bank’s core competency. Such a bank will centralize purchasing to take advantage of discounts, when available, and will simultaneously limit the discretionary expenditures of officers and employees. In essence, the bank cuts back or defers certain expenditures. Another approach is to aggressively search out new revenues. Many banks react by raising fees and service charges. They no longer waive charges recognizing that they may lose some business. They may also consciously drive unprofitable customers out of the bank by the higher fees. Some banks sell high cost (low RORAC) lines of business.
Bank stock analysts have a history of influencing managers to adjust strategies in line with analyst recommendations. A common criticism is that managers focus too much on short-term earnings targets, for example, the quarterly earnings per share (EPS) estimate that analysts provide to investors. In 2001-2002, the analyst community, in general, fell under increased scrutiny as many analysts were accused of providing favorable commentary and ratings on the stocks of companies for which the analysts’ employers (investment banks) provided investment banking services. This produced legislation and regulatory scrutiny on whether analyst reports were truly independent of the employers’ investment banking business. Still, the entire process of analysts covering a stock in order to make buy or sell recommendations typically induces most managers to spend too much time on meeting quarterly earnings estimates instead of focusing on longer-term strategic planning to achieve a competitive advantage.