Thank God for Non-Interest Income

Looking at their performance over the past decade, bankers have some serious reasons to gloat. Despite dire predictions about our industry’s future, these pinstriped dinosaurs have figured out how to pump out $100+ billion(a) in annual earnings on a consistent basis. Amidst the tatters of a conflicted Wall St. and the ashes of arrogant dot.coms, banks stand strong and healthy. Since 1992, the banking industry has managed to push its efficiency ratio down from 65% to 55%. Revenue per employee has skyrocketed from $133,000 to $228,000 in the same time period. How in the world did we improve our margins so significantly? Two words: non-interest income.

Poring through a decade of FDIC statistics has helped me realize just how critical “NII” has been to our industry’s mongo profitability. Here’s why. To lower their efficiency ratio, banks basically have to grow revenue faster than expenses. Here’s what’s happened between 1992 and 2002:

• Non-interest expense grew by 5.1% annually while…
• Total revenue grew 6.75% annually.

This is a nice spread that, compounded over 10 years, has led to much higher earnings. But let’s take a closer look at where we got the revenue growth:

• Traditional net interest income has grown by only 5.25% annually, barely on pace with non-interest expense growth. Plain old loan and deposit growth has not been the major source of stronger earnings.
• Non-interest income has grown by a whompin’ stompin’ 9.6% annually or nearly twice the rate of net interest margin growth.

With this tremendous increase, non-interest income now represents 42% of the banking industry’s total revenue versus only 30% 10 years ago. This growth has come from a variety of sources.

Here are the average annual growth rates over 10 years(b) for the four NII categories that the FDIC tracks:

Growth in deposit service charges	7.60%
Growth in fiduciary income	7.75%
Growth in trading income	7.50%
Growth in “other” non-interest income	10.90%

Unfortunately, a great portion of this fee income growth sits in the infamous “other” bucket on the FDIC call reports. That big bucket now represents 65% of all non-interest income and 26% of our industry’s total revenue. It looks like the FDIC needs to expand the detail in this report so banks have more meaningful management information.

Now let’s dig a bit into that “other” category. The following table summarizes both the detailed non-interest income categories and the breakdown of the major pieces in the “other” section:

Deposit service charge income	$30 billion
Fiduciary income	$21 billion
Trading income	$14 billion
Other non-interest income	$116 billion

Memo:

Securitization income	$19 billion
ATM/debit revenue	$16 billion (est. by Gonzo)
Servicing income	$12 billion
Investment banking/brokerage	$10 billion
Gain on sale of loans	$7 billion
Insurance income	$4 billion

These categories have been the engines of bank performance improvement over the past decade. However, looking over the list, one may get a bit concerned about keeping the same pace with fee income growth in the years ahead:

1. Banks must be nearing a peak in the dubious “overdraft privilege” revolution that has pumped up deposit service charges. The rabid encouragement for consumers to bounce checks is starting to attract the attention of industry watchdog groups and regulators. Can this lever be pulled much more?
2. Fiduciary income has been impossible to grow lately because of losses in trust and investment portfolios. Here’s one dirty little secret of our industry’s NII growth: a lot of trust revenue during the ’90s came from boom-time asset appreciation – not from dramatic customer growth or product innovation.
3. ATM/debit card income should continue to see growth due to rapid increases in debit card transactions, but there is a major risk here. Gonzo estimates indicate that banks could lose as much as $2 billion in revenue if PIN-based debit transactions ever replaced the more popular signature-based transactions today. Banks are scurrying to introduce new loyalty programs for signature-based transactions while imposing fees on the consumer for PIN-based. No one knows how this will shake out.
4. Securitization, investment banking and brokerage fees will all be down heavily while an amoral Wall St. licks its wounds.
5. Gains on loan sales should peak soon for banks as the unprecedented mortgage refinance boom (finally?) starts to tire out.

So what’s next for bankers? The next few years will be about staying disciplined in our “cash cow” sources of fee income while seeking out new businesses that can help replace this revenue as it wanes. It’s clear to me that future sources of fee income will require more creativity from bankers than in the past. Here’s some key strategies I’d keep in mind:

Deposit Fees

In this category, the game will be about garnering as much fee income as the customer and market will bear. Obsessive tracking of fee income collection rates and market pricing will be vital. Stronger discipline on collecting commercial account analysis feeds needs to follow the improvement we have seen on the retail side.

Debit Cards

This is one area where banks must ensure they are exploiting all of their fee income potential. Do more than 80% of your retail checking accounts have debit cards? Are the vast majority used actively with more than eight transactions per month? These type of figures need to become religion at monthly management meetings. Finally, let’s not tick off the consumer yet another time: banks should go for signature-based loyalty programs over penalty fees for PIN-based transactions.

Wealth Management

The next few years will present a tremendous opportunity for banks to steal market share from traditional brokers and self-directed investors who bought a little too much Yahoo. Everyone is stinging from investment losses and looking for a safe, professional place to park the money that’s left. From a branding standpoint, banks should go head on with Wall St. and emphasize their Trust department’s conservative yet consistent investment performance over the past few years. In terms of innovation, it’s time for banks to get more creative with retirement and insurance services packaged specifically to their business clients. The penetration of wealth management services into a bank’s commercial loan client base is just plain abysmal.

The One-Offs

To achieve necessary levels of non-interest income growth, many banks will simply need to find their “one-off” source of income – something that is not directly related to core banking that the bank has created by building a strategic niche. Folks like State Street (custody), Synovus (credit cards), M&I (data processing), and First Tennessee (wholesale brokerage) have found their one-offs. The key for banks that haven’t yet created an independent source of fee income is to stay focused. Banks that succeed will find one major outside source of fee income and not succumb to the temptation of having 46 irons in the fire to generate new revenue. Experimentation is fine… a complete lack of focus is not.

However much the stock analysts like to abuse them, bankers have done an excellent job building fee income over the past 10 years. If bankers had only grown non-interest income at the same level as their net interest income (5.25%), industry profits would be $36 billion lower than they are today, and the average bank would be running at an ROA below 1% instead of the hefty 1.34% enjoyed right now.

Hats off, Gonzo Bankers, to a job well done! Now let’s get cracking on some tougher, non-interest income challenges in the future.
-spw

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(a) Industry figures quoted in the column refer to banks and thrifts combined. To develop an accurate picture of long-term trends, it is necessary to take into account significant merger activity between banks and thrifts.
(b) FDIC data utilized was from 12/31/92 to annualized figures from 6/30/02.