Does non‐interest income make banks more risky? Retail‐ versus investment‐oriented banks

• Published date: 01 November 2014
• Author: Matthias Köhler
• DOI: http://doi.org/10.1016/j.rfe.2014.08.001
• Date: 01 November 2014

Does non-interest income make banks more risky? Retail- versus

investment-oriented banks☆

Matthias Köhler ⁎

DeutscheBundesbank, Wilhelm-Epstein-Straße14, 60431 Frankfurtam Main, Germany

abstractarticle info

Articlehistory:

Received27 March 2014

Receivedin revised form 24 July 2014

Accepted9 August 2014

Availableonline 16 August 2014

JEL classification:

G20

G21

G28

Keywords:

Banks

Risk-taking

Businessmodel

Non-interestincome

Incomediversification

In this paper, we show that th e impact of non-interest i ncome on bank risk differs b etween retail- and

investment-oriented banks. Morespecificall y, while retail-oriented banks such as savings, cooperat ive and

other banks that focus on lending and deposit-taking services become significantly more stable (in thesense

of having a higher Z-score)if they increase their share of non-interest income,investment-oriented banks be-

come significantlymore risky. Theydo not only generate a higher shareof their income from non-traditional ac-

tivities, but also engage in significantly differen t activities from retail-oriented banks. T his might limit the

potential benefits to investment-oriented banks of diversifying into non-interest income. Overall, the refore,

our paperimplies that it is important to distinguishbetween retail-and investment-orientedbanks when draw-

ing generalconclusions regardingthe impact of non-interest incomeon bank risk.

© 2014 ElsevierInc. All rights reserved.

1. Introduction

In this paper, we analyze how non-interest income affects bank risk.

Non-interest income is a mixture of heterogeneous components that gen-

erate incomeother than interest income. It comprises fee and commission

income that is closely related to market-oriented activities such as under-

writing andsecuritization, but alsoincome that is related to traditional

banking activities such as payment services fees and commission income

arising from the sale of insurances and other products. Non-interest in-

come also includes the income banksgenerate with their trading and

market-making activities and other operating income. Because non-

interest income is usually more volatile than interest income, it is often

held to be more risky. This is particularly the case for trading income as

was illustrated by the2007–8financial crisis. While large investment-

oriented banks with substantial trading activities experienced a large

drop in their profitability,smaller, retail-oriented banks were affected

much less.

1

Following on from this, the first hypothesis tested in this

paper is that investment-oriented banks become more stable if they

reduce their share of non-interest income. This contrasts with retail-

oriented banks. They depend heavily on interest income and might bene-

fit from diversifying into non-interest income. They also engage in signif-

icantly different activities from investment-oriented banks, a fact which

might also influence the way in which non-interest income impacts on

bank risk. The second hypothesis postulated in thispaper, therefore, is

that retail-oriented banks will become more stable if they increase their

share of non-interest income. To summarize, hence, we examine in this

paper whether the impact of non-interest income on bank risk differs be-

tween retail- and investment-oriented banks.

We show that the impact of non-interest income on bank risk indeed

significantly differs between retail- and investment-oriented banks. More

specifically, while retail-oriented banks such as savings, cooperative and

other banks that focus on lending and deposit-taking services become sig-

nificantly more stable (in the sense of having a higher Z-score) if they in-

crease their share of non-interest income, investment-oriented banks

Reviewof Financial Economics 23 (2014)182–193

☆Theauthor would like to thank ChristophMemmel, HeinzHerrmann, the participants

at theBundesbank seminar,the conference on “Banking,Finance, Money and Institutions:

The Post Crisis Era”and the 6th I FABS Conference on “Alternative Futures for Global

Banking”andan anonymous refereefor their comments and suggestions.

⁎Tel.:+ 49 69 95664765; fax: +49 69 9566 4765, +49 69 9566 2551.

E-mailaddress: matthias.koehler@bundesbank.de.

1

Laevenet al. (2014) show that large banks performedsignificantly worse duringthe

2007–8financial crisis than small banks. They are characterized by less-stable funding

and moremarket-based activities andare more organizationallycomplex. For a descrip-

tiveanalysis of the performanceof small, medium-sizedand large banks in Europeduring

the financialcrisis, see also Köhler (2014).

http://dx.doi.org/10.1016/j.rfe.2014.08.001

1058-3300/©2014 Elsevier Inc. All rightsreserved.

Contents listsavailable at ScienceDirect

Review of Financial Economics

journal homepage: www.elsevier.com/locate/rfe