Disadvantages of Non-Interest Income

In the previous article, we learned about the non-interest income at various commercial banks. We have also understood what these sources of non-interest income are and why they are preferred by many banks. It is true that there are several advantages to having sources of non-interest income. However, it is equally true that advantages are only one side of the story. Just like there are many advantages to having a non-interest income, there are also several disadvantages to having the same.

In this article, we will have a closer look at what are the various disadvantages of having non-interest income as a significant portion of the overall income of a commercial bank.

  1. Requires High Investment in Technology: The ability of a commercial bank to generate non-interest income is directly dependent upon the technological capabilities of the bank. Most of the periodic fees which banks charge from their clients are actually fees for the use of the technological infrastructure owned by the banks. However, the problem with technological infrastructure is that it requires very high investment. Also, the personnel required to maintain this infrastructure charge a lot of money.

    Hence, the commercial bank has to bear all these expenses. The problem is that technology also tends to get outdated very soon. In that case, the bank also tends to lose a lot of money in the form of depreciation. Hence, generating non-interest income can require a significant upfront investment from the bank’s point of view even though the recurring expenses are quite low.

  2. Competition from Fintech: Another problem with generating non-interest income is that the commercial bank is forced to deviate from its core competency. For many decades, commercial banks have been focusing on developing relationships. However, when it comes to non-interest income, they are forced to develop the technology. This puts them in direct competition with the fintech industry.

    Now, the fact of the matter is that fintech companies are more technologically inclined and are likely to provide better products and services as compared to the banking industry. Hence, commercial banks are playing a losing game when it comes to competing with the fintech industry. As a result, they are better off avoiding this competition.

  3. High Operating Leverage: As mentioned above, firms have to invest a lot of fixed capital in building the infrastructure which is required to provide services that help earn non-interest income. Not only does building the infrastructure take money but so does maintaining it. All of these expenses are fixed expenses that happen regularly. They are not related to the scale of operations performed by the bank.

    Hence, the costs related to such operations also tend to be stagnant. This means that the costs do not go up or down along with the bank’s operations. This creates operating leverage which means an additional risk for the bank. This is because the bank has to pay the same outflow even if the scale of operations is lower in a given month. This is in stark contrast to interest-based earnings which go up and down with the scale of operations. This is the reason that non-interest-based earnings have the potential to cause bank failures.

  4. Systemic Risk: It is important to understand the entire banking system works as a single unit. Hence, it can be said that if one bank fails, it has the potential to bring the finances of other banks under pressure as well.

    As we have seen in the above point that non-interest-based earnings can create operational leverage and magnify risks at the commercial bank. Hence, if a bank does not contain its own risk, it can create problems for other banks which are not taking as much risk. It is for this reason that many studies have predicted that the high percentage of increasing non-interest income in commercial banks has the potential to cause systemic risk.

    Over time, the regulators are waking up to the possibility of a contagion triggered by high operating leverage in a few banks. Hence, they are also creating rules in order to prevent an economic catastrophe.

  5. High Customer Churn: Last but not the least, services that generate non-interest income are very transactional in nature. We can consider the case of payment processing as an example.

    Payment processing is a service that is generally automated and can be performed by almost any bank in a similar manner. Hence, there is no relationship management which is generally a differentiating factor.

    From the bank’s point of view, the inability of competitive differentiation means that customers can rapidly change service providers without any hassles. From a commercial bank’s point of view, the only thing they can compete on is price. This inevitably leads to price wars and eats into the profitability of the bank as a whole. Since there is very little that commercial banks can do to avoid such customer churn, they do not prefer to have non-interest-based sources of income.

The fact of the matter is that non-interest income provides much-needed diversification to the revenue mix of the commercial banks. However, there is generally a very high cost associated with it as well. Commercial banks need to carefully weigh the pros and cons before they finally make a decision.

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Commercial Banking