Fee Versus Interest Income: Finding the Right Mix

This is a chapter in a book I helped boutique investment banker Cohen Bros. & Company create. The Cohen family has a notable heritage in banking and financial services, and with this work they wanted to formalize some of their thinking and observations on banking gleaned over the years.

Cohen Bros. & Company

Present Value: Essays on Community Banking, Winter, 2005

In July 1960, marketing prophet and Harvard Business School professor Theodore Levitt wrote a groundbreaking article entitled “Marketing Myopia.” In his commentary, he urged leaders of industry to understand precisely what utility they brought to their customers. He took the railroad industry to task for simply running trains and failing to see that they were really in the transportation business. (Interestingly, just one year earlier, President Dwight D. Eisenhower launched the Interstate Highway program, which ultimately would do in the railroads, no matter how they thought about themselves.)

Like Cleopatra’s face, which launched a thousand ships on a whim, Levitt’s ideas launched a multitude of business leaders on a mission to diversify their businesses to the ultimate boundaries of their industry classifications. Suddenly, hotels were in the hospitality industry, sports franchises entered the pantheon of the entertainment industry, sporting goods manufacturers became part of the leisure market, and even Big Blue, once a purveyor of “big steel” mainframe computers, morphed into a so-called “solutions provider.”

It took some time -– perhaps 30 years -– but banks became card-carrying members of the financial services industry. Today, one end of the spectrum is occupied by Citigroup, a true financial services behemoth offering global corporate banking, investment banking, retail banking, insurance and retail brokerage. At the other end, there are a multitude of thrifts just now getting comfortable with business lending. In the middle is a large percentage of the banking industry that diversified into wealth management, insurance, trust services and loan commitments, or simply began to focus more intently on the service fees offered by their deposit franchise.

Today, noninterest revenue is a material part of the income statements of most banks. As Figure XXX shows, over the past 20 years noninterest income has gone from just over 7 percent of total revenues -– an amount on the lower rungs of materiality –- to more than 32 percent today. This begs an important question: For a bank, what is the optimal mix between interest and noninterest income?

The answer not as clear as the question. In fact, there is no single answer per se, but there are some ranges. For instance, once noninterest income goes north of 30 percent, many investors can and should begin to look carefully at this tranche of revenue for higher than acceptable levels of risk. When it is below 10 percent, investors can reasonably question whether or not management is capitalizing on the low-hanging –- and very high-margin — fruit that their deposit and customer franchise offers in the form of overdraft protection, ATM charges and service fees.

Beyond these boundaries, the best practice in terms of the right mix between fee and interest income is very subjective. Specifically, it depends largely on the management team and partially on geography.

The geography question is easy to dispatch. Many areas of the country, particularly rural ones, will simply not support a large-fee business. There are fewer assets to manage, less property to be insured, and sensitivity to fees. At the same time, while metropolitan regions offer markets for fee- as well as interest-income business, competition in loan markets is stiff. Larger banks with more sophisticated liability management tools at their disposal can offer loan pricing that smaller players find hard to compete with.

How do the opportunities and constraints of geography play out in terms of best practices? Ultimately, they speak to the credibility of management’s strategic plan for growing the bank and delivering a competitive return on equity. Specifically, claims that either loan growth or fee income “will drive our business forward” need to be carefully evaluated in terms of what the bank’s geography has to offer these businesses.

The question as to why a best practice exists at all with respect to the balance between fee and interest income owes its genesis to conventional wisdom and its seemingly inaccurate assessment of the benefits that fee revenue confers on a bank’s income statement.

Specifically, the conventional wisdom in the banking business was that noninterest income — from such items as fees on loan commitments, wealth management and insurance brokerage services and, for larger banks, investment banking and capital markets services — would help dampen the earnings volatility that was part and parcel of an interest-rate-dependent loan business.

Rigorous analytical studies and the experience of several banks appear to refute this thinking. For instance, a 2002 study of aggregate banking data by Federal Reserve research officer Kevin Stiroh, entitled “Is Noninterest Income the Answer?”, found that noninterest income was in fact more volatile than traditional net-interest income. There are several reasons for this apparent contradiction. First, aggregate data is disproportionately influenced by trading and investment banking revenues, which are generated with some degree of scale at large regional, superregional and money center banks.

