The trade off between interest income and non interest income of vietnam commercial banks

The trade off between interestincome and non-interest income of Vietnam commercial banks VU THI LE GIANG University of Economics HCMC – giangvtl@ueh.edu.vn HOANG HAI YEN University of Ec

The trade off between interest

income and non-interest

income

of Vietnam commercial banks

VU THI LE GIANG

University of Economics HCMC – giangvtl@ueh.edu.vn

HOANG HAI YEN

University of Economics HCMC – yenhh@ueh.edu.vn

1 Introduction

The main traditional activities of banks include deposit takingand lending Besides these activities, banks also diversify theiractivities to non-interest income activities and this trend becomemore and more popular Research of Stiroh (2004) on Americanbanks stated that in 1980s non-interest income activities accountfor 19% total banks’ income while 2001 this number was 43%.Studies of Lepetit, Nys, Rous, and Tarazi (2008) on Europeanbanks also got the same results, the percentage of non-interestincome increased from 26% to 41% This trend is also repeated

in other countries such as Australia, China although the growthrate is not as high as in US and Europe The strong increasing innon-interest income raises a question for bank managers andresearchers: whether increasing in non-interest income activities

is good for banks? Should banks continue this trend? Manyresearches related to this field are conducted but results are mixfindings

Vietnam also follows this trend With difficulties in creditexpansion, banks are increasingly seeking revenues from non-interest income activities Results of this shift are not fullyassessed Prior researches in Vietnam only studied about thesole impact of diversify income (interest income and non-interestincome) to profit or to risk but these researches haven’t assessedsystematically the trade-off between risk and return of interestincome activities and non-interest income activities That thereason why we study about “the trade-off between interestincome and non-interest income of Vietnam commercial banks”

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Non-interest income include “fiduciary income, service charges,trading revenue, and fees and other income” (Stiroh, 2004) Inour research, we use “Total Non-interest Operating Income” inthe balance sheet of banks as a noninterest income To exploit theproblems, we use two ratios to measure the trade-off betweenrisk and return (Vi and RAP as Williams and Prather (2010) Datafrom 27 Vietnam commercial banks between 2006 and 2015 iscollected from Bankscope We find that diversification activities tonon- interest income increases return against one unit of risk.However, this return will reduce if we continue to shift to non-interest income activities This result encourages banks to invest

in non-interest income activities but they also need to controlthese activities to avoid over-investment

Our paper is constructed into five parts The next part will beliterature review about income diversification The third partdescribes data and methodology The fourth part discusses theresults and final part is conclusions

2 Literature review

Researches about diversification banking activities tononinterest income activities got mix findings Some researchconclude that shifting toward noninterest income activities canbring back higher returns for banks while other studies provethat diversification doesn’t add benefit for banks but bankshave to suffer higher risks However, all the researches agreed

at the same point that traditional activities are less risk thannoninterest activities

DeYoung and Roland (2001) examines on 472 US commercialbanks between 1988 and 1995 They tried to answer whether,how and to what degree the shifts to noninterest income affectthe volatility of bank earnings Results reveal that shifting fromtraditional activities to non-traditional activities was increasingand bank’s return increased when they diversify to noninterestincome activities However, the volatility of bank earnings wasalso higher Stiroh (2004) had the same point of view withDeYoung and Roland (2001) that non-interest income was morevolatile than traditional income Author studied US banks fromthe late 1970s to 2001 to examine the affections of non-interestincome to banks profit and revenue He found that there was areduction in volatility of bank revenue growth in 1990s but thiswas because of the lower volatility of net interest income “ratherthan the diversification benefits from increased noninterestincome” (Stiroh, 2004) He concluded that noninterest income

Vu Thi Le Giang & Hoang Hai

interest income Other research conducted in Europe by Lepetit et

al (2008) using data from 734 banks also found the same result.Authors compared risk level of banks which diversified tountraditional activities with banks which didn’t follow this strategy.Results revealed that diversifying banks suffered higher risks andthese risks highly correlated with commission and fee incomesthan trading activities In Vietnam, (Vo & Tran, 2015) studied 37commercial banks from 2006 – 2013 They concluded that banksincreasing fee-based activities may get lower profits and higherrisks than banks pursuing traditional activities

In contrast with the above researches, the following studiesconfirmed that shift to noninterest income activities bringbenefits to banks Smith, Staikouras, and Wood (2003) studiedthe variability and the correlation between interest and non-interest income for banks in European countries from 1994-

1998 Sample included 200 large banks having total assets over

10 billions USD and 2455 small banks The research found thatshift to non-interest income make profits in European banksstable in the research period In addition, recent study of Lee,Yang, and Chang (2014) for 967 banks of 22 Asia countries from

1995 to 2009 about the impacts of non-interest income onprofits and risks found that non-interest income reduced risks butdid not increase profit Especially, results became complicatedwhen bank specialization and a country's income level wereconsidered To saving banks, profit reduced and risks increasedwhen they shift to non- interest income activities In high incomecountries, these activities increased bank risks while in middleand low income countries, non-interest income activities increasedprofits and decreased risks

Other researches did not examine sole impacts of shifting tofee-based income activities to returns and risks but they accessedthe trade-off between returns and risks Results from theseresearches are also mix findings Some empirical researches findfee- based income activities have negative impacts to the trade-off between returns and risks while other studies get oppositeresults DeYoung and Rice (2004) proved that increasingnoninterest income activities lead to higher volatilities in returns.They researched 4,712 commercial banks in United State from

1989 to 2001 with 37,175 observations about the relationships ofnon-interest income, business strategies, market conditions,technological changes and financial performance The resultsstated that increasing in non-interest income made the trade-offbetween risks and returns poorer In addition, study of Stiroh andRumble (2006) for Financial Holding Companies – FHCs in United

State also got the same results They researched 1800 FHCs from

1997 to 2002 and found evidences about the benefits ofdiversification However, these benefits were offset by increasingcompanies’ investments in non-interest income activities whichwere volatility and “not necessarily more profitable thantraditional activities” Stiroh and Rumble (2006) With sometypical companies, shift to fee-based income decreased risk-adjusted returns This confirmed that these FHCs must acceptmore risks to get non-interest incomes

Besides studies stated that non-interest income had negativeimpacts to the trade-off between risks and returns, some studiesfound opposite results Williams and Prather (2010) stated therewas a positive impact to the trade-off between risks and returnswhen banks shift from traditional activities to fee-based incomeactivities Williams and Prather (2010) researched on 49commercial banks which included 4 big banks accounted for 65%total assets of commercial banks in Australia and issued most offinancial products, the second group was domestic banksspecialized in retail finance and the third group was foreignbanks They concluded that non-traditional activities wereriskier than traditional activities However, combining these twoactivities was benefit for shareholders in diversification theirportfolio and reduced risks for banks

3 Data description and methodologies

3.1 Data description

Our research uses data of 27 commercial banks in Vietnamfrom 2006-2015 Foreign bank, foreign bank branches, joint-venture banks aren’t included in the sample because data ofthese banks aren’t updated in Bankscope As statistic of StateBank of Vietnam, there are 33 commercial banks This researchexcludes 6 commercial banks: Global Petro Bank, National CitizenBank, BacA Bank, KienLongBank, HDBank and Vietbank becausedata of these banks aren’t updated in 5 years consecutive from2006-2015

When studying the differences between state-owned banksand other joint stock commercial banks, we use the classification

of State Bank of Vietnam However, group of state-owned banksjust includes 4 banks: Bank for Foreign Trade of Vietnam, Bankfor Investment and Development of Vietnam, Vietnam Bank forAgriculture and Rural Development, Vietnam Joint-StockCommercial Bank for Industry and Trade The other state-ownedbanks were acquired by State Bank of Vietnam during the

Vu Thi Le Giang & Hoang Hai

restructuring

non-Second, in order to understand whether diversification intonon-interest income activities is benefit for banks, the authorsundertake three steps.

Calculate correlation of five elements: net interest incomeagainst total assets, non- interest income against total assets, netinterest income against total equity, non-interest income againsttotal equity and ROE before tax Results reveal whether thecombination of both traditional and non-traditional activities canreduce bank risks or not Besides, results also state if non-interest income activities is benefit for shareholders

Calculate Vi (Williams & Prather, 2010) This index state howmuch risk banks have to tradeoff for one unit of return

бi is the annual standard deviation of returns for income source i

µi is the average annual return for the income source i

Calculate RAP (Williams & Prather, 2010) which is the returnpremium for each unit of risk Comparison RAP of net interestincome, RAP of non-interest income and RAP of total income willgive the conclusion whether shift to non-interest income bringbenefit for banks or not

Vu Thi Le Giang & Hoang Hai

Where:

ri : the average annual return for the income source i

over the study period rf : the average annual return for

the risk-free asset over the study period

бi : the annual standard deviation of returns for the income source i for the study period

Results getting from the above three steps will be discussed andsummarized to find the final results for the research

interest income/To tal assets

Non-Net interest income /Total assets

Interest income /Total income

Source: Calculated from Bankscope by authors

Means of net interest income aren’t different for banks in twogroups However, standard deviation of net interest income forstate owned banks is smaller than that value for other joint stockcommercial banks About non-interest income against totalassets, mean of state-owned banks is higher than the value ofjoint stock commercial banks but the volatility of non-interestincome against total assets for second group of banks is muchhigher than the first group The results from table 1 also statetraditional activities are main source of income for banks with theproportion of interest income in total income is above 90%

During the 80s, non-interest incomes in United State accountedfor 19% total income while in 2001 this rate was 43% (Stiroh,2004) The same trend also happened in Europe with increasingfrom 26% in 1989 to 41% in 1998 (ECB2000) In Vietnam, shift tonon- interest income activities is not as strength as the aboveregions Statistic in research period from 2006-2015, thepercentage of non-interest income only accounts for 8% of totalincome and this proportion has been reducing since 2010 untilnow Before 2011, the percentage of non-interest income wasabout 11% of total income but in 2011-2015, it was only 5-6%.These number state that there was a strong reducing in theproportion of non-interest income We don’t investigate thereasons of this reducing However, the time starting for the downtrend was the same with the time the State Bank of Vietnamstarted to restructure the banking systems Therefore, wequestion whether the restructuring banking systems had impacts

to the proportion of non-interest income From the above analysis,

we divide the research period into two parts: first period is from

2006 to 2010 and the second period is from 2011-2015

Figure 1: The proportion of interest income and non-interest income

over total income

of non- interest income against total income

The proportion of non- interest…

3.50%

3.00%

2.50%

interest income against total assets 2.00%

Vu Thi Le Giang & Hoang Hai

Source: calculated from Bankscope data

Figure 2: The percentage of net interest income and non-interest income against

total assets

Source: calculated from Bankscope data

The above figures state that during the research period from

2006 to 2015, net interest income was still the main source of

income for banks and two sources of income had opposite trend

Therefore, we expect that these two sources of income may have

negative correlation and combination these two sources of

income in the investment portfolio of banks may reduce total risk

4.2 The risks and returns trade-off when banks invest

in both traditional activities and fee income

activities

To determine whether investing in non-traditional activitiesreduces risks or not, we calculate the correlation betweentraditional income and non-interest income The results state thatthe correlation of these two sources of income for the group of allbanks or for the group of join stock commercial banks arenegative These results confirm that combining interest incomeactivities and non-interest income activities can reduce total riskfor banks In addition, the correlations between pre-tax ROE andnon-interest income against equities for these two groups ofbanks are positive It means that increase non- interest incomewill have positive impact to pre-tax ROE

The correlation between net interest income and non-interestincome of state-owned bank group is small and the signs ofcorrelation are both negative and positive The correlationbetween non-interest income against total assets and netinterest income against total assets is -0.05 while the correlationbetween non-interest income against total equity and netinterest income against total assets is +0.04 Therefore, fromthe above information, it’s hard to conclude whether thecombination of interest income activities and non-interest incomeactivities is good or not for state-owned banks

Table 2

Correlation of elements

Net interest income/

tot al

interest income/

Non-tot al assets

Net interest income/

tot al

interest income/

Non-tot al equity

Pretax ROE

STATE-OWNED BANKS