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How do banks make money?
The fallacies of fee income

By Robert DeYoung and Tara Rice

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Introduction and summary

"How do banks make money?" is a deceivingly simple question. Banks make money by charging interest on loans, of course. In fact, there used to be a standard, tongue-in-cheek answer to this question: According to the "3-6-3 rule," bankers paid a 3 percent rate of interest on deposits, charged a 6 percent rate of interest on loans, and then headed to the golf course at 3 o'clock.

Like most good jokes, the 3-6-3 rule mixes a grain of truth with a highly simplified view of reality. To be sure, the interest margin banks earn by intermediating between depositors and borrowers continues to be the primary source of profits for most banking companies. But banks also earn substantial amounts of noninterest income by charging their customers fees in exchange for a variety of financial services. Many of these financial services are traditional banking services: transaction services like checking and cash management; safe-keeping services like insured deposit accounts and safety deposit boxes; investment services like trust accounts and long-run certificates of deposit (CDs); and insurance services like annuity contracts. In other traditional areas of banking, such as consumer lending and retail payments, the widespread application of new financial processes and pricing methods is generating increased amounts of fee income for many banks. And in recent years, banking companies have taken advantage of deregulation to generate substantial amounts of noninterest income from nontraditional activities like investment banking, securities brokerage, insurance agency and underwriting, and mutual fund sales.

Remarkably, noninterest income now accounts for nearly half of all operating income generated by U.S. commercial banks. As illustrated in figure 1, fee income has more than doubled as a share of commercial bank operating income since the early 1980s.

This shift has been larger than most industry experts expected, and we have only recently begun to understand the implications of this shift for the financial performance of banking companies. Only a handful of systematic academic studies have been completed thus far, and those studies have tended to contradict the conventional industry beliefs about noninterest income. Many in the banking industry continue to discount, underestimate, or simply misunderstand the manner in which increased noninterest income has affected the financial performance of banking companies.

This article documents the dramatic increase in noninterest income at U.S. banking companies during the past two decades, the myriad forces that have driven this increase, and the somewhat surprising implications of these changes for the financial performance of commercial banks. We pay special attention to two fundamental misunderstandings about noninterest income at commercial banks. The first is the belief that noninterest income and fee income are more stable than interest-based income. We review the most recent evidence from academic studies that strongly suggest, contrary to the original expectations of many, that increased reliance on fee-based activities tends to increase rather than decrease the volatility of banks' earnings streams. The second misunderstanding is the belief that banks earn noninterest income chiefly from nontraditional, nonbanking activities. We perform some calculations of our own and demonstrate that payment services, one of the most traditional of all banking services, remain the single largest source of noninterest income at most U.S. banking companies.

This is the first of two articles in this issue of Economic Perspectives that examine "how banks make money." The companion piece that follows describes the wide diversity of business strategies being used by commercial banking companies, some of which rely disproportionately on activities that generate noninterest income, and compares and contrasts the risk-return profiles of banking companies that employ those strategies.

Noninterest income, deregulation, and technological change

Banks earn noninterest income by producing both traditional banking services and nontraditional financial services. In fact, even before deregulation provided banks with increased opportunities to sell nontraditional fee-based services (say, in the mid-1980s), noninterest income already represented about $1 out of $4 of operating income generated by commercial banks. And the dramatic increase in noninterest income at U.S. banking companies over the past two decades reflects not only a diversification of banks into nontraditional activities, but also a shift in the way banks earn money from their traditional banking activities.

Table 1 organizes selected fee-generating activities into two groups: traditional activities that have always been provided by commercial banks and nontraditional financial services that banks have only recently begun to provide. (This is a selected list of activities for illustrative purposes only and is not meant to cover all fee-based activities.)

The first column in table 1 would have been empty for the years prior to the deregulation of the financial industry. Deregulation opened the door for commercial banks to earn fee income from investment banking, merchant banking, insurance agency, securities brokerage, and other nontraditional financial services. The key deregulation was the Gramm, Leach, Bliley (GLB) Act of 1999, which created a financial holding company (FHC) framework that allowed common ownership of, and formal affiliation between, banking and nonbanking activities. Although GLB was the "big bang" that eliminated most of the Glass, Steagall Act (1933) prohibitions on mixing commercial banking and other financial services, partial deregulation had occurred during the 1980s and 1990s. In the late 1980s the Federal Reserve allowed commercial banks to set up investment banking subsidiaries with limited underwriting powers, and in the mid-1990s the Office of the Comptroller of the Currency granted national banks the power to sell insurance from offices in small towns.

