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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

Fiduciary activities
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)
Other NIM

Fiduciary Activities

Trust department

Deposit service charges

Checking acct fees

Net servicing fees

Servicing real estate morgages, credit cards, etc.

Other NIM

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

Cost cutting

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

Goodwill impairment
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

Efficiency ratio

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

Efficiency ratio

"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

Productivity Ratios

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

Customer profitability

High Value Customers ("A" clients)
Value Customers ("B" clients)
Average Customers ("B" clients)
Low Value Customers ("C" clients)
High Maintenance Customers ("C" clients)

Expense Components

Noncredit services
Credit services
Business risk expenses

Noncredit services

Check processing expenses are the major noncredit cost item for commercial customers

Credit services

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

Transaction risk

the current and prospective risk intherent in transactions from fraud;theft; error;integrity of computing systems

Revenue Components

Investment income from deposit balances
Fee income from services
Loan interest

Investment income from deposit balances

Result of every deposit that customers hold

Fee income

Financial firms increasingly rely on noninterest income to supplement earnings

Loan interest

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


Profitability analysis

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

Expense reduction
Operating efficiencies

Expense reduction


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
Improving workflow

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

Revenue enhancement

Involves changing the pricing of specific cproducts and services (price elasticity) but maintaining a sufficently high volume of business so that total revenues increase.

Contribution gorwht

Management allocates resources to best improve overall long term profitability

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