Next to CASA, the parameter which Indian commercial banks have probably stressed most (among others) as key to their overall profitability in recent times has been non-interest income.

At one level, the emphasis on non-interest income signifies that banks have moved quite some distance from the good, old “3-6-3” rule. Shareholders, analysts, the investing community and even bank managements seem to have grown fond of the earnings, risk diversity, growth potential and market insulation that non-interest income may provide.

Indeed, fee income from non-traditional banking activities, such as investment banking, securities underwriting, sales of third party products, and so on — given the freedom from interest rate risk and credit risk that it delivers — is sometimes considered the way to go.

But viewed from a larger macroeconomic and financial risk perspective, one wonders if non-interest income is the unmixed blessing it is portrayed to be.

In this piece, we attempt to list out the peculiarities, intricacies and challenges involved in focusing on non-interest income.

Sales of third party products

The argument that follows is mainly based on a theoretical analysis of the issue. The data on non-interest income of Indian commercial banks are not available in great detail for us to make an empirical study.

It is a reasonable guess that while non-interest income is quite significant in Indian banking — accounting for close to 30 per cent on average of operating income across bank categories — bulk of that income is still generated from traditional banking services such as deposits, payments and loans.

That is, fees on traditional banking services such as savings and transaction account charges, payment services, safe custody services and that on credit products/quasi-credit products such as LCs, BGs and customer foreign exchange still account for the lion's share of fee income.

Non-traditional services such as insurance and mutual fund agency, investment banking comprising equity and debt underwriting, advisory and related services, and so on, still do not form a notable part of overall fee income.

The arguments given below therefore may not immediately and fully apply to Indian banks — particularly the public sector variety.

As is well known, almost all commercial banks in India — both in the public and private sectors — have entered into agency agreements with insurance companies to sell life insurance products through their branch network.

Indeed, with close to 80,000 bank branches and some 60 per cent of those in urban, metropolitan and semi-urban areas, the distribution reach of Indian commercial banks is quite strong.

It is no surprise that the life insurance industry desires to tap into this network to sell its products. It may take years for them to create a matching physical network. The fixed/semi-fixed expenditure which would be incurred in creating and maintaining such a network would be significant.

Large scale deployment of advanced communication technologies could obviate the need for a physical network matching that of banks' but even a network half as wide could be a resource challenge.

From the perspective of commercial banks also, selling third party financial products such as mutual funds and insurance for generating fee income seems to make “eminent” sense.

This is an activity whose impact would not be directly seen on the balance-sheet of the bank but rather only in the income statement. Since the impact would not be directly visible on the balance-sheet, there is a distinct attractiveness attaching to the activity — no credit risk involved and therefore no capital consumption. That combination of enhanced income but no capital consumption could indeed be seen as an unmixed blessing.

Is it really so?

An analysis of the issue shows that any fee-income or non-interest income generating activity from non-traditional banking services may not be an unmixed blessing.

To be sure, there is no credit risk involved and, therefore, no capital consumption.

The downside is that banks have to incur considerable fixed and semi-fixed expenditure or inputs — primarily wages and related overheads — in commencing and sustaining such activities.

These expenditures “normally” cannot be wound down or modified in line with the level of third party products selling. Such activities enhance the level of operating leverage the bank is exposed to. Higher the level of operating leverage, higher the variability in a bank's operating revenues.

The same argument applies in case of any other non-interest income generating activity. Be it investment banking, financial markets and commodities trading, debt syndication, equity capital markets underwriting and such other activities, the bank is exposed to a higher operating leverage and the ups and downs of the business cycle.

As a contrast, in the context of the main lending business of a bank, the critical “input” to expanding interest income is a variable item only — interest expense. You just borrow more and lend more. Operating leverage is not enhanced since only variable costs are incurred in seeking to expand operating income.

Switching costs

A more important feature in the context of the main lending business is that “switching costs” — or the costs of breaking a relationship — are quite high both for the borrower customer as well as the banker. Given the high switching costs, revenue flows from lending relationships are generally far more stable and are not subject to the vicissitudes of the business cycle.

In the case of non-interest income generating activities, of course, there is no particular or individual relationship with “customers” and therefore switching costs are quite low. In a competitive market situation, customers may not lose much as they can go to the next bank offering such services. For the bank, though, lost business has to be matched against the overheads which will continue to be incurred.

Financial leverage

Another downside can be noted as a corollary to the above. Since these activities do not consume capital on the balance-sheet (except where some credit risk may be assumed, say in securitisation), there is the incentive for a bank to enhance the level of debt to fund these activities. Therefore, these activities could also increase the level of financial leverage on the balance-sheet.

Higher operating and financial leverage, per se , is not a negative. It just increases the level of risk attaching to a bank's earnings stream. (It is interesting to note here that the non-interest income of some major public sector banks in India has fluctuated considerably in the past decade).

In the specific context of mutual funds and insurance, it is also possible they cannibalise the savings products viz. deposits, which banks themselves offer. Technically, insurance is a (mortality) risk hedging tool and cannot cannibalise the bank deposit. But at the level of bank branches, will the distinction between a bank deposit and an endowment assurance be that clearly appreciated?

That awareness can be created only by intensive education campaigns both for bank staff as well prospective customers. That, in turn, could inflate overheads expenditure again.

All in all, fee income generating activities do not seem to be the unmixed blessing they are made out to be. Rigorous scenario analyses may be called for as banks take up more non-traditional products/services to boost their earnings stream.

(The author is Vice-President (Economic Research), Shriram Group Companies, Chennai. The views are personal.)

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