Copyright © 2000 by Harcourt, Inc. All rights reserved. 9-1 Chapter 9 Managing Nointerest Revenues...

Copyright © 2000 by Harcourt, Inc. All rights reserved.

9-1

Chapter 9Managing Nointerest Revenues and

Associated Risks


9-2

Why fee income businesses?

They represent ways to increase competitiveness.

They help replace lost market share in traditional banking.

They provide a diverse source of income. They help create consistent earnings. They require a small capital investment.


9-3

Illustration:National City Bank Corporation’s Fee-Income

Strategy

NCC developed three primary forms of fee income:

• an item processing division;

• a trust operation; and

• a mortgage servicing division.

NCC’s fee income grew at double-digit rates from 20% to 40% of total revenues over a decade.


9-4

NCC’s Keys to Success

Being selective in choosing appropriate businesses.

Realizing that the appropriate mix of nontraditional and traditional services will vary over time.

Creating a culture that encompasses cross-selling without violating laws.


9-5

Being aware of special considerations in acquiring fee businesses.

Using effective measures to evaluate

performance.


9-6

How much noninterest revenue do banks produce?

National Averages for Banks Relative to Average Assets (1997)

NIM 3.90%

Noninterest Income 2.24%

Overhead Expense (3.70%)

Provision for Loan Losses (0.42%)

ROA 1.30%

ROE 15.46%


9-7

Noninterest income helped U.S. banks in 1997 to cover overhead expenses and provision for loan losses.

In 1997, the ten largest banks in the U.S. had NIM=2.76% and noninterest income to assets of 2.12%.• Gains in noninterest income have come

from investment banking, trading, and brokerage activities.

In the first quarter of 1998, 39.7% of bank earnings were attributable to noninterest sources, increasing from 24.7% in 1984.


9-8

Traditional Sources of Fee-Based Income

Deposit Service Fees Credit Card Fees Electronic Funds Transfer (EFT) Fees Trust and Personal Planning Services Corespondent Banking Services Corporate Cash Management and

Management Consulting Services


9-9

Two Primary Aspects of Investment Management and Trust Business

Asset management business has high margin and fast growth opportunities. Business includes:

• personal trust and retail mutual funds;

• defined benefits and defined contribution pensions;

• corporate money management.


9-10

Accounting and record keeping business has low-margin and limited growth opportunities. Business includes:

• master trust;

• global and domestic custody; and

• corporate trust and paying agencies.

OCC in 1995 removed state restrictions permitting U.S. national banks to provide trust services nationwide.


9-11

Ways Banks Can Become More Competitive In Trust and Investment Services

Expand Product Breadth Pay Competitive Salaries to Sales

Representatives Improve Coordination Between Private Banking

and Trust Personnel More Advertising of Nonbank Products Offer Customized Financial Planning Services to

Affluent and Less Affluent Clients


9-12

Correspondent Banking

Correspondent banks sell management and administrative services to smaller financial institutions (respondents).

Prior to1980, respondents paid for services through compensating demand deposit balances and fees.

Prior to 1980, services were bundled in a package and a single fee was charged for the package of services.


9-13

DIDMCA of 1980 mandated universal reserve requirements and access to Fed services for all depositories.• Small to medium size depositories had option

to choose between the Fed and correspondent banks.

DIDMCA of 1980 mandated the explicit pricing of Fed services.• Correspondents offered unbundled price list

and more competitive pricing for services. Correspondent banking services are also sold by

bankers’ banks.


9-14

Corporate Cash Management Services

Lockboxes to assist bank customers in collecting payments

Sweeping to assist bank customers in disbursement activities

Concentration banking to assist bank customers in managing and tracking large pool of funds

Financial EDI to allow the electronic transfer of financial information and funds between parties


9-15

Newer Fee-Based Activities: Securities Activities

State-chartered banks can engage in: • full or discount brokerage in 38 states; and• municipal bond underwriting in 26 states.

Securities activities are attractive because of high ROE.• Average pre-tax ROE of 25.83% between 1980-

1996 for the securities industry. ROE is volatile because activities are market

sensitive.• ROE for the securities industry in the market

downturn of 1990 was -0.7%.


