Noninterest income: A diversification story or a risky proposition?

In this study we examine how noninterest income, or fee income, affects financial services firms’ performance in the post Gramm-Leach-Bliley Act era. In a sample of bank holding companies from 2001 to 2009, we find that overall noninterest income improves banks’ performance. Although some activities increase banks’ volatility and exposure to systematic risk, we find evidence of economies of scope and scale, and that noninterest income can improve traditional intermediation or lending activities. Our study expands the literature on noninterest income in two ways. First, to our knowledge this is one of the few studies that examine how different noninterest income components affect banks in the post-GLBA era. The deregulation that occurred represents a major shift in banking practices because it eroded long standing barriers that prevented banks from engaging in insurance, and securities activities. Despite this shift, DeYoung and Rice (2004a, b) observe that intermediation activities remain the banks’ primary focus. Accepting deposits and reinvesting the funds into loans and other credit products has traditionally been the primary focus of banks’ operations. While previous research focuses on portfolio theory and how correlations between noninterest activities and interest income affect the volatility of bank earnings, we believe a more encompassing approach is warranted. We not only examine noninterest income’s affect on traditional market-based risk measures, but evaluate potential economies of scope and scale from combining noninterest income and intermediation activities. Finally, we test noninterest income’s affect on intermediation efficiency, and the liquidity and capital adequacy of the banks. Results show that for large banks, noninterest income offers limited diversifica-tion benefits for idiosyncratic and total risk. Fee income, securities activities in particular, are associated with increases in systematic risk which is consistent with previous studies (Bhargava and Fraser, 1998; Allen and Jagtiani, 2000; Baele et al., 2007). Results for in-terest rate risk suggest that income streams from insurance activities are exposed to fluc-tuations in interest rates, while trading income is used as a hedging tool. Many studies have suggested that some noninterest activities, insurance for ex-ample, may have significant economies of scope or scale when combined with banking. Results show that insurance income reduces salaries paid per employee and increase non-interest revenue per dollar of expense. Even though the skilled labour hired for trading and investment banking practices increase the average salary for employees, overall total noninterest income increases income per employee salary, and revenue relative to ex-penses. For intermediation efficiency, noninterest income is associated with increases to return on loans, increases in the net interest margin, a reduction in credit risk, and is negatively related to the loan loss reserve ratio. This result is significant because it shows that the shift to noninterest income has a positive impact on traditional banking activities. Despite the more volatile nature of noninterest income streams, diversification into fee income provides benefits that extend beyond traditional portfolio theory and risk reduc-tion. Finally, although some noninterest income activities may require higher levels of equity capital in case of unforeseen shocks, overall fee income reduces liquidity risk. Consistent with previous research we find that noninterest income can increase certain market-based risk measures. However, there is evidence that noninterest income can improve the performance of banks’ traditional intermediation activities