The fees generated by these new, nontraditional activities are uneven across banking companies. On the one hand, investment banking has been a natural addition to the product lines of large banking companies that have large corporate clients. On the other hand, insurance agency has been a good fit for banking companies of all sizes that wish to cross-sell new financial services to their retail (household) clients.

In contrast, the fee-generating activities listed in the second column of table 1 are very traditional banking activities. Banks have always earned noninterest income from their depositors, charging fees on a variety of transaction services (for example, checking and money orders), safe-keeping services (for example, insured deposit accounts, safety deposit boxes), and cash management services (for example, lock box or payroll processing). Other traditional lines of business for which banks have always earned fee income include trust services provided to a wealthy retail clientele and providing letters of credit (as opposed to immediate dispersal of loan funds) to corporate clients.

In recent years, advances in information, communications, and financial technologies have allowed banks to produce many of their traditional services more efficiently. These efficiencies not only reduced per unit costs, enhanced service quality, and increased customer convenience, but also represented a source of increased fee income for banks. Some examples are displayed in the third column of table 1. Advances in credit-scoring models and asset-backed securities markets have transformed the production of consumer credit and home mortgages from a traditional portfolio lending process, where banks earn mostly interest income, to a transaction lending process, in which banks earn mostly noninterest income (for example, loan origination fees and loan servicing fees). Advances in communications and information technologies have led to new production processes for transactions and liquidity services, such as ATMs (automated teller machines) and online bill-pay, and deposit customers have been willing to pay fees for these conveniences. (The phase out of Regulation Q ceilings on deposit interest rates assisted banks in this regard, allowing them to price depositor services in a more rational and competitive fashion.)

Similar to the noninterest income generated by nontraditional activities, the fee income derived by these new production methods is uneven across banking companies. Securitized lending processes generate significant scale economies, and as a result fee income from securitized consumer and mortgage lending has flowed predominantly (though not completely) to large banking companies. In contrast, the scaleable technologies necessary to produce ATM and Internet banking services are accessible to even relatively small banks.

Financial statement data

Taking advantage of the highly detailed financial statements that commercial banks and bank holding companies provide to their regulators, we collected data for established U.S. banking companies in 1986, 1990, 1995, 2000, and 2003. This multi-year, multi-company dataset allows us to observe how business strategies differ across banking companies in a given year and how banking strategies have changed over the past two decades as regulatory, technological, and competitive conditions have changed.1 For the purpose of our analysis, an "established banking company" is either an independent commercial bank that is at least ten years old or a bank holding company (BHC) or financial holding company (FHC) that controls one or more commercial banks that are on average at least ten years old. These categories of banking companies are inclusive of all mature U.S. commercial bank charters and, as such, they include banking companies of all sizes, from small, independently organized community banks to large financial holding companies, that operate using a diverse array of banking business strategies.

We approach these data somewhat differently than most financial analyses of the commercial banking industry. First, we pay as much attention to bank income statements as we do to bank balance sheets. Financial analysis of commercial banks often concentrates on bank balance sheets, which display the most direct evidence of banks' traditional intermediation activities between depositors and borrowers. (Deposits are the largest single item on the liability side of most banks' balance sheets, and loans are the largest single item on the asset side of most banks' balance sheets.) But balance sheets have become an increasingly incomplete records of banks' profit-generating activities; they convey very little information about the fee-based activities that now generate over 40 percent of total operating income in the banking industry.

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Robert DeYoung is a senior economist and economic advisor and Tara Rice is an economist in the Economic Research Department of the Federal Reserve Bank of Chicago. The authors thank Carrie Jankowski and Ian Dew-Becker for excellent research assistance and Bob Chakravorti, Cindy Bordelon, and Craig Furfine for helpful comments.