Bank Management , 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning
1
William Chittenden edited and updated the PowerPoint slides for this edition.

 Deregulation in the 1990s lead to an increase in competition
 Average NIM fell since 1992 due to this increased competition
Net Interest Margin over Time
1992
4.32%
4.50%
4.00%
3.50%
3.00%
2.50%
2004
3.61%
2.00%
1.50% 1945
1.46%
1.00%
'34 '39 '44 '49 '54 '59 '64 '69 '74 '79 '84 '89 '94 '99 '04
2

Net Interest Margins by Bank Asset Size,
1992–2004
5.0%
4.8%
4.6%
4.4%
$100M - $B
< $100M
4.2%
4.0%
3.8%
3.6%
> $1B
3.4%
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
3

 Core deposit growth has slowed due to “disintermediation”
 Loan yields have fallen on a relative basis due to credit scoring and increased competition among lenders
 NIM is being squeezed, so banks must concentrate more on non-interest income to grow profits.
4

 Banks must rely less on net interest income and more on non-interest income to be more successful
 Banks must grow their non-interest income relative to non-interest expense if they want to see net income grow.
5

 The highest earning banks will be those that generate an increasing share of operating revenue from noninterest sources, like fee income
 All fees are NOT created equal

Some fees are stable and predictable over time, while others are highly volatile because they are cyclical

Consider NSF charges on checkwriting
6









Fiduciary Activities
Deposit Service Charges
Trading Revenue, Venture Capital Revenue, and
Securitization Income
Investment Banking, Advisory, Brokerage, and
Underwriting Fees and Commissions

Insurance Commission Fees and Income
Net Servicing Fees
Net Gains (Losses) on Sales of Loans
Other Net Gains (Losses)
 Sale of premises and other fixed assets
Other Non-Interest Income
 Safe Deposit, Money Order & Notary Fees
7

Non-Interest Income is increasing as a proportion of net operating revenue
 Largest contributors are deposit service charges and other non-interest income
 Largest banks rely more on noninterest income than their smaller counterparts
8

Composition of Noninterest Income by Bank
Size as a Percentage of Total Assets, 2004
0.8%
0.7%
0.6%
0.5%
0.4%
0.3%
0.2%
0.1%
0.0%
< $100M
>$1B
$100M-$1B
All Comm. Banks
9

Non-Interest income is increasing as a proportion of net operating revenue
90%
80%
Trends in Net Interest Income and Non-interest Income
90%
80%
70%
70%
Net Interest Income
60%
50%
60%
50%
40%
40%
30%
20%
Noninterest Income
Actual Data Predicted
30%
10%
20%
0% 10%
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

 Stable source of revenue
 Relatively price inelastic
 What level of fees is too high given a bank’s desire for strong customer relationships?
11

Deposit Service Fees:
Non-Interest Checking Accounts
 Single-Balance, Single-Fee
 No fee if minimum balance is met; otherwise monthly fee
 Account Fee-Only
 Monthly fee regardless of balance plus a possible per-check-charge
 Free
 No fees of any kind
12

Fee Structures by Bank Size and Type of
Services, 1999 and 2002: Noninterest Checking
Account availability and fee averages
Dollars except as noted
1999
Institution Size
2002
Institution Size
All Large Medium Small All Large Medium Small
Percent offering noninterest checking 96.10 92.90 93.00 96.10 96.90 97.00 95.40
Single-balance, single-fee account 1
Percent offering
Monthly fee (low balance)
Minimum balance to avoid fee
37.20
6.17
50.80
8.20
42.30 33.80 32.30
6.77 5.58 7.35
39.40
9.75
32.20
7.77
31.80
6.78
517.72 723.01 583.42 455.61 591.46 890.43 582.00 566.28
Minimum balance to open
Fee-only account 2
Percent offering
Monthly fee
Check charge
Percent charging
Average
Minimum balance to open
Free account 3
Percent offering
Minimum balance to open
109.05 102.61 108.03 110.37 159.21 122.72 136.88 179.61
4.95
37.30 64.50 42.80 32.70 39.90 64.80 44.90 34.10
5.02 5.05 4.88 5.27
36.80 38.50 45.30 31.10 23.70
6.09
4.70
5.25
25.00
5.14
24.70
0.39 0.63 0.45 0.30 0.22 NS 0.26 0.19
60.98 56.73 65.47 58.68 78.41 98.29 70.22 82.98
13.60
41.87
21.90
53.66
16.50 11.50
53.63 NS
30.10
73.82
38.20
NS
31.20
66.27
28.60
73.65
13