9-16

Newer Fee-Based Activities: Mutual Funds

Benefits of mutual fund activities

• Increased noninterest revenue

• Improved customer retention

Role of banks in mutual fund management

• Brokers for nonproprietary funds

• Investment advisors for proprietary funds

• Third-party funds using banks “brand name”


9-17

Proprietary funds require a critical mass to reap economies of scale and survive competition.

Third-party funds allow banks to compete with fund families by creating a more sophisticated area of funds for investors to purchase.

Regulatory concerns include:• investor awareness that bank funds are not FDIC-

insured; and

• higher risk of having funds withdrawn more quickly during market downturns due to the level of sophistication of bank fund investors.


9-18

Newer Fee-Based Activities: Real Estate

FIRREA (1989) curtailed direct equity participation for thrifts.

State-chartered banks real estate privileges include:

• real estate brokerage in 13 states;

• real estate equity participation in 23 states; and

• real estate development in 27 states.


9-19

In 1987, the Fed permitted BHCs to own real estate subsidiaries, with limitations tied to capital ratios.

National banks and their BHCs are prohibited from operating subsidiaries for either:

• property management; or

• residential real estate brokerage


9-20

Newer Fee-Based Activities: Insurance

Most bank have the power to:

• underwrite credit life insurance; and

• sell annuity policies.

Garn-St Germain (1982) allowed BHCs with assets of less than $50m in towns of less than 5,000 unlimited rights to engage in insurance activities.


9-21

Supreme Court decisions

• 1995 affirmed the legality of national banks to sell annuities

• 1996 permitted national banks to sell most types of insurance from small towns

Bank vehicles to enter the insurance business

• acquisitions of independent insurance agencies

• joint ventures with insurance companies to sell insurance to bank customers


9-22

What is value at risk (VAR)?

VAR asks “how much could the value of a bank’s portfolio decline over a given period of time with a given probability?”

VAR requires banks to:

• designate a given time period to examine,

• designate a given probability of loss, based on a given statistical distribution; and

• obtain historical data on the volatility of interest rates, foreign exchange or stock price movements.


9-23

Limitations of VAR

Models focus on a single point in a distribution of potential profits and losses versus looking at the entire distribution.

Models do not included information on how risks would be managed in extreme market crises.

VAR is not useful for long-term bank assets and liabilities that are infrequently traded.

Ignores all bank risks other than market risk.


9-24

Economic Value Added (EVA)

EVA provides an overall dollar measure of a firm’s profit after the cost of capital employed in all activities is subtracted.

EVA = NOPAT - (Cost of Capital for Financial Capital Employed)where:NOPAT = operating profits before any costs are paid to

investors and excluding any accounting conventions that misrepresent cash flows


9-25

EVA provides a mechanism by which to quantify the bank’s overall risk structure in terms of capital allocated and its cost.

EVA can be used for individual decisions such as determining the profitability of different types of bank operations.

EVA can be used for objective goal-setting for incentive compensation plans.


9-26

Types of Off-Balance Sheet Activities

Loan Commitments Letters of Credit

• Standby

• Commercial

Note Issuance Facilities Foreign Exchange Transactions


9-27

Loan Sales

Customer Perspective

• Access to long-term loans

Bank Perspective

• Reduction in long-term loans and interest rate risk

• Loans sold without recourse require no capital backing

• Generate fee income


9-28

Types of Loan Sales

Participation• The originating bank continues to service.

Assignment• The buyer of the loan has the right to take action

against the borrower in the event of default.

Novation• All rights and obligations of the selling bank are

transferred to the buyer.


9-29

Mechanics of Securitization

InvestorBuys Certificates

Limited purpose companyPurchases loans

Immediately sells loans

Guarantor

Issues L/C or Surety

TrustPurchases loans

Issues Certificates

BankOriginates, sells, and

services loans

Guaranty

$Certificates

Servicing

Repurchasing obligation

Loans

Loans

$

$


9-30

13% Loan Interest

Bank

Guarantor

InvestorLoan

Principal

Servicing (1.5%)

Excess Servicing (2.5%)

Credit Enhancement (1%)

Pass through rate (8%)

Scheduled Payments

Prepayments

Copyright © 2000 by Harcourt, Inc. All rights reserved. 9-1 Chapter 9 Managing Nointerest Revenues...

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Transcript of Copyright © 2000 by Harcourt, Inc. All rights reserved. 9-1 Chapter 9 Managing Nointerest Revenues...