“In the end, banking is a very good business unless you do dumb things. You get your money extraordinarily cheap, and you don’t have to do dumb things.”
Warren Buffett, one of our greatest investors, understands and invests in banks.
Part of our challenge in investing in banks orbits around understanding their financials. Banks, like insurance companies, speak a different language.
Looking at their financial statements, you will see net interest and non-interest income.
These two terms help us understand how a bank makes money. Most of us think it revolves around loans and fees that they charge. While much of that remains true, banks also have many other ways they earn income, and today’s post will focus on one of those areas. Understanding the language of banks will allow us to analyze them better.
In today’s post, we will learn:
- What is Non-Interest Income?
- Examples of the Types of Non-Interest Income
- How Non-Interest Income Helps a Banks Profitability
- Why Do Some Banks Focus on Non-Interest Income?
- Examples of Non-Interest Income
Okay, let’s dive in and learn more about non-interest income.
What is Non-Interest Income?
Non-interest income equals bank income earned from fees. These fees can include transaction and deposit fees, plus, NSF (insufficient fees), and annual and monthly account fees, among others.
These types of fees are not only regulated by banks. Credit card companies earn these types of fees as well. For example, American Express earns fees from penalty fees like late charges.
Bank of America and American Express charge these fees as another avenue to grow revenue. These fees are all part of the non-interest income these financials earn.
These fees help improve profitability, along with improving liquidity. After the Great Financial Crisis in 2007, banks realized they needed other ways to improve their liquidity.
In part, the banks found these rules forced upon them to ensure they wouldn’t fail. But executives also realized they needed to branch out, no pun intended.
We can find non-interest income on a bank’s income statement. The same applies to credit card companies or investment banks.
But the primary focus of the term relates to banks.
The primary purpose or core of the bank’s operating model is to generate income from interest. At their core, banks make money from lending. They generate income from the spread between interest from loans and interest paid on deposits.
Interest is the cost of lending money, and the bigger the spread between lending and deposit interest rates, the more profits they earn.
But the focus on interest income puts banks at risk as rates increase or decline. The bottom line, they have become too reliant on interest rates.
Diversified banks with a balanced approach to earning income become less reliant on interest rate fluctuations.
For example, Ally Bank relies heavily on auto loans, which will thrive during higher interest rates. But plummet when rates fall.
Banks can use the non-interest income to encourage customers to choose one bank over another.
For example, when rates are higher, they can lower their non-interest income sources, which could entice one customer to choose Bank of America over Wells Fargo.
Examples of the Types of Non-Interest Income
Below we will list some of the more common non-interest income fees earned by financials.
Before we dive into that, consider the idea of non-interest income. For most businesses, their method of earning money revolves around non-interest income.
For example, Texas Instruments earns revenue from producing analog semiconductor chips. Their core business revolves around these chips. And they earn money from the production and sales of these chips.
So any company whose core activities revolve around selling goods or services earns income from non-interest income.
In the banking world, the core business revolves around interest income from lending. Banks deal in cash from the deposits they take in and the loans they give out.
Now that we understand the difference between banks and “normal” businesses, let’s look at the non-exhaustive list:
- Service charges
- NSF (insufficient fees), i.e., overdrafts
- Loan processing fees
- Loan origination fees
- Late payments fees (banks/credit card companies)
- Over limit (credit cards/checking accounts)
- Annual fees for credit cards (American Express)
- ATM fees
- Withdrawal fees/Transfer fees
Some of the above fees remain focused on banks, but we can translate many to other financials. For example, credit card companies charge late payment fees or over-limit fees.
How Non-Interest Income Helps a Banks Profitability
According to a report from the Federal Reserve Bank of Minneapolis written in 1999, the last twenty years have seen a big uptick in profitability. They attribute the growth to the growth of non-interest income.
They reported the increase in non-interest income which helped the banks reduce risk and promote more diversification in revenue.
Many analysts refer to non-interest income as “fee income” because the majority of the income stems from fees.
They reported banks saw a switch from a supportive role in income to an equal footing or increase beyond interest income. In the 1950s and 70s, interest and non-interest income grew similarly. But in the 1980s, they began to separate, with non-interest income growing at rates twice the national average of interest income.
As we can see from the chart below, we can see the growth in non-interest income has grown from $154 billion in 2000 to $285 billion in 2021, equaling a 3.13% CAGR.
During the same time, net interest income rose from $203 billion in 2000 to $489 billion in 2021, doubling non-interest income. The growth over the period equals a 4.45% CAGR.
Despite the falling interest-to-non-interest income ratio, the latter still provides greater profitability because of the lower costs associated with those revenues.
For example, fees associated with ATM fees don’t require much maintenance, or the fees associated with account maintenance do. In many cases, the tech running these background services largely remains legacy.
In many cases, the bank installed the legacy tech long ago, meaning any revenues generated on top of it remain more profitable.
The mix of non-interest income has morphed over the years. According to the Cleveland Federal Reserve report in 2018, the nature of non-interest income changed from 2000 to 2018.
In the report, the Cleveland Fed reports that non-interest income equaled 34% of the bank’s operating income. Before the Great Financial Crisis, the ratio reached 46% of all banks before falling to the current levels. From 2005 to 2018, non-interest income rose in absolute terms, but overall operating income for banks rose faster. Over the period, non-interest income rose 25%, but operating income rose 71%.
