Does fee income hedge banks and credit unions from spread swings?

The drum is starting to beat again for fee income in the minds of banking executives and in financial institution strategy sessions. This week I heard "hedge" against interest rate fluctuations, a comment more common in the late 1990's to mid 2000's. So I ran some numbers, and the answer to the post title is: it depends.

Fee income comes in many sources. And for most community banks, which I define as banks with less than $10 billion in assets, fee income comprises 10%-20% of total revenue, on average. See the table for a break down of fee income sources by Call Report category for community banks.

With all the talk about fee income lines of business, much if not most of our fee income comes as additional revenue from traditional spread products, such as deposits or residential mortgages. This makes sense. It is our primary business, and fees improve the profitability of bread and butter banking.

But what about this hedge philosophy? I was skeptical. I know from my company's profitability measurement service that fee income products contributed 1% to profits at the average, and -0.8% at the median of all clients. Admittedly, this includes loss leader products such as safe deposit boxes. But, in the main, fee based products are not dropping much to the bottom line.

However, when I sorted top fee based banks and compared their Return on Average Assets to the industry, it appears as though having significant amounts of fee income does protect the institution from the ski slope decline in financial performance that plagued the industry. In effect, high levels of fee income gave financial institutions a softer landing at the bottom (see chart).

But if financial institutions want more from fee based lines of business than to soften their fall, they must focus on delivering profits. This has been a challenge. When I hear executives clamor over fee income, they more often than not focus on revenue generation, not profits. In my experience, profits have been elusive. 

I hear lots of excuses why fee-based LOBs don't make money: soft insurance market, best efforts execution on mortgages, stock market decline, high pay to keep talent, yadda, yadda, yadda. I once heard a complaint from a head of Trust about having to share the copier expense with another department that used said copier more. 

Bottom Line: Insurance, Trust, Investment Advisory, Mortgage Banking, these are all businesses that are common sense complements to traditional spread banking. Almost all of bank customers demand these services. 

Why can't we deliver them profitably?  

~ Jeff

Banking's Curious Lack of Profits in Fee-based Businesses

Remember the good old days when bankers talked big about their fee income prowess? And bank stock analysts issued glowing reports about revenue diversification, and the banks that get “it”. As a side note, if anybody knows what “it” is, please let me know. Because in the fee based business game, “it” appears to be wasted effort.

Why? Because most of us are not making serious money, if we’re making anything at all, from our fee-based lines of business (LOBs). What do I base this on? My firm has been measuring the profitability of LOBs and products since our inception. The average profitability of fee-based products was -10% during the first quarter of 2003, and is –7% during the first quarter of 2012. Are there exceptions? Yes. But on the whole, we have laid a giant egg.

This sad truth reared its head in profit improvement engagements that I worked on. Banks that have meaningful fee based LOBs typically dropped little to the bottom line. We recommend changes to not only get profits to where they should be, as defined by RMA’s common sized income statement (see table for Insurance Agencies), but also to absorb some overhead/support costs from the bank.

I like using RMA numbers because 1) bankers use these statistics to evaluate borrowers by industry, and 2) they are an amalgamation of profit performance of largely private companies by NAICS code. Sure, I could use publicly traded companies. But we have to be cautious comparing a community financial institution’s brokerage operation to Charles Schwab.

But publicly traded companies can be instructive. They typically operate independently, containing HR, IT, and Marketing Departments. These departments are not usually found in community FIs brokerage arms. That is why it is important to measure these units’ profitability with an overhead/support allocation. They rely on HR, IT, etc. from the bank. They should pay for it.

I am not against fee-based LOBs. In fact, managing finances, employee benefits, and risk is becoming increasingly complex for individuals and businesses… i.e. our customers. Developing expertise can clearly be consistent with your FIs strategy.

But they must be developed and managed to deliver meaningful profits to the bottom line. Succeeding will increase the amount of business you do with existing customers, make them stickier, and your FI more valuable to them. It will also increase your profits, reduce dependence on the spread, and reduce the relative size of your big three balance sheet risks… credit, interest rate, and liquidity.

Increase profits, make customers stickier, and decrease risk. Worth it? I would say so.

How about you?

~ Jeff