What is a Non-Interest Expense?
A non-interest expense is an operating expense incurred by a bank, and it is separate from the interest expense on customer deposits. It includes the bank’s operating and overhead expenses, such as employee salaries and bonuses, unemployment tax, operating and maintenance of facilities, equipment rental, marketing, insurance, furniture, and amortization of intangibles.
Generally, non-interest expenses are essential to the day-to-day operations of a bank, and therefore, the bank needs to keep its operational costs at an optimal level to maximize its annual profits.
If the operational costs are not properly managed, they will directly affect profits. A bank’s non-interest expense is usually offset by service fees from loan origination, annual fees, credit facility fees, and late charges on loans.
Components of Non-Interest Expense
Non-interest expense represents the operating costs incurred by banks. The majority of non-interest expenses includes personnel costs, information technology costs, legal fees, consulting services, postage and stationery, material cost components, and costs associated with renting or leasing buildings and other fixed assets. A bank with lower operating costs enjoys economies of scale in banking because it can spread the operating costs over large revenues.
Since non-interest expenses are a major component of a bank’s overall expenses, they are considered bank overheads and are used to calculate the overhead ratio. The overhead ratio is calculated by dividing non-interest expense by the average assets. A low overhead ratio is preferred since it shows that the company incurs lower operating costs.
However, when a bank reports a high overhead ratio for a long period, it means that it faces high operating costs, which may affect its reported earnings. Banks address the problem by minimizing its personnel costs since they account for the majority of non-interest expenses.
What is the Bank Efficiency Ratio?
The bank efficiency ratio is a financial tool used to determine the financial performance of a bank. It is the ratio of non-interest expense to the net operating revenue.
The formula for the bank efficiency ratio is as follows:
The efficiency ratio shows the operating cost incurred to earn each dollar of revenue, and it varies across banking firms. Typically, the efficiency ratio varies from 50% to 80%. A 50% efficiency ratio is the optimal ratio, and it means that every $1 of expenses, the bank earns $2 in revenues.
A higher efficiency ratio indicates that the bank faces higher operating costs, which can directly affect the bottom line. When calculating the efficiency ratio of a bank, the numbers needed to compute the ratio are obtained from the bank’s income statement.
Banks use their operating income to offset their non-interest expense. The operating income includes net interest income on loans and noninterest income.
1. Net interest income
The net interest income is the income earned by the banks on loans, and it is obtained by finding the difference between the interest charged on loans and the interest paid on customer deposits. Usually, when customers deposit their money with the bank, the bank invests that money by issuing different types of loans, such as personal loans, MSME loans, and mortgages.
The bank may also invest the money on stocks, bonds, and other investments in different financial markets. The interest earned on the loans and financial market investments is recorded as interest income in the bank’s income statement. The bank then pays interest on customer deposits, usually at a lower rate than what is charged on loans advanced to borrowers. The difference between the interest income and the interest expense is the net interest income.
2. Non-interest income
The non-interest income is the revenue earned through fees other than interest income on loans. Examples of non-interest income include origination fees on mortgages, penalties on late payments and overdraft fees, bank-issued cards swap fees, and the monthly maintenance fees on accounts. These revenues help complement interest income on loans and financial markets investments.
Non-Interest Expense in Different Types of Banks
Investment banks tend to incur higher non-interest expenses than commercial banks. Generally, investment banks engage in more demanding investment activities, such as asset management, IPO issues, capital markets advisory, etc., which require higher employee involvement.
Therefore, employee compensation makes up the majority of the overall non-interest expense, with other operating activities accounting for the remaining share of the non-interest expense. On the other hand, commercial banks mainly focus on holding customer deposits and creating loans to potential borrowers, which does not require the same level of employee involvement and compensation compared to investment banks.
Also, commercial banks are constrained by regulatory requirements on the investment activities that they can engage in and how they use depositor’s funds.
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