Operating income for banks equals net interest income and non-interest income.
We can see from the chart above the mix of non-interest income changed from a higher percentage of Other and Trading fees to a bigger mix of Service Charges and Investment Bank fees.
The fees associated with investment banks include items such as:
- Administrating trust funds
- Gains and losses on venture capital investments
- Fees from underwriting activities
The predominant theory before the GFC equaled banks focusing on non-interest income during low-interest rate periods. But in the period following the GFC, we observed a rise in net interest income.
So what gives?
Instead, we observed a rise in service charges as banks moved away from “punitive” fees to charging for value-added services. We also saw a decline in trading fees associated with reduced or fee-free brokerage trades.
All of this coincided with a growth in the service fees as banks tried to create value from the different services they could offer customers.
The main benefit of this idea was the continued diversification of revenue streams not correlated to each other.
The profit ratios of service fees remain bigger than net interest income, and as non-interest income grows as a percentage of revenue, it provides a greater overall profit margin.
Why Do Some Banks Focus on Non-Interest Income?
We have four main reasons for the continued drivers of non-interest income:
- Economic scenarios take into account the fluctuation in non-interest income to some extent. The minimal interest rate paid on the sanctioned loan value determines a substantial portion of the interest income. The interest rate depends on the benchmark rate set by the Federal Bank. Currently, Federal Bank lowers interest rates as a precautionary step when the economy faces challenges from deflation.
- In such a situation, the banks must credit consumers for the lower interest rates. Banks accomplish this by changing the loan interest rates. The bank’s interest income decreases as a result. The banks slightly raise the fees assessed on transactions that make up the non-interest income to make up for the decrease in revenue.
- Similarly, the Federal Reserve will boost interest rates when the economy experiences inflation to increase the cost of borrowing and curb price increases. And as they raise rates, the income from interest increases.
- The consumer avoids borrowing the money at the higher cost of funds, which results in a drop in loan origination changes, loan servicing charges, late payment charges, etc. Non-interest income, however, declines as a result.
After a certain point, it is more profitable for a bank to employ fee and charge reductions as a marketing strategy to attract new deposits than as a technique to boost earnings. Once one bank takes this action, the fee market competition resumes.
Bottom line: the more sources of income a bank has, the better able the bank can withstand challenging economic times.
Examples of Non-Interest Income
To better explain how non-interest income works, let’s use a couple of examples to define the term better.
For example, let’s assume JP Morgan lent $100,000 to Microsoft at an interest rate of 6% for a ten-year loan. Over the life of the loan, JP Morgan will earn $60,000 in interest income. But, at the loan’s origination, JP Morgan also charged a 0.5% loan origination fee equaling an upfront payment of $5,000, plus another $500 in service fees.
Throughout originating and paying out the money for the loan to Microsoft, JP Morgan earned a total of $65,500 in interest charges, origination fees, and service fees.
The $65,500 gets assigned to the income statement, but not all is interest or non-interest income. The different sources would break down as the following:
- $60,000 in interest income (net interest income)
- $5,000 in origination fees (non-interest income)
- $500 in service fees (non-interest income)
If we examine a few banks, we can see the differences in income streams and how each bank focuses on balancing its income.
For example, according to their latest 10-K, dated 2/21/23, JP Morgan shows overall net revenue of $128,695 million. Of which:
- Noninterest income = $61,985
- Net interest income = $66,710
Which gives us a percentage of each equaling 48% and 52%, respectively. And each percentage over the previous two years equals:
- 2021 – 56% Non-interest/44% Net Interest
- 2020 – 54% Non-interest/46% Net Interest
Notice the investment banking fee fluctuations over the three years. Those fees fluctuate with market activity, and the drop from 2021 to 2022 makes sense when you think about the market dropping from all-time highs in 2021.
Overall, we could say JP Morgan has diversified revenue streams.
Looking at Ally, we can see a different picture. Diving into their latest 10-K, dated 2/24/23:
Looking at the breakdown of non-interest income to net interest income, we see a bigger disparity between the two.
A note concerning Ally’s finances: they refer to non-interest income as Other revenue and net interest income as net financing revenue. Sometimes companies will list items by different terminology.
If we look at the last three years, we see:
- 2022 – Net interest income 81% / Non-interest income 19%
- 2021 – Net interest income 75% / Non-interest income 25%
- 2020 – Net interest income 70% / Non-interest income 30%
Non-interest income plays an important role in the banking industry. Many banks lean on those revenues during hard times related to interest rates. Others continue to move towards value-added services, which they can use to generate additional fees.
But the continuing core of most banks remains net interest income or monies earned from lending money.
To invest in banks or any financials, we must understand the accounting language of banks. Digging into terms such as non-interest income remains part of understanding bank financials.
As Buffett mentioned, investing in banks can offer great returns, provided we find good banks run by good people.
But part of analyzing banks is understanding the language they speak. Non-interest income remains a large part of banks and provides alternative income-generating options.
Regulations will attempt to reduce certain fees, for example, exchange fees for debit cards or account fees.
But banks will find other ways to generate revenues, and as much as they remain unliked or wanted, they remain a vital part of our economy.
And with that, we will wrap up our discussion for today.
Thank you for taking the time to read today’s post, and I hope you find something of value. If I can further assist, please don’t hesitate to reach out.
Until next time, take care and be safe out there,