In my last article, I discussed some of the major determinants of financial crises. In this piece, I would like to elaborate on two of the more important and less understood factors recently found to strongly correlate with financial crises, particularly the global financial crisis of 2008.
Before we start, recall that academic studies published in leading finance and economic journals generally identified a set of bank failure determinants including the number of nonperforming loans, high concentrations of mortgage-related loans (aka subprime mortgages), managerial inefficiency, lax regulations, capital inadequacy, low profitability, high credit deposit ratio, high asset growth, financial leverage, widespread use of exotic financial instruments and moral hazard problems stemming from deposit insurance schemes.
It is interesting to note that one of most important predictors of bank failure, the bank net interest margin mentioned in my last article, is infrequently or rarely discussed in the popular press. The probability of a GFC is lower for countries with a higher net interest margin.
I'll try to explain, without mathematical and econometric models, how the shift from traditional-deposit-taking-bank activities to nontraditional, or fee-based, activities has contributed to the global financial crisis.
Banks traditionally make money by taking deposits from customers and generating loans. Net interest margin-the ratio of net interest income to earning assets-represents the return on the bank's earning assets such as loans and leases. It is analogous to the gross profit margin of nonfinancial firms.
The higher this ratio, the better the bank is in using its earning assets to generate income. If this number is negative, the bank is paying more in interest than it is earning. In the last few decades, these margins have been consistently declining, especially in developed countries, because of increasing competition on the earning assets' returns and the cost of bank funds.
Growth in core deposits at banks, for example, has decreased because customers now have other alternatives that offer similar services and pay higher interest rates, such as cash management accounts and mutual funds. Increased competition has reduced the advantage banks had in getting funds and weakened their position in the loan market.
Banks, therefore, have tried to offset this decrease in the net interest margin with nontraditional incomes derived from nontraditional banking activities such as off-balance-sheet services. Nontraditional income now makes up about half of all operating income generated by U.S. commercial banks and a significant amount of total income in many mature economies.
Off-balance-sheet products provide "fees income," but are not shown as assets or liabilities on the balance sheet and are less regulated. Many financial economists have attributed the global financial crisis to the Graham-Leach-Bliley Act of
1999, which allowed banks to diversify into fee-based activities such as investment banking, security brokerage, insurance underwriting and venture capital.
Before the law was passed, banks were under stringent restrictions on the types of activities banks could engage in.
Fees generated from such activities include trading gains and fees, investment banking and brokerage fees, net servicing fees, insurance commissions, net gains on asset sales, fiduciary income, service charges on deposit accounts, other foreign transactions and other noninterest income.
As discussed in previous articles, the financial crisis was not only caused by the collapse of a few "too-big-to-fail" financial institutions, but also the failure of hundreds of smaller banks that were heavily engaged in many of these activities.
The likelihood of the crisis of 2008 is inversely related to net interest margin, according to one of the recent influential studies. In other words, a higher level of margin motivates banks to focus on traditional activities like making loans, instead of pursuing generally riskier options such as security trading. And banks with low levels of net interest margin are likely to be involved in riskier activities to maintain the same level of profitability, thus leading to lower risk-adjusted profits and financial instability.
It should be noted that while many studies prior to the global financial crisis suggested a positive relationship between nontraditional banking and financial stability, most recent measurable results indicate a negative effect.
As always, I encourage you to learn more about modern finance-one of the most popular, and useful, majors at top universities-by reading voraciously on topics related to banking stability and regulations. Enrolling in college courses such as Financial Markets and Institutions or Money and Banking is a great way to further explore these issues.