Does expansion into non-interest activities affect bank risk and lending conditions (interest rate spreads)?

Presentation for

Product diversification in the European banking industry : Risk and loan pricing implications
Laetitia LEPETIT, Emmanuelle NYS, Philippe ROUS, Amine TARAZI

LAPE, University of Limoges

tarazi@unilim.fr

BACKGROUND AND RESEARCH MOTIVATION

Functional Diversification and expansion into nontraditionnal fee-based activities (share of non-interest income in total income 43% in 1998 against 26% in 1989 date of ECB Directive). Higher Competition on the loan market with a drop in interest rates and interest margins. Are banks underpricing credit facilities to increase market shares and gain more fees?

1. 2.

Implications for the safety of the banking system It is not clear whether by widening their range of products banks improve their risk/return trade off and their default risk. The provision of a larger set of products increases the incentives for cross-subsidisation which may distort risk exposure
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AIM OF THE PAPER

To assess the risk implications of product diversification extending the earlier work by Considering the case of European banks while previous work on bank diversification was essentially dedicated to U.S. banks. Raising the issue of cross-selling among traditional and nontraditional activities and incentives to underprice loans and credit risk whereas previous papers focused on portfolio diversification effects. Introducing the impact of non-interest activities in the bank interest margin literature. To explore whether banks engaged in diversification underprice loans using them as a loss leader which could be linked with the higher risk reported in some studies (De Young and Roland, 2001; Stiroh, 2004).
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PRESENTATION
1. Relationship between the changing structure of bank income and risk in the European banking industry
Recent US studies find no gains from diversification and in some cases higher risk (De Young and Roland 2001; Stiroh, 2004). Do we obtain similar results for Europe?

2. Lending rate and non traditional activities

Do banks more engaged in non-interest activities set a lower interest margin and/or charge a lower lending rate then they should? Do banks more engaged in non-interest activities underprice credit risk?

3. Conclusion
Product diversification in the European banking industry: Risk and loan pricing 4

1. Bank risk and product diversification

Data set
Sample period : 1996 to 2002 Database: Annual income statements and balance sheets for individual banks Bankscope Fitch IBCA. Daily stock indexes and individual bank stock prices Datastream International Two samples of European commercial and cooperative banks (14 countries) are used: Banks for which sufficient information is reported in Bankscope for the purpose of our study throughout the 7 years we consider. This sample contains 951 banks. 156 listed banks
Product diversification in the European banking industry: Risk and loan pricing 5

1. Bank risk and product diversification Degree of diversification : an income structure approach
We split our samples into different panels of banks on the basis of the value of the ratio of net non interest income to net operating income (NNII): diversified banks for which the value of the NNII ratio is higher than the third quartile (Q75), non diversified banks with a NNII ratio lower than the first quartile (Q25). Our diversification criteria is also disaggregated to allow for deeper insights. We distinguish two components of NNI: - ratio of net commission and fee income to net operating income (COM) - ratio of net trading income to net operating income (TRAD)

Product diversification in the European banking industry: Risk and loan pricing

1. Bank risk and product diversification Degree of diversification and risk : stylised facts
We conduct univariate mean tests and spearman rank correlation tests : Using a set of risk measures and probability of failure measures based on accounting data SDROA, SDROE, CVROA, CVROE, LLP, Z-scores and market data SD daily returns, BETA, Specific Risk, Z-scores, Distance to Default H0 : The level of risk of diversified banks is not higher than the level of risk of non diversified banks H1 : The level of risk of diversified banks is higher than the level of risk of non diversified banks
Product diversification in the European banking industry: Risk and loan pricing 7

Product diversification, risk and default risk : results based on daily market data (1996-2002)
Risk Measures SDRET NNII > Q75 Mean (Obs.) 0.05 39 0.66 39 0.04 39 37.30 39 15.51 38 BETA RSPEC Insolvency risk measures MDZ DD

NNII < Q25

Mean 0.02 0.18 0.02 51.31 26.13 (Obs.) 39 39 39 39 38 T-statistic of the mean Test 4.800*** 4.970*** 3.900*** -2.060** -1.870** T statistics test for the null:"Risk/Insolvency is not higher for high level of product diversification". ***, ** and * indicate significance respectively at the 1%, 5% and 10% levels for a unilateral test. Variable definitions: NNII = ratio of net non interest income to net operating income; COM = ratio of net commission income to net operating income; TRAD = ratio of net trading income to net operating income; SDRET = standard deviation of daily stock returns; BETA = market model beta; RSPEC = standard deviation of the market model residual; MDZ = market data based Z-score; DD = distance to default.

