How Banks Make Money

Topics: Bank, Banking, Balance sheet Pages: 37 (11840 words) Published: March 26, 2012
How do banks make money? The fallacies of fee income

Robert DeYoung and Tara Rice

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

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.


4Q/2004, Economic Perspectives

for illustrative purposes only and is not meant to cover all fee-based...
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