Fee Income Potential For Community Banks

Fee Income

Compared to larger lenders, community banks have faced significant challenges in generating non-interest income. Just on the lending side alone we recently identified 11 ways that community banks can increase fee income (HERE). We want to highlight one of those ways again as it is particularly appealing to community banks in today’s challenging interest rate environment and competitive loan market. We recently came across an earnings report from a community bank that underscores our recommendation.

 

Example of Fee Income

 

A community bank in the mid-West (under $3B in assets) reported its 2016 income and management made the following comments:

 

Loan-related fees were $1.8 million and $5.8 million during the three and twelve months ended December 31, 2016, respectively.  These amounts compared to $889,000 and $2.3 million during the same periods in 2015, respectively….  The largest source of fees in this revenue category is interest rate swap fees related to commercial loan relationships.  Bank mitigates the interest rate risk associated with certain of its loan relationships by executing interest rate swaps…  The increases in loan-related fees in the 2016 periods were the result of increased loan production, as well as a generally lower interest rate environment that increased borrower preference for the types of loan transactions that generate interest rate swap fees.  

 

The above-stated fees are significant for a bank that size and the increase from the previous comparable period are especially noteworthy. Management later discussed its strategy for using interest rate hedging as follows:

 

This rate environment also improved the competitiveness of Bank's loan offerings linked to its interest rate swap loan program…  Because of this improvement, Bank was able to increase new loan production, as well as retain in its loan portfolio a larger portion of construction loans transitioning to permanent financing than it typically has in prior periods

 

We find the bank’s analysis noteworthy for a few reasons.  Historically community banks have maintained higher net interest margin (NIM) but lower return on assets (ROA).  The graph below shows NIM for three categories of asset bands (banks under $1B, $10 to 25B, and over $25Bn).  Since 2012, and even before that time period, smaller banks have consistently enjoyed a higher NIM, but slightly lower ROA.  

 

Net Interest Margin

 

 

Analysis consistently shows that community banks have substantial opportunity to increase non-interest income. The graph below shows non-interest income to total revenue for banks in the three asset bands defined above. It is clear that larger banks generate substantially more fee income. 

 

Non-interest Income

 

We then compared various sources of fee income between banks in these asset bands.  We looked at fee income from the following sources:  service charges on deposits, insurance commission fees, investment banking and advisory services, securitization, venture capital, and loan fees (which include hedge fee income). Many community banks do not offer some of the services available at larger banks. However, perhaps surprisingly, larger banks generate only a small amount of fee income from businesses that community banks do not offer. Instead, the higher fee income is derived from slightly more service charges on deposits (shown below) and much higher loan fees (which includes hedge income). Loans and deposits are business lines that community banks do offer and where substantial fee generation improvement is available. 

 

Service Charges

 

 

 Why Hedge Fee Income Is Important

 

First, hedge fee income is very powerful because it magnifies the value of the fee over the life of the loan.  The hedge fee is the cumulative sum of a spread on the loan and is paid in lump sum and may be recognized upfront by the bank.  For example, we recently worked with a bank that closed a loan refinancing for $4.25mm and that bank was able to generate $57,549 in fee income or 1.35% of the loan amount. This full hedge fee is recognized in income immediately.

 

Second, the hedge fee income is particularly important when interest rates are low and NIM businesses are struggling to generate traditional banking ROAs. As interest rates increase the hedge fee income becomes less important to sustain a bank’s profitability. However, when funding costs cannot be substantially below Fed Funds level, NIM-driven profitability is challenged.

 

Third, an argument has been made that hedge fee income is just a substitute for wider margin and banks may simply choose wider NIM instead of recognizing a fee. This is not a fair argument because margin goes away when the loan prepays or is refinanced, but the fee income stays with the bank. Given a choice, banks would prefer the fee.

 

Fourth, hedge fees, with only a few comparable products such as SBA 7A loans, do not require the customer to make an out-of-pocket payment.  Clients resist and complain about making actual dollar payments to their bank. Hedge fees monetize future loan payments from borrowers into funds immediately available for banks today, all without any immediate cost to the borrower.  This is the most potent power of hedge fees – they are not visible to the client. That makes hedge fees less likely to be negotiated, or alternatively, more marketable for fee sensitive clients as banks can lower their loan’s upfront fee.

 

Conclusion

 

Historically hedge fees have been largely the domain of national banks. However, community banks are also able to generate hedge fee income and the amount of these fees can make a marked impact on community banks’ performance.  Hedge fees also have the added benefit of not engendering client frustration because there is not billing or collection or immediate charges. While the ability to generate certain types of loans may be a good reason for community banks to use hedge programs, another important reason is the substantial amount of potential fee income.