Product diversification in the European banking industry: Risk and loan pricing

Product diversification, risk and default risk : results based on daily market data and for the two components, trading income and commission and fee income (1996-2002)
Risk Measures SDRET COM > Q75 Mean (Obs.) COM < Q25 Mean (Obs.) T-statistic of the mean Test TRAD > Q75 Mean 0.04 0.68 0.03 38.80 16.09 (Obs.) 34 34 34 34 33 TRAD < Q25 Mean 0.03 0.32 0.03 43.55 21.29 (Obs.) 34 34 34 34 33 T-statistic of the mean Test 0.970 3.070*** 0 -0.850 -0.890 T statistics test for the null:"Risk/Insolvency is not higher for high level of product diversification". ***, ** and * indicate significance respectively at the 1%, 5% and 10% levels for a unilateral test. 0.05 39 0.03 39 3.270*** 0.57 39 0.21 39 3.560*** 0.04 39 0.03 39 2.540*** 36.15 39 55.92 39 -2.820*** 15.37 38 28.95 38 -2.350** BETA RSPEC Insolvency risk measures MDZ DD

Product diversification in the European banking industry: Risk and loan pricing

1. Bank risk and product diversification Trends in diversification and risk changes
To study the link between the shift towards non interest income and bank risk we conduct tests based on high frequency data (market data) As a first step we investigate if banks with a high annual growth rate in non traditional activities (NNII > 3% per year) exhibit a higher increase in risk than banks with a relatively low annual growth rate of NNII (NNII < 1% per year). Faster diversification As a second step we control for the relative position of each bank with respect to the average level of diversification in our sample by excluding banks with a diversification level lower than the sample mean reached in 2002. Faster AND Higher diversification A similar procedure is adopted for the two components of net non interest income (COM and TRAD).

Product diversification in the European banking industry: Risk and loan pricing

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Faster diversification and changes in risk for European listed banks (19962002)
Growth rate of risk Measures Growth rate of insolvency measures SDRET BETA RSPEC MDZ DD

COM > 3%
Mean (Obs.) COM < 1% Mean (Obs.) T-statistic of the mean Test TRAD > 3% Mean (Obs.) TRAD < 1% Mean (Obs.) T-statistic of the mean Test 13.77 72 11.68 11 2.690 *** 15.05 23 14.02 53 1.460 94.29 72 -47.45 11 3.590 *** -49.63 23 -15.73 53 -2.610 12.00 72 7.30 11 6.330 *** 13.01 23 11.62 53 2.00 ** 24.24 72 26.31 11 -2.950 -5.61 61 14.69 11 -4.650

20.39 23 26.73 53 -8.220

-15.54 21 0.22 44 -6.210

***, ** and * indicate significance respectively at the 1%, 5% and 10% levels for a unilateral test.

Product diversification in the European banking industry: Risk and loan pricing

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Faster and higher diversification and changes in risk for European listed banks (1996-2002)
Growth rate of risk Measures SDRET BETA RSPEC Growth rate of insolvency measures a MDZ DD

COM > 3% and COM > COM average of the banking industry in 2002
Mean 21.90 251.38 18.21 23.59 (Obs.) 29 29 29 29 COM < 1% and COM < COM average of the banking industry in 2002 Mean (Obs.) T-statistic of the mean Test 9.89 10 9.320*** -35.62 10 2.820*** 5.16 10 10.66*** 26.31 10 -1.460 1.97 23 16.47 10 -1.630

TRAD > 3% and TRAD > TRAD average of the banking industry in 2002
Mean 12.47 -113.97 9.04 21.25 (Obs.) 14 14 14 14 TRAD < 1% and TRAD < TRAD average of the banking industry in 2002 Mean (Obs.) T-statistic of the mean Test 14.64 35 -53.15 35 12.26 35 25.96 35 -9.91 14 9.29 29

-2.010 -2.580 -3.120 -4.300 -5.270 T-statistics test for the null: "Risk/Insolvency growth is not higher for banks which have actively diversified their activities on the whole period and have reached a relatively high level of diversification in 2002". ***, ** and * indicate significance respectively at the 1%, 5% and 10% levels for a unilateral test.

