Non-Interest Expense

A non-interest expense is an expense for a bank other than those related to interest paid on customer deposits.

Office rent, insurance premiums, amortization of intangible assets, employees' salaries, and several other operational expenses form a bank's non-interest expense.

A bank would want to minimize its operational costs, which would ultimately lead to increased profits, further maximizing shareholder wealth. Non-interest costs have to be incurred by a bank to ensure its smooth day-to-day functioning.

Service fees such as late charges on loans, annual fees, and loan approval fees are used to compensate for the non-interest expenses incurred by the bank. If these costs are not efficiently managed, they may affect the bank's profitability.

Nowadays, shareholders tend to look more deeply into executive salaries to ensure they do not get unnecessary compensation. Shareholders would want to reduce the company's costs, so they prefer competitive pay for managers.

Constituents

This expense is the operating cost of a bank. Employee costs, information technology costs, legal fees, consulting services, postage and stationery, material cost components, and costs associated with renting or leasing buildings constitute the non-interest expenses. 

Banks with low operating costs will enjoy economies of scale, allowing them to spread lower costs over larger revenues. Non-interest expenses are a major constituent of a bank's overall expenses; the overhead ratio is calculated using non-interest as an overhead.

We obtain the overhead ratio by dividing the non-interest expense by the average assets. A high overhead ratio is not preferred as it would mean that the bank is incurring high operating costs and is not being run efficiently.

If a bank reports an operating expense to income ratio constantly, it will indicate that it has high operating costs, reducing its profitability. Therefore, minimization of employee costs is a bank's strategy to reduce its operating expenses.

Constituents of Operating Income of a Bank

Operating income is used by banks to offset their non-interest expenses, which include net interest income and non-interest income.

1. Net interest income

A bank's net interest income is the difference between interest paid on customer deposits and the interest charged on loans.

Banks issue several types of loans using the deposits they receive from their customers in the form of mortgages, personal loans, loans to financial institutions, etc.

They also invest a certain amount of money in financial instruments such as stocks, bonds, and other alternative investments such as mortgage-backed securities, real estate, commodities, etc.

The bank's profit and loss statement record the interest earned on loans and coupon payments received periodically for holding bonds as interest income.

The bank has to pay interest on its customer deposits because money has got time value attached to it. Therefore, the interest rate paid to customers is usually lower than what they charge on loans given. The difference is what the banks earn, i.e., the net interest income.

2. Non-interest income

The income earned by a bank other than its interest income on loans is its non-interest income, which would include bank-issued cards, swap fees, maintenance fees on accounts, overdraft fees, etc.

These revenues should not be the primary source of a bank’s income and are complementary to interest income on loans.

Bank Efficiency Ratio

Analysts often use a ratio of non-interest expense to net operating revenue to measure a bank's performance. This ratio is known as the bank efficiency ratio.

The formula for the bank efficiency ratio is given below:

Efficiency Ratio = Non-Interest Expense/ (Net interest income + non-interest income)

This ratio tells us about the amount of money the bank has spent to earn each dollar of revenue. The efficiency ratio can differ from bank to bank and generally ranges between 50% and 80%.

An efficiency ratio of 50% or less is pretty good, which means that to earn a revenue of $1, the bank has to spend only 50 cents.

A lower efficiency ratio would indicate that the bank has low operating costs, which would, in turn, increase the profits. The variables required to calculate the efficiency ratio can be obtained easily from a bank's P&L statement.

What is the difference between investment and commercial banks in relation to non-interest expenses?

Non-interest expenses for a commercial bank are generally lower than those for an investment bank.

Investment banks are generally involved in activities that involve high employee compensation and involvement, such as mergers and acquisitions, private equity, raising capital in the primary market, etc.

Thus, employee salaries and bonuses form a major chunk of the non-interest expense for an investment bank. In contrast, other activities have a very minute share of the non-interest costs.

Commercial banks’ main targets are to hold customer deposits for longer periods and give out loans to potential borrowers, which requires very low employee compensation and involvement. Thus, commercial banks have low non-interest expenses.

The central bank regulates commercial banks regarding their investment activities and the liquidity ratios required to be maintained, i.e., ratios like the statutory and cash reserve ratios need to be at certain levels, reducing their ability to invest compared to an investment bank.

Researched and authored by Kunal Goel | LinkedIn

Free Resources

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