A quick look at some well-known banks would seem to bear this out. For instance, after Fleet bought BankBoston Corp., it saw its noninterest income fluctuate dramatically due in no small part to BankBoston’s earlier -– and disastrous — acquisition of San Francisco-based investment bank Robertson Stephens.

The following data depicts the variance in Fleet’s fee revenues.

Fleet: Fee Income by Year in $Billions
2002 $5,036
2001 $4,555
2000 $7,559
1999 $6,091
1998 $5,303

Likewise, Bank of America experienced fluctuation in its fee business, losing more than $1 billion in noninterest income between 2000 and 2002.

Bank of America: Fee Income by Year in $Billions
2002 $13,571
2001 $14,348
2000 $14,582
1999 $14,179
1998 $12,189

According to Stiroh’s study, the inflection point at which noninterest revenue ceases to diversify risk and, in fact, adds to it occurs when interest income and noninterest income are positively correlated. When this occurs, banks with higher noninterest income tend to have lower profitability per unit of risk.

This is the ugly side of synergy. Cross selling is fine, but simply selling more products to the same customers does not necessarily lead to the promised diversification benefits. In fact, it concentrates exposure to firm, industry and lending-market troubles. Figure #XXX dramatically illustrates just how volatile noninterest income is; the volatility appears to be greatest for banks that are engaged in securities trading.

The way in which a concentration of interest and noninterest revenue among customers increases risk offers a potent clue about the best practices for banks and depositories when it comes to fee income: the independence of its business units.

As a case in point, consider Winston-Salem-based regional powerhouse BB&T Corp. First opening in eastern North Carolina as a sleepy banking institution known as Branch Banking & Trust, BB&T aggressively built its fee business. In the process, it created the sixth-largest insurance agency in the United States with customer premiums of nearly $5.5 billion annually.

What was critical to this success? The freedom and independence that senior management gave to BB&T insurance executives to run and grow the business according to the dictates of the industry, not the bank per se. While BB&T is firmly entrenched in Georgia, the Carolinas, Virginia, Maryland, and eastern Kentucky and Tennessee, the insurance business is going national. “We realized that to continue to grow -– a must in our business –- it was time to look outside our footprint,” said BB&T chief operating officer Henry Williamson.

Independence cannot win the day in and of itself, however. For success, it appears that the officers of the subsidiaries also need to have a significant amount of management experience.

The conventional wisdom has always been that a vast preponderance of fee business naturally flows from corporate and retail customers. From this idea sometimes comes a well-meaning but often disastrous idea: Since the new wealth management, or insurance business, will be comprised of existing customers, a bank executive on staff can launch and manage the enterprise. This is the wrong approach. There is no substitute for experience.

Support for this notion comes from the very existence of the vibrant third-party brokerage business built by Linsco/Private Ledger (LPL Financial Services), one of the nation’s largest providers of turnkey brokerage solutions for community and regional banks. Linsco thrives precisely because many well-run banks recognize the management issues associated with fee-based businesses.

Specifically, the retail stock brokerage business was deemed so complex that only superregional and money center banks could afford to buy their way into the business or bring on the kind of Wall Street talent that was required to make a reasonable run at the securities business. But even this recruiting strategy can backfire — as Mellon Bank would attest -– having witnessed a brain drain after it acquired Dreyfus, an institutional money management and mutual fund business.

Finally, as banks enter new businesses, they should buy existing franchises, not build their loan and deposit business on a de novo basis. Although building de novo is an accepted and established practice, there’s no overlooking the fact that it’s a long and evolutionary process.

While there are merits to building fee businesses gradually, their scale — in terms of the ability to make an impact on a bank’s income statement — requires a jump-start at the beginning. Remember, while interest on loans is generally a multiple of interest expense, many fee-based businesses are measured as basis points of assets under management or policies in force. With a base business in place, the institution can make the required cultural shifts and build on the book of business that’s already in-house.

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