Most managers and analysts believe that over time financial firms will rely less on net interest income and more on noninterest income to increase profitability
Today, a fundamental issue for managers is how to determine the appropiate customer mix and business mix that will grow profits at high rate.
Factors that led to a decrease of NIM since 1992:
Where there is profit, competition follows
Glass Steagall and Regulation Q
Designed to limit competition and promote a safer banking system
Many customers moved funds out of the FDIC-insured deposits, which started to significantly erode the market share of depository institutions
The 1990s represented a period of deregulation as well as innovation for nondepository institutions to enter the banking business
Commercial banks and customers of savings institutions routinely excercised their implicit "option" to refinance their loans. When interest rate fell,loan customers refinanced at lower rates, which thereby loweted the yields that the banks charged
Sources of NIM
Deposit of service charge
Trading revenue, venture capital reenue, and securitization income
Investment banking, advisory, brokerage, and underwriting fess and commission
Insurance commission fees and income
Net servicing fees
Net gains (losses) on sales of loans
Other net gains (losses)
Deposit service charges
Checking acct fees
Net servicing fees
Servicing real estate morgages, credit cards, etc.
safe deposit boxes, sale of bank drafts, money-orders, letters of credit, notarizing, penalties on C.D.'s, etc...
The biggest contributor to Noninterst income are deposit service chargers and other noninterest income regardless of size
While all depository institutions are focusing on increasing their noninterest income, the largest institutions rely much more on this source of revenue than smaller depository institutions, whcih still rely more heavily on net interest income
Income from investing banking=volatile
Large financial institutions generally price services differently than smaller institutions do. According to the results of the 1999 and 2002 studies of the Annual Report to the Congress on Retail Fees and Services of Depository Instituions, on average, LARGE COMMERCIAL BANKS CHARGED HIGHER FEES AND HAD HIGHER MINIMUM BALANCE REQUIREMENTS than did smaller commercial banks just about all noninterest income products
The avg. NSF charge in 2002 was more than $6 hihger per item at large banks at just over $26 versus $20 at smaller institutions
Deposit services fees
Change over times
Deposit service fees facts
1. Banks are unbundling their products and now charge fees for individual services rather than offering many "free services"
2. Competition has lowered the basic monthly fees for checking accounts while those for NSF and overdraft charges, as well as ATM fees are increasing
3. Banks systematically raise fees annually
source of earnings growth
In market merger
the two firms have signficant duplication of banking offices and services such that any merger leads to the elmination of branches personnel. COST SAVINGS
Components of bank's Noninterst expneses
Other intangible amortization
Rent and depreciation
Amort. from impaired goodwill
Amortization expense and imperment losses for other intangible assest
Burden/Net overhead expense
Burden=noninterst expense-noninterst income
Net noninterest margin=burden/Avg. total assets
The smaller a bank's vurden and net overhaead, the better a bank has performed
Measures the amount of noninterst expense paid to earn one dollar of net operating revenue. Lower=more efficient
Efficient ratio=Noninterest expense/ Net interest income + noninterest income
Lower efficient ratios are derived from:
A combination of cost control (cost cutting)
Improvements of noninterest income
Abilit to grow NIM or slow its decline
"You must spend money to make money"
Criticisms of efficiency ratios
1. Does not take into account a bank's mix of businesses
2. Not directly teid to a bank's target return of shareholders
Operating risk ratio
the lower, the better bank's operating performance because it generates proportionately more of its revenues from noninterest income or fees, which are more stable and thus more valuable.
Operating risk ratio= [noninterst expense-noninterest income(fees) ]/ Net interest margin
Asses wheter they are getting the maximum use of employees and capital. Higher number is goodl
Assets per employee=avg assets/number of fulltime employess
Average personnel expense=personel expense/ number of full time employees
Dollar amounts of loans per employee= average loans (dollars)/ number of full tiem employees
Net income per employee=NI/Number of full time employees
Today many large banks evaluate line-of-busines profitability and risk via:
RAROC or RORAC systems
Ris adjsuted return on capital.
RAROC= Risk adjusted income/capital
Return on risk adjusted capital
RORAC= Income/allocated-risk capital
Gral customer profitability rule
20% of a firm's customers contribut about 80% of overall profits
Acct revenues >=<acct expenses+targetprofit
If revenues exceed the sum of expenses and profit, the acct generates a return in excess of the minimum return required by the bank
If they are equl, the account just meets the required return objective
If revenues fall short the acount is unprofitable
High Value Customers ("A" clients)
Value Customers ("B" clients)
Average Customers ("B" clients)
Low Value Customers ("C" clients)
High Maintenance Customers ("C" clients)
Business risk expenses
Check processing expenses are the major noncredit cost item for commercial customers
represent the largest expese and are related to the size and type of loan. inclued the const of financing the lona as well as loan admin expenses.
Loan admin expense
cost of a lona's credit analysis and execution
Business risk expense
Transaction risk=the larges single risk with respect to noncredit services
Default risk=the largest single risk with respect to credit services
the current and prospective risk intherent in transactions from fraud;theft; error;integrity of computing systems
Investment income from deposit balances
Fee income from services
Investment income from deposit balances
Result of every deposit that customers hold
Financial firms increasingly rely on noninterest income to supplement earnings
The primary revenue source in a vast majority of financial institutions, as loans are the dominant asset in their portofolios
Difference bw profitable and unprofitable accoutns
Profitable customers maintain multiple rlationships with the financial institution, such as substantial loan and investment business.
Unprofitabe customers tend to go where they get the best proce or do not use multiple products
To increase noninterst income, financial firms should attempt to make unprofitable customers profitable by providing them with incentives to buy more services or buy a package of services that meet their wants and needs
Most customers are not profitable.
Pricing by profit need - not by tradition.
Profitability analysis and predicting "next product" is not easy.
General concept: Allocate resources to the most profitable lines of business.
Cost management strategies
Operating efficiencies achieved by: (increasing productivity)
Reducing costs but maintaining the existing level of products and services
Increasing the level of output but maintaining the level of current expenses
Economies of scale
Exist when avg costs decrease as output increase
Economies of scope
Focus on how to join costs of providing several products change as new products are added or existing products output is enhanced
Involves changing the pricing of specific cproducts and services (price elasticity) but maintaining a sufficently high volume of business so that total revenues increase.
Management allocates resources to best improve overall long term profitability