Does non-interest income boost banks’ bottom lines?

Before summarizing the study’s results, let us highlight how important this topic is for bank executives and policymakers alike. First, from a regulatory point of view, incentives for banks to rely on interest income have changed fundamentally. This is may be best illustrated by a quote of a senior bank executive in the Economist:

“Under Basel 1 (in the 1980s) banks were rewarded for being a diversified financial institution; under Basel 3, the reverse is true. You actually get penalized.”^[2]

Not surprisingly, regulators’ (knee-jerk) reaction to the 2007-2009 banking crisis has been similar to that of the Crash in 1929 and the subsequent Great Depression: Blame is to be laid on large financial institutions and their presumably risky operations outside the core (interest income-based) banking business. The result, in both cases, was an attempt to separate commercial from investment banking, laid out in the Glass-Steagall (1933) and Dodd-Frank (2010) Acts, respectively.

From a business perspective, challenges caused by the ever-changing interest rate cycle (currently arrived at an extreme caused by Zero Interest Rate Policy (ZIRP)) and innovation in financial markets seem to favor a broader footprint for financial institutions. While diversification and cross-selling has a mixed track record in banking, universal banks have for the longest time proven to be quite resistant to exogenous shocks. Many victims of the financial market crisis, on the other hand, have not been universal banks (Bear Stearns, Countrywide, Fannie Mae & Freddy Mac, Merrill Lynch, Lehman Brothers etc.).

The study, which is based on a sample of 368,006 quarterly observations on 10,341 US banks during the period 2002-2012, offers some striking results: In all three market regimes, covering the pre-crisis, the crisis, and the post-crisis period, banks with a higher reliance on non-interest income exhibited a higher profitability. On top of that, a higher fraction on non-interest income does not imply higher risk of insolvency. This risk-return profile, as it is implied by the study, surely must seem counterintuitive to many policymakers in favor of “ring-fencing” core banking.

The study offers an excellent starting point, potentially to be extended into multiple directions. To name a few: Incorporating European banks would be useful to determine whether results have been screwed by idiosyncrasies of the US banking industry and the US market regime; more work on the impact of components of non-interest income (proprietary trading, various forms of fee income etc.) would furthermore help to compare and contrast competing business models in banking; regulatory fines and reputational damage could be (more explicitly) worked into the analysis.