Why Non-Interest Income of Banks is On the Rise
Banks are like the centrepieces of an economy that require substantial upkeep but the slightest errors in lighting and colour (or macroeconomic realities!) could spell disaster.
No wonder banks around the world have had a tough time coping with the adjusted realities of the pandemic. However, if the results of the first quarter of this financial year are to be believed, they are slowly but steadily falling into the growth recovery lines.
Take the Q1 numbers of ICICI Bank which came out over the weekend, for instance. The country’s second-largest private sector bank witnessed a 78% growth in YoY profit and an 18% rise in net interest income (NII) from a year ago.
But buried in the fine print is another revelation that is slowly becoming an industry trend — there has been a significant rise in the “non-interest income” (or income which is “non-core” in a way — to be explained later) of ICICI Bank, 56% up this quarter, moving from 20% of its total income in June 2020 to 25% as at June 2021.
And no, ICICI is not alone. Most Indian banks, be it Kotak Mahindra or Yes Bank have witnessed a likewise rise in non-interest incomes over the past twelve months.
Now is that a bad thing? And more importantly, how does it affect the banking sector’s performance at large?
Here’s our take.
All About the Interest
The core activities of any bank or financial institution is to accept deposits from depositors at one end to (simplistically speaking) lend them to those in need. The “net interest income” or NII is the difference between the interest earned on loans and the interest expended to depositors, with the former being charged at a higher rate than the latter. Otherwise what’s the point!?
So essentially, the NII is the operating income generated from the core activity of the bank i.e. lending.
But this isn’t the only source of a banks’ income. Any other revenue not directly generated by this difference in interest rates (or lending activity) is clubbed into another category called the non-interest income.
These include loan processing fees, late payment fees, broker fees, investment banking fees, commissions from other products and services offered by the bank (like mutual funds, insurance) etc.
It is important to understand that unlike non-banks or regular companies which rely entirely on non-interest income, banks and financial institutions make most of their money through interest income. Lending is their principal operating activity. In an ideal world, they would like to make their margins on lending, and optimise margins on non-interest components such as loan processing fees.
However things change during a crisis when there is a credit crunch (usually because of enhanced risk of default amongst borrowers or risk perception) and low interest rates, which further squeezes the spread between the cost of funds and the average lending rate. Banks are incentivised to charge a higher fee on cheaper loans, thereby tilting their mix of income.
Case in point can be seen below. Whenever the credit cycle has been at its worst, non-interest income as a percentage of total income has gone up.
History doesn’t repeat but surely rhymes.
The Downside
So what’s the problem? Money is money, right? We wish. One issue is predictability. Non-interest income sources are useful but not always stable.
In order to commence and sustain many of these fee-based activities, banks would have to incur considerable fixed or semi-fixed expenses like wages, up and running digital infrastructure and related overheads, which may not be enticing considering the track record of Indian banks with the fool-proofication of their networks.
These expenses can’t be reduced easily either because they are usually embedded as part of third-party services (payments gateway, insurance brokers etc.). Consequently, they increase the level of operating leverage that a bank is exposed to.
More operating leverage means more variation in revenues because now there is more exposure to the ups and downs of the business cycle.
A Mixed Bag of Interests
On the other hand, interest incomes are comparatively stable. You borrow and lend as necessary. Switching costs (cost of breaking a commercial relationship) and other variable costs are low too.
The point is, non-interest income sources for banks are not without bane. COVID-19 has undoubtedly exacerbated the challenges faced by Indian banks which are coping hard to improve financial performance and asset-qualities.
However, with gradual lifting of restrictions and the expansion in scope of ECLGS, the uptick in disbursals in the near term would be keenly watched. Large private banks may in fact be better positioned, with their better liability franchise and stronger balance sheets.
It is no wonder that ICICI, trading at 2.87x price to book (a discount to HDFC Bank and Kotak), may still be one of the right horses to back, in a gradually shrinking stable of studs that is Indian banking.
(Originally published July 31st 2021 in transfin.in)