Deposit Service Fees:
Interest-Bearing Checking Accounts
 Single-Fee NOW Accounts
 No fee if minimum balance is met, otherwise monthly fee
 Single-Fee, Single Check NOW
Account
 Monthly fee regardless of balance plus a possible per-check-charge
 No-Fee NOW Accounts
 No fees of any kind
14

Fee Structures by Bank Size and Type of
Services, 1999 and 2002: Interest Checking
Account availability and fee averages
Dollars except as noted
1999
Institution Size
All Large Medium Small All
2002
Institution Size
Large Medium Small
Percent offering NOW
(interest checking) Accounts
Single-fee account 1
Percent offering
Monthly fee (low balance)
93.3 90.8 96.7 91.8
51.9 51.8 49.6 53
8.24 10.37 8.5 7.97
95.6 96.8 96.4 95
40.9 53.2 40.1 40.5
8.71 10.05 9.13 8.26
Minimum balance to avoid fee 1,014.23 1,444.78 1,096.75 946.6 1,090.78 1,755.94 1,048.41 1,049.79
Minimum balance to open 587.23 431.34 393.36 686.62 469.59 606.54 449.47 469.37
Single-fee, single-check-charge account 2
Percent offering 12.4 12.2
Monthly fee (low balance)
9.6 13.8
6.35 6.84 7.08 6.07
12.5
7.06
17.5
7.83
12.3
7.28
12.3
6.82
Check charge 0.21 0.33 0.23 0.19 0.25 0.33 0.24 0.24
Minimum balance to avoid fee 1,002.25 1,543.02 941.09 988.84 1,034.36 1,407.35 1,007.07 1,010.71
Minimum balance to open
No-fee account
683.4 634.27 459.07 762.13 591.05 388.12 392.3 760.15
Percent offering
Minimum balance to open
0.9
1
0.3
NS
1 0.9 1.8
NS NS 199.44
7.2
NS
1.3
NS
1.7
NS
15

Deposit Service Fees:
Special Fees
 NSF Checks
 Check is returned
 Overdrafts
 Check is honored
 Deposit Items Returned
 Stop-Payment Order
16

Fee Structures by Bank Size and Type of
Services, 1999 and 2002: Special account fees
Account availability and fee averages
Dollars except as noted
1999
Institution Size
2002
Institution Size
All Large Med. Small All Large Med. Small
Special Account Fees
Stop-payment orders average fee 15.26 20.46 17.61 13.70 18.93 23.54 21.06 17.00
NSF checks average fee 1
Overdrafts average fee 2
17.88
17.66
22.84 20.05
22.95 20.24
16.43 21.73
15.97 21.80
26.19 23.41
26.84 23.69
20.14
20.00
Deposit items returned average fee 6.33 7.47 6.37 6.16 6.88 6.13 6.82 7.03
17

Deposit Service Fees:
ATM Services
 Annual Fees
 ATM Card Fees
 “On us” Withdrawal Fees

Fees levied on bank’s own customers for withdrawals from the bank’s own
ATMs
 “On others” Withdrawal Fees

