Thesis Proposal: Effects of Non-Traditional Banking Activities on Revenue Diversification of Universal and Commercial Banks in the Philippines from 2007 – 2012 By mikashee 1. INTRODUCTION 1. 1 . Background of the Study: The Banking Industry in the Philippines is one of the (recorded) contributors to GDP under the Service Sector. Despite being one of the least contributing industries in the Philippines, its purpose is highly relevant in different markets.
Aside being a category under the Service Sector for GDP reporting, the Banking Sector is the largest medium for Financial Intermediation in the Philippines.
Over the years, banks has been one of the common financial intermediaries that provides lending and deposit services for people who’re short in funds and people who have no place to use their excess money on.
In order to become more profitable and increase the level of competition, Financial Liberalization was introduced in the banking industry wherein some banking regulations have been lifted so that banks could offer other banking services other than the traditional Loans and Deposits.
After the financial liberalization came into the market, banks, particularly Universal nd Commercial banks, have found new sources of income other than the traditional interest income. Examples of these activities, as given by researchandmarkets. com(2012), are Portfolio Management, Derivatives trading, Mobