Discussion Paper. Does non-interest income make banks more risky? Retail- versus investment-oriented banks Matthias Köhler (University of Giessen) - PDF

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Discussion Paper Deutsche Bundesbank No 17/2013 Does non-interest income make banks more risky? Retail- versus investment-oriented banks Matthias Köhler (University of Giessen) Discussion Papers represent

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Discussion Paper Deutsche Bundesbank No 17/2013 Does non-interest income make banks more risky? Retail- versus investment-oriented banks Matthias Köhler (University of Giessen) Discussion Papers represent the authors personal opinions and do not necessarily reflect the views of the Deutsche Bundesbank or its staff. Editorial Board: Klaus Düllmann Heinz Herrmann Christoph Memmel Deutsche Bundesbank, Wilhelm-Epstein-Straße 14, Frankfurt am Main, Postfach , Frankfurt am Main Tel Please address all orders in writing to: Deutsche Bundesbank, Press and Public Relations Division, at the above address or via fax Internet Reproduction permitted only if source is stated. ISBN (Printversion) ISBN (Internetversion) Non-technical Summary In this paper, we analyze the impact of banks non-interest income share on risk in the German banking sector for the period between 2002 and Using linear and quantile regression estimators, we find that the impact of non-interest income on risk depends on the business model of a bank. More specifically, while banks with a retail-oriented business model such as savings banks, cooperative banks and other retail-oriented banks become significantly more stable if they increase their share of non-interest income, investment-oriented banks become significantly less stable. In contrast to retail-oriented banks, the latter already generate a large share of their income from non-interest activities. The activities used to generate noninterest income significantly differ between retail- and investment-oriented banks as well. Our results are in line with recent findings for the EU banking sector which indicate substantial benefits from income diversification for smaller and more retail-oriented banks. Larger and more investment-oriented banks, in contrast, should increase their share of interest income to become more stable. Our results may, thus, not only be relevant for Germany, but also for other European countries. Our paper has two important implications. First, our results indicate that it might be beneficial for retail-oriented banks to increase their share of non-interest income to become more stable, since this allows them to better diversify their income structure and to become more resilient to overall economic conditions that affect their loan portfolio. Furthermore, a higher share of non-interest income makes them less dependent on maturity transformation and interest rate risk. Investment-oriented banks, in contrast, become significantly less stable if they increase their non-interest income share. They already have a large non-interest income share and engage in different activities than retail-oriented banks. To become more stable, these banks should increase their share of interest income. Overall, therefore, our results imply that banks are more stable if they have a more diversified income structure and depend neither heavily on interest nor on non-interest income. Second, the decomposition of non-interest income into fee and commission and trading income shows that impact on bank stability comes from fee and commission income. Trading income, which is significantly more volatile than fee and commission income, in contrast, has no significant effect on bank stability. Nicht-technische Zusammenfassung In der vorliegenden Arbeit untersuchen wir, ob deutsche Banken mit einem hohen Anteil an Nichtzinseinkommen im Verhältnis zu ihrem gesamten operativen Einkommen im Zeitraum zwischen 2002 und 2010 riskanter waren als solche mit einem geringen Anteil an Nichtzinseinkommen. Lineare Schätzverfahren und Quantilsregressionen deuten darauf hin, dass Banken mit einem retail-orientieren Geschäftsmodell wie beispielsweise Sparkassen, Kreditgenossenschaften sowie andere retail-orientierte Banken signifikant stabiler werden, wenn sie ihren Anteil an Nichtzinseinkommen am gesamten Einkommen erhöhen. Banken mit einem Fokus auf Investment Banking-Aktivitäten werden hingegen deutlich riskanter. Sie erzielen im Unterschied zu retail-orientierten Instituten einen deutlich höheren Anteil ihres Einkommens aus Nichtzinseinkommen. Darüber hinaus unterscheiden sich die Aktivitäten, mit denen retail- und investment-orientiere Banken ihre Nichtzinseinkommen generieren, deutlich. Die Resultate der vorliegenden Arbeit stimmen mit aktuellen Ergebnissen für den EU Bankensektor überein. Danach profitieren insbesondere kleinere und stärker retail-orientere Banken von einer besseren Diversifikation ihres Einkommens. Größere Banken mit einer stärkeren Ausrichtung auf Investment Banking-Aktivitäten sollten hingegen ihr Zinseinkommen erhöhen, um stabiler zu werden. Die Ergebnisse dieser Arbeit könnten somit nicht nur für den deutschen Bankensektor von Relevanz sein, sondern auch für andere europäische Länder. Die vorliegende Arbeit erlaubt zwei wichtige Schlussfolgerungen. Erstens deuten unsere Ergebnisse darauf hin, dass Banken, die sich auf das Einlagen- und Kreditgeschäft konzentrieren, von Diversifikationseffekten profitieren, wenn sie den Anteil des Nichtzinseinkommens im Verhältnis zu ihrem gesamten operativen Einkommen erhöhen. Das bedeutet, dass es für diese Banken sinnvoll sein kann, ihr Nichtzinsgeschäft auszuweiten, anstatt es zu reduzieren, wenn sie stabiler werden wollen. Banken mit einem Fokus auf Investment Banking- Aktivitäten werden hingegen deutlich riskanter, wenn sie sich stärker im Nichtzinsgeschäft engagieren. Sie erzielen bereits einen großen Teil ihrer Gewinne aus dem Nichtzinsgeschäft und verfolgen andere Geschäftsaktivitäten als retail-orientierte Banken. Um stabiler zu werden, sollten diese Banken den Anteil des Zinseinkommens am gesamten operativen Einkommen erhöhen. Insgesamt deuten unsere Ergebnisse somit darauf hin, dass Banken mit einer diversifizierten Einkommensstruktur, die weder einseitig von Zins- noch von Nichtzinseinkommen abhängig sind, weniger riskant sind. Zum anderen weisen unsere Ergebnisse noch darauf hin, dass der Einfluss des Nichtzinseinkommens auf die Stabilität einer Bank vom Provisionsgeschäft ausgeht. Das Handelseinkommen, das deutlich volatiler ist als das Provisionseinkommen, hat im Gegensatz hierzu keinen signifikanten Einfluss auf das Risiko einer Bank. BUNDESBANK DISCUSSION PAPER NO 17/2013 Does non-interest income make banks more risky? Retail- versus investment-oriented banks Matthias Köhler1 Deutsche Bundesbank Abstract In this paper, we analyze the impact of banks non-interest income share on risk in the German banking sector for the period between 2002 and Using linear and quantile regression estimators, we find that the impact of non-interest income on risk significantly differs depending on banks overall business model. More specifically, we show banks with retail-oriented business model such as savings banks, cooperative banks and other retail-oriented banks become significantly more stable if they increase their share of non-interest income. Investment-oriented banks, in contrast, become significantly more risky. They do not only report a significantly higher share of non-interest income, but also differ in terms of their activities from retail-oriented banks. Overall, this indicates that retail-oriented banks should increase their share of non-interest income to become more stable. Investment-oriented banks, in contrast, should decrease it. Our results imply that banks are significantly less risky if they have a more balanced income structure and neither depend heavily on interest nor on non-interest income. Furthermore, they indicate that the impact of non-interest income on risk significantly depends on the activities used to generate non-interest income with retail-oriented activities being significantly less risky than investment-oriented activities such as those pertaining to capital markets activities. JEL-Classification: G 20, G 21, G 28 Keywords: Banks, risk-taking, business model, non-interest income, diversification 1 Deutsche Bundesbank, Wilhelm-Epstein-Straße 14, Frankfurt am Main, Germany. The paper represents the author s personal opinions and does not necessarily reflect the views of the Deutsche Bundesbank or its staff. The author would like to thank Christoph Memmel, Heinz Herrmann and the participants at the Bundesbank seminar for helpful comments and suggestions. 1. Introduction The financial crisis of 2007/2008 has revealed the weaknesses of many banks business models. In particular, investment-oriented banks were hit by the crisis due to their heavy reliance on wholesale funding and non-interest income that exposed them to greater income fluctuations than retail-oriented banks that provide traditional banking services such as lending and use customer deposits a primary source of funding. Due to pressure from investors and regulators many investment-oriented banks have started to change their business model. On the liability side, they have increased the share of customer deposits to put their funding on a more stable basis. On the asset side, they have cut back their trading activities and increased their lending to customers in order to reduce their reliance on noninterest income. While these adjustments may make investment-oriented banks less risky, retail-oriented banks that generate the largest part of their income from interest may become more stable if they increase their non-interest income share as this allows them to better diversify their income structure and to offset declining interest margins. Figure 1, for example, shows that the net interest margin of German banks declined between 2003 and 2008, while the non-interest income margin increased up to Starting in 2008 this relationship has started to reverse with the non-interest margin starting to decline and the interest margin beginning to increase again. In the future, the net interest margin is, however, expected to decrease again as recent changes in banking regulations such as the introduction of a Liquidity Coverage Ratio (LCR) will likely increase the competition for deposits which should increase deposit rates. Lending rates, in contrast, will likely decrease, since many banks have increased their lending activities in response to changes in their business models. The process of disintermediation will also likely continue in the future and depress net interest margins further. This suggests that it may be beneficial for retail-oriented banks to increase their non-interest income activities to offset declining interest margins. In this paper, we analyze the impact of banks non-interest income share on risk in the German banking sector for the period between 2002 and Using linear and quantile regression estimators, we show that the impact of non-interest income on risk significantly differs between retail- and investment-oriented banks. More specifically, we find banks with a more traditional business model such as savings banks, cooperative banks and other retail-oriented banks become significantly more stable if they increase their share of non-interest income. Investment-oriented banks, in contrast, become significantly more risky. They do not only report a significantly higher share of non-interest income, but also differ in terms of their activities from retail-oriented banks. To the best of my knowledge, this is the first paper that shows that these differences have an important impact on how non-interest income affects bank risk-taking. Our results indicate that retail-oriented banks should increase their share of non-interest income to become more stable. Investment-oriented banks, in contrast, should decrease it. This implies that banks are significantly less risky if they have a more balanced income structure and neither depend heavily on interest nor on non-interest income. Furthermore, they suggest that the impact of non-interest income on risk significantly depends on the activities used to generate non-interest 1 income with retail-oriented activities being significantly less risky than investment-oriented activities such as those pertaining to capital markets activities. Theory provides no clear prediction regarding the impact of non-interest income on risk. 2 On the one hand, does a higher share of non-interest income make banks less dependent on interest income and improve risk diversification which should make them more stable (Boyd et al., 1980). On the other hand, non-interest income is usually more volatile than interest income, because it is more difficult for borrowers to switch their lending relationship due to information costs (DeYoung and Roland, 2001). Non-interest income also increases operational leverage, since expanding into non-interest income may imply a rise in fixed costs (DeYoung and Roland, 2001). Financial leverage is also higher because regulators require banks to hold less capital against non-interest income activities (DeYoung and Roland, 2001). Both increases the volatility of non-interest income and makes it more risky than interest income. Consistent with this view Altunbas et al. (2011) and Demirgüc-Kunt and Huizinga (2010) show that banks with a high share of non-interest income are more risky. Common to both studies is that they focus on listed banks which are larger and have a more investment-oriented business model than banks not listed. Since the majority of banks in the EU are not listed, Köhler (2012) includes a large number of unlisted banks to make more general conclusions about the impact of non-interest income on risk. In contrast to listed banks, unlisted banks such as savings and cooperative banks are usually smaller and have a more retail-oriented business model with a focus on lending and deposit-taking activities. Enlarging the sample of banks significantly changes the results. While the previous studies find that banks become more risky if they increase their share of non-interest income, Köhler shows substantial benefits from income diversification, in particular, for smaller banks (Köhler, 2012). Larger banks, in contrast, should increase their share of interest income to become more stable. They have a more investment-oriented business model and are more active in volatile and risky trading and off-balance sheet activities such as securitization which may increase risk. Previous research for Germany shows that banks have significantly higher risk-adjusted returns as well if they generate a large fraction of their income from non-interest income activities (Busch and Kick, 2009 and Busch, 2011). However, these studies also find that commercial banks have significantly more volatile returns if they are active in non-interest income activities and conclude that a strong engagement in fee-generating activities makes commercial banks more risky. Savings and cooperative banks, in contrast, are not affected. Our paper is closely related to these papers. It examines the link between non-interest income and risktaking for the German banking sector. Using data from the prudential database of the Deutsche Bundesbank (BAKIS) we are able to construct a dataset on banks income structure for a large sample of savings banks, cooperative banks and other banks such as the big banks, the head institutions of the cooperative and savings banks sector, regional banks or other credit institutions for the period between 2002 and This allows us to investigate whether a higher share of non-interest income makes 2 Non-interest income includes activities such as income from trading and securitization, investment banking and advisory fees, brokerage commissions, venture capital, and fiduciary income, and gains on non-hedging derivatives. 2 German banks more risky or whether it allows them to better diversify their income structure and to become more stable. A priori, we would expect banks with a higher share of non-interest income to be more risky, since non-interest income is more volatile than interest income which is reflected in Figure 2, in particular for the group of big banks and other banks. The non-interest income of savings and cooperative banks, in contrast, is more stable. However, savings and cooperative banks non-interest income also seems to be more correlated with their net interest income which reduces the potential for income diversification. Overall, therefore, there seems to be a trade-off between income volatility and correlation in noninterest income. While a higher share of non-interest income allows banks to better exploit diversification advantages due to lower correlations with banks net-interest income, it also exposes them to significantly higher income volatility. Our paper is different from Busch and Kick (2009) and Busch (2011) in three important aspects. First, while they have data up to 2007, we include the crisis years from 2008 to This allows us to examine whether a higher share of non-interest income has made banks more stable or more risky during the crisis. This is particularly important from the policy perspective as, for instance, recent proposals by the Liikanen Group (2012) on structural reforms in the EU banking sector have been made based on experience made during the crisis. Second, we show that the effect of a higher share of non-interest income on bank risk significantly differs depending on whether a bank has a more retail- or investment-oriented business model. The distinction is important because investment-oriented banks not only generate a significantly higher share of their operating income from non-interest income, but also differ in terms of their activities from retail-oriented banks. For example, while the latter usually earn account administration, insurance or consumer credit fees, investment-oriented banks derive most of their fee and commission income from underwriting, brokerage, treasury management, securitization and clearing and other transaction-related services. To my knowledge, this is the first paper that shows that these differences have an important impact on how non-interest income affects bank risk-taking. Finally, we use quantile regression to examine the relationship between bank s business model and risk. Quantile regression gives a more complete picture on the effect of a set of regressors on the different quantiles of bank risk and allows us to examine whether the effect of non-interest income differs with to the level of risk (Koencker and Hallock, 2000). They are appropriate when a large degree of variation in the data suggests that there may be more than a single slope parameter describing the relationship between the dependent variable and the regressors. For example, as we will show later there is considerable heterogeneity in banks business models not only across, but also within bank groups in Germany. There is also considerable variation in bank size as our dataset comprises a large number of small and retail-oriented banks such as savings and cooperative banks, but also large, investmentoriented banks such as the big banks and the head institutions of the cooperative and savings banks sector. Thus, numerous factors suggest that bank risk may vary considerably across the distribution. Quantile regressions better accommodate this heterogeneity and offer more detailed insights into the factors driving bank risk across the distribution. Therefore, quantile regression can be considered su- 3 perior to the previously used estimation techniques, since it provides more precise estimates of the impact of the determinants of bank risk. We follow the literature and measure bank risk-taking with the Z-Score, defined as the number of standard deviations that a bank s return on asset has to fall for the bank to become insolvent (Laeven and Levine, 2009, Altunbas et al., 2011 and Demirgüc-Kunt and Huizinga, 2010 and Köhler, 2012). In addition, we examine the effect of a higher share of non-interest income on risk-adjusted returns and return volatility. Our sample indicates considerable heterogeneity in risk-tak
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