Fees levied on bank’s own customers for withdrawals from another bank’s
ATM
18

Fee Structures by Bank Size and Type of
Services, 1999 and 2002: Special account fees
Account availability and fee averages
Dollars except as noted
1999
Institution Size
2002
Institution Size
All Large Med. Small All Large Med. Small
Automated teller machines
Percent offering ATM card 83.10 96.20 97.20 75.30 93.40 98.80 98.00 89.60
Percent charging annual ATM fee 16.20 13.10 10.20 20.30 10.30 5.50 7.20 13.20
Average fee $
Percent charging ATM card fee
7.97 15.47 7.35 7.83 11.65 NR 9.77 12.25
7.70 2.60 4.10 10.40 4.00 1.20 1.80 6.00
Average fee $ 4.16 NS 5.18 3.92 6.39 NS NS 5.73
Percent charging “on others” ATM fee 72.00 87.20 75.70 68.20 69.00 76.90 78.50 60.70
Average fee $
Percent charging ATM surcharge fee
1.17
81.50
1.27 1.23
85.30 86.70
1.12 1.14
77.60 89.40
1.31 1.21
93.50 92.20
1.04
86.60
Average fee $ 1.25 1.36 1.28 1.21 1.36 1.42 1.38 1.33
19

The UBPR lists five components of noninterest expense:
 Personnel Expense
 Occupancy Expense
 Goodwill Impairment
 Other Intangible Amortization
 Other Operating Expense
Cost savings in these areas often drive bank mergers
20

 Burden
Burden

Non Interest Expense Non Interest Income
 Lower is better (Burden > 0)
 Net Non-Interest Margin
Net Non Interest Margin

Burden
Average Total Assets
 Lower is better
21

Non-Interest Expense: Efficiency Ratio
 Efficiency Ratio
Efficiency Ratio

Net
Non
Interest
Interest
Income
Expense

Non Interest Income
 Larger banks tend to have lower
(better) efficiency ratios because they generate more non-interest income
 Low efficiency ratios do not always lead to higher ROEs
22

Efficiency Ratios of U.S. Commercial
Banks, 1992–2004
75.0%
70.0%
65.0%
60.0%
55.0%
50.0%
<$100M
$100M-$1B
>$1B
23

Non-Interest Expense:
Operating Risk Ratio
 Operating Risk Ratio
Operating Risk Ratio

Non Interest Expense Fee Income
Net Interest Margin

Lower is better because proportionally more income comes from fees
24

Operating Risk Ratio Signals the Benefit of Fee Income
Operating Risk Ratio:
Ratio
Return on a ssets (ROA)
Net i nterest m argin (NIM)
Percent of average total assets:
Net i nterest i ncome
Noninterest i ncome ( f ee)
Operating r evenue
Noninter est e xpense
Earning a ssets
Taxes
Efficiency Ratio:
Bay Bank
1.40%
4.000%
3.20%
1.40%
4.60%
3.00%
80.00%
0.20%
65.22%
=0.03 / (0.032 + 0.014)
40.00%
= (0.03 0.014) / 0.04
River Bank
1.40%
4.625%
3.70%
0.90%
4.60%
3.00%
80.00%
0.20%
65.22%
=0.03 / (0.037 + 0.009)
45.41%
= (0.03 0.014) / 0.04625
25

Productivity Ratios
 Productivity Ratios
 Assets per Employee
Assets Per Employee

Number
Average of Full -
Assets
Time Employees
 Average Personnel Expense
Average Personnel Expense

Personnel
Number of Full -
Expense
Time Employees

Can be biased on the high side due to senior management compensation
26

Community banks often examine two additional productivity ratios
 Loans per Employee
Loans Per Employee

Number
Average of Full -
Loans
Time Employees
 Net Income per Employee
Net Income Per Employee

Number of
Net
Full
Income
Time Employees
 Loans typically represent the largest proportion of assets for community banks
27

 Risk-Adjusted Return on Capital
RAROC

Risk Adjusted Income
Capital
 Return on Risk-Adjusted Capital
RORAC

Income
Allocated Risk Capital
28

 Analyses of customer profitability profiles suggest that banks make most of their profit from a relatively small fraction of customers.

View is that 20% of a bank’s customers account for 80% of profits.

