The cross-selling of bank credit and services

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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_at_unilim.fr
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BACKGROUND AND RESEARCH MOTIVATION

• Functional Diversification
• and expansion into non-traditionnal 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?

• 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 non-traditional 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
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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
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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
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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
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Product diversification, risk and default risk
results based on daily market data (1996-2002)

Product diversification in the European banking
industry Risk and loan pricing
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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)
Product diversification in the European banking
industry Risk and loan pricing
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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 gt 3 per year) exhibit a higher
  increase in risk than banks with a relatively low
  annual growth rate of NNII (?NNII lt 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 (1996-2002)
, 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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Faster and higher diversification and changes in
risk for European listed banks (1996-2002)
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
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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
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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
Product diversification in the European banking
industry Risk and loan pricing
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2. Lending rate and non traditional activities
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)
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)
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 fee- based 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
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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.