Product diversification in the European banking industry: Risk and loan pricing

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PRODUCT MIX and LOAN PRICING Consistent with some US studies banks with higher non-interest income share of total income exhibit higher risk but this result is driven by commission and fee based activities. Higher reliance on trading activities is not associated with higher risk. Robustness checks (regressions controlling for various factors) The European banking industry might have experienced different changes and because commission and fee activities are linked to lending activities (cross selling of products to a core customer) we further look at the relationship with

bank interest margins and interest rate setting.

METHOD AND THEORETICAL BACKGROUND We revisit the literature on optimal bank interest margin (Klein, 1971; Monti, 1972; Ho and Saunders, 1981; Angbazo, 1997; Wong, 1997; Saunders and Schumacher, 2000; Drakos, 2003; Maudos and Guevara, 2004) by AUGMENTING the traditional models with cross-selling determinants.
Product diversification in the European banking industry: Risk and loan pricing 13

2. Lending rate and non traditional activities THE DIFFERENT STEPS

Estimation of several standard models controlling for various factors. Estimation of AUGMENTED models and checking for robustness (cross section, time trend, first-order difference, size) to test the two following hypotheses Hypothesis 1 : Banks more heavily engaged in non interest activities and particularly in commission and fee activities set a lower interest margin and/or charge a lower lending rate. Hypothesis 2 : Banks more engaged in non interest activities and particularly in commission and fee activities underprice credit risk
Product diversification in the European banking industry: Risk and loan pricing 14

MODEL SPECIFICATION
Dependent variable 1) The risk premium on loans is first proxied by a : - broad definition of the spread: W_SPREAD = the ratio of net interest income to total earning assets - the 10 year government bond rate, - narrow definition of the spread: N_SPREAD = the lending rate determined as the ratio of interest from loans to net loans - the 10 year government bond rate. 2) For consistency with previous studies, we also consider two measures of the net interest margin : - a broad definition of the margin: W_MARGIN = ratio of net interest income to total earning assets, - a narrow definition of the margin: N_MARGIN = the ratio of interest income from loans to net loans - the ratio of interest expenses to total liabilities

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2. Lending rate and non traditional activities

We estimate two sets of equations :

MARGINit = 1i + 2 R3M j(i)t +3 LLPit +4 LIQUIDITYit + 5 EQUITYit + 6 TA _ Rit + 7 EXPENSESit it MARGINit = 1i + 2 R3M j(i)t +3 LLPit +4 LIQUIDITYit + 5 EQUITYit + 6 TA _ R it + 7 EXPENSESit 8 NNIIit + it MARGINit = 1i + 2 R3M j(i)t +3 LLPit +4 LIQUIDITYit + 5 EQUITYit + 6 TA _ Rit + 7 EXPENSESit 8 NNIIit 9 COMSHAit + it MARGINit = 1i + 2 R3M j(i)t +3 LLPit +4 LIQUIDITYit + 5 EQUITYit + 6 TA _ R it + 7 EXPENSESit 10 COMit 11TRADit + it
MARGINit = 1i + 2 R3M j(i)t +3 LLPit +4 LIQUIDITYit + 5 EQUITYit + 6 TA _ R it + 7 EXPENSESit 8 NNIIit LLPit /100+ it

MARGINit = 1i + 2 R3M j(i)t +3 LLPit +4 LIQUIDITYit + 5 EQUITYit + 6 TA _ R it + 7 EXPENSESit 8 NNIIit LLPit /100 9 COMSHAit LLPit /100+ it
MARGINit = 1i + 2 R3M j(i)t +3 LLPit +4 LIQUIDITYit + 5 EQUITYit + 6 TA _ R it + 7 EXPENSESit 10 COMit LLPit /100 11 TRADit LLPit /100+ it

i and t are respectively indices for banks i and time t; MARGINit is defined either as : W_MARGIN = net interest income/total earning assets (equations 1 to 4); or N_MARGIN = interest income from loans/net loans interest expenses/total liabilities (equations 1 to 4); R3Mjt : the three months interbank rate for country j of bank i at time t; VR3Mjt : Volatility of the three months interbank rate (standard deviation computed with daily data) for country j; LLPit = loan loss provisions/net loans;

LIQUIDITYit = net loans/deposits; EQUITYit = equity/total assets; TA_Rit = total assets for bank i divided by the sum of the total assets of the banking system; EXPENSESit = personnel expenses/total assets; NNIIit = net non-interest income/total net operating income; COMit = net commission and fee income/ total net operating income; TRADit = net trading income/ total net operating income; COMSHAit = net commission and fee income/ net non-interest income.

Product diversification in the European banking industry: Risk and loan pricing

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2. Lending rate and non traditional activities

SPREADit = 1i + 2 VR3M jt + 3 LLPit + 4 EQUITYit + 5 TA _ R it + 6 EXPENSESit it SPREADit = 1i + 2 VR3M jt + 3 LLPit + 4 EQUITYit + 5 TA _ R it + 6 EXPENSESit 7 NNIIit + it SPREADit = 1i + 2 VR3M jt + 3 LLPit + 4 EQUITYit + 5 TA _ R it + 6 EXPENSESit 7 NNIIit 8 COMSHAit + it SPREADit = 1i + 2 VR3M jt + 3 LLPit + 4 EQUITYit + 5 TA _ R it + 6 EXPENSESit 9 COMit 10 TRADit + it
SPREADit = 1i + 2 VR3M jt + 3 LLPit + 4 EQUITYit + 5 TA _ R it + 6 EXPENSESit 7 NNIIit LLP /100+ it

SPREADit = 1i + 2 VR3M jt + 3 LLPit + 4 EQUITYit + 5 TA _ R it + 6 EXPENSESit 7 NNIIit LLPit /100 8 COMSHAit LLPit /100+ it
SPREADit = 1i + 2 VR3M jt + 3 LLPit + 4 EQUITYit + 5 TA _ R it + 6 EXPENSESit 9 COMit 10 TRADit + it

i and t are respectively indices for banks i and time t; SPREADit is defined either as : W_SPREAD = net interest income/total earning assets - the 10 year government bond rate (equations 5 to 8); or N_SPREAD = interest from loans/net loans - the 10 year government bond rate (equations 5 to 8); R3Mjt : the three months interbank rate for country j of bank i at time t; VR3Mjt : Volatility of the three months interbank rate (standard deviation computed with daily data) for country j; LLPit = loan loss provisions/net loans;

LIQUIDITYit = net loans/deposits; EQUITYit = equity/total assets; TA_Rit = total assets for bank i divided by the sum of the total assets of the banking system; EXPENSESit = personnel expenses/total assets; NNIIit = net non-interest income/total net operating income; COMit = net commission and fee income/ total net operating income; TRADit = net trading income/ total net operating income; COMSHAit = net commission and fee income/ net non-interest income.

Product diversification in the European banking industry: Risk and loan pricing

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2. Lending rate and non traditional activities (two-way fixed effect panel data estimations)
Equation R3M LLP LIQUIDITY (+) (+) (+) Dependant variable: W_MARGIN (2342 obs.) 0.115*** 0.071*** 0.000* (5.622) (3.850) (1.760) 0.100*** 0.047** -0.000 (3.955) (2.443) (-0.076) Dependant variable: N_MARGIN (2342 obs.) 0.140*** 0.149*** -0.001* (3.923) (5.067) (-1.680) 0.159*** 0.114*** -0.000*** (5.349) (3.390) (-4.861) VR3M (+) LLP (+) EQUITY (+) EQUITY (+) 0.035*** (4.715) 0.032*** (4.449) -0.070* (-1.769) -0.022 (-0.819) EXPENSES (+/-) EXPENSES (+/-) 0.404*** (6.433) 0.415*** (6.653) 0.204 (1.635) 0.135 (1.045) TA_R (+/-) TA_R (+/-) 0.137 (0.094) 0.304 (0.275) 1.672 (0.691) 1.707 (0.748) NNII (-) NNII (-) -0.019*** (-5.308) -0.010** (-1.967) COMSHA (-) COMSHA (-) COM (-) TRAD (-) R2

[1] [2]

0.920 0.929

[1] [2]

0.799 0.843

Equation

COM (-)

TRAD (-)

R2

Dependant variable: W_SPREAD (2342 obs.) 0.942 0.145*** 0.007 0.335* 9.924 0.776 (1.527) (3.065) (0.517) (1.740) (1.537) [6] 0.899 0.136*** -0.014** 0.629*** 9.608 -0.015*** 0.790 (1.516) (2.817) (-2.097) (4.698) (1.414) (-2.642) Dependant variable: N_SPREAD (2342 obs.) [5] 0.973* 0.231*** -0.006 0.224*** 4.417 0.815 (1.669) (4.697) (-0.296) (2.914) (1.429) [6] 0.954* 0.240*** -0.013 0.324*** 4.180 -0.014*** 0.818 (1.676) (5.201) (-0.589) (5.205) (1.351) (-3.012) ***, ** and * indicate significance respectively at the 1%, 5% and 10% levels. t-statistics are corrected for heteroskedasticity following Whites methodology. [5]

Product diversification in the European banking industry: Risk and loan pricing

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2. Lending rate and non traditional activities (two-way fixed effect panel data estimations)
Equation VR3M (+) LLP (+) EQUITY (+) EXPENSES (+/-) TA_R (+/-) 9.550 (1.424) 6.978 (1.322) 4.091 (1.318) 7.523*** (3.558) TA_R (+/-) NNII (-) -0.016*** (-2.659) COMSHA (-) -0.065* (-1.853) COM (-) -0.053*** (-2.838) -0.046** (-2.619) TRAD (-) -0.001 (-0.262) -0.006* (-1.943) R2 Dependant variable: W_SPREAD (2342 obs.) 0.891 0.138*** -0.015** 0.627*** (1.526) (2.852) (-2.068) (4.699) 0.733 0.124** 0.002 0.251 (1.528) (2.430) (0.116) (1.343) Dependant variable: N_SPREAD (2342 obs.) 0.949* 0.234*** -0.014 0.316*** (1.685) (5.093) (-0.620) (5.077) 0.717 0.141*** -0.006 0.197** (1.177) (3.195) (-0.293) (2.165) VR3M (+) LLP (+) EQUITY (+) EXPENSES (+/-)

[7] [8]

0.791 0.791

[7] [8]

-0.014*** (-2.784) -

-0.053** (-2.257) -

0.818 0.807

NNII*LLP/100 (-)

COMSHA*LLP/100 (-)

COM*LLP/100 (-)

TRAD*LLP/100 (-)

R2

Dependant variable: W_SPREAD (2342 obs.) [12] 0.840 0.437*** -0.025*** 0.831*** 9.203 -0.615*** (1.420) (3.805) (-3.158) (7.022) (1.631) (-3.408) [13] 0.833 0.479*** -0.025*** 0.829*** 9.172 -0.628*** -4.114* (1.416) (4.293) (-3.227) (6.977) (1.640) (-3.493) (-1.744) [14] 0.788 0.598*** -0.024*** 0.829*** 8.656 -1.218*** -0.007 (1.402) (6.628) (-3.125) (7.536) (1.592) (-8.289) (-0.149) Dependant variable: N_SPREAD (2342 obs.) [12] 0.850 0.664*** -0.006 0.333*** 8.582*** -1.097*** (1.247) (5.311) (-0.224) (3.289) (4.325) (-4.864) [13] 0.847 0.682*** -0.006 0.331*** 8.503*** -0.943*** -5.407 (1.243) (5.279) (-0.252) (3.285) (4.261) (-4.499) (-1.490) [14] 0.838 0.659*** -0.005 0.327*** 8.600*** -1.047*** -0.701 (1.208) (5.972) (-0.188) (3.261) (4.303) (-4.120) (-0.075) ***, ** and * indicate significance respectively at the 1%, 5% and 10% levels. t-statistics are corrected for heteroskedasticity following Whites methodology.

0.789 0.789 0.791

0.807 0.808 0.807

Product diversification in the European banking industry: Risk and loan pricing

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3. Conclusion (1)
Our study first shows that banks which have expanded into non-interest income activities present a higher level of risk than banks which principally supply traditional intermediation activities - but a closer investigation shows that this result is driven by feebased activities but not trading activities. - Similar findings are obtained for the link between risk changes and faster diversification within our sample period. Our tests for a possible cross-selling behaviour of interest and non-interest products show that higher reliance on fee-based activities is associated with - lower lending rates - and that borrower default risk might be underestimated raising the issue of how cross-selling strategies should be addressed by regulators to control for bank risk.
Product diversification in the European banking industry: Risk and loan pricing 20

3. Conclusion (2)

Our findings are based on the assumption that banks do not charge higher fees when lending to more risky borrowers and that on average higher income from commission and fee activities does not serve as a buffer against default risk along with traditional instruments such as loan loss provisions. A deeper investigation on this issue requires access to more detailed data on individual borrower default risk and lending conditions but also on individual prices for banking services.

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