This supports the increase in fees assessed by most banks over the past few years.
29

80
70
60
50
40
30
20
10
0
-10
High Value
Customers
Who are they, what do they need?
How do you move them up?
Value
Customers
Average
Customers
Move up or move out
Low Value
Customers
High
Maintance
Customers
30

Expense Components
 Non-Credit Services
 Check-processing expenses are the major non-credit cost item for commercial customers
 Transaction Risk

Risk of fraud, theft, error, and delays in processing, clearing, and settling payments
 Credit Services
 Cost of Funds
 Loan Administration Expense
 Default Risk

Business Risk Expense
 31 Losses and allocations for potential losses

Customer Profitability:
Revenue Components
 Investment Income from Deposit
Balances
 Earnings Credit
 Non-Interest Income
 Fee Income
 Loan Interest
32

Aggregate Profitability Results
 Profitable customers maintain multiple relationships with the bank
 Unprofitable customers tend to “shop” for the lowest price and do not use multiple products
33

 Manage Fee Income in a Portfolio Context
 One suggestion:

30% - Deposit Activities

10% - 15% - Investment Banking and Trading

55% - 60% - Specialty Intermediation and Fee-
Based Operating Business
 Consumer Finance
 Specialty Leasing
 Factoring
 Insurance
 Mutual Funds
 Investment Management
34

Percentage of Various Components of
Total Noninterest Income, 2004
Percentage of Total Noninterest Income
Deposit service charges
Fiduciary activities
Trading, venture cap. and securitizations
Net servicing fee s
Investment banking, advisory, brokerage, and insurance
Insurance commissions and fees
Net gains (losses) on sales of loans and other assets
Net gains (losses) on other as sets
Other noninterest income
<
$100M
$100M -
$1B >$1B
All
Comm.
Banks
45.7% 30.7% 15.9% 17.5%
8.7% 13.6% 12.2% 12.2%
0.0% 4.3% 18.3% 17.5%
8.7% 4.3% 8.5% 8.3%
1.1%
4.3%
2.1% 5.7%
2.1% 2.4%
5.2%
2.2%
3.3% 7.1% 4.1% 3.9%
0.0% 0.7% 1.2% 0.9%
28.3% 35.0% 31.7% 32.3%
35

Product Offerings at Community Banks to Generate Noninterest Income
Percentage Offering Product
0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0%
Residential Mortgages*
Debit cards
Credit Life
Phone banking
Online banking
ACH orgination
Check image statements
Credit Cards
Fee-based overdrafts
Annuities
Mutual Funds
Life insurance
SEP IRA
Cash management
Personal trust
Stock brokerage
401(k) plans
Financial Planning
P&C insurance, personal
Courier service
P&C insurance, buiness
Title insurance
Payroll processing
Farm insurance
Online brokerage
RE brokerage/management
Debt cancellation contracts
Muni bond underwriting
Travel agency
2.8%
2.1%
1.9%
16.9%
13.0%
12.0%
11.8%
9.7%
8.9%
7.7%
5.2%
3.1%
30.4%
30.4%
28.3%
27.3%
23.0%
38.8%
35.7%
33.9%
31.1%
58.6%
54.6%
52.7%
52.3%
47.7%
46.1%
70.0% 80.0% 90.0%
85.0%
73.0%
36

 Cost Management Strategies
 Expense Reduction
 Operating Efficiencies
 Revenue Enhancement
37

Expense Reduction
 Be careful not to just focus on reducing costs, rather, move them in line with strategic objectives.
 Begin by identifying excessive expenses and eliminating them
 Largest non-interest expenses are personnel, occupancy, and data processing costs. These are often the areas where cuts are initially made.
38
 Outsourcing

Operating Efficiencies
 Reducing costs while maintaining existing level of products and services
 Increasing the level of output while maintaining the level of current expenses
 Improving work flow (doing things faster)
 Operating efficiencies of:
 Economies of Scale
 Economies of Scope
39

 Price Elasticity
 Identify products or services that exhibit price inelastic demand
 Change the pricing of specific products while maintaining a sufficiently high volume of business so that total revenue increases
 Contribution Growth
 Management allocates resources to best improve overall long-term profitability
 Increases in expenses are acceptable, but they must coincide with greater anticipated increases in associated revenues
 In the short-run, expenses rise, but expenses are cut in the long-run
40

Bank Management , 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning
41
William Chittenden edited and updated the PowerPoint slides for this edition.