How do banks make money? The fallacies of fee income
Last Updated: 11/08/04
This article documents the dramatic increase in noninterest income at U.S. banking companies during the past two decades, the myriad forces that have driven this increase, and the somewhat surprising implications of these changes for the financial performance of commercial banks. We pay special attention to two fundamental misunderstandings about noninterest income at commercial banks. The first is the belief that noninterest income and fee income are more stable than interest-based income. We review the most recent evidence from academic studies that strongly suggest— contrary to the original expectations of many—that increased reliance on fee-based activities tends to increase rather than decrease the volatility of banks’ earnings streams. The second misunderstanding is the belief that banks earn noninterest income chiefly from nontraditional, nonbanking activities. We perform some calculations of our own and demonstrate that payment services—one of the most traditional of all banking services—remain the single largest source of noninterest income at most U.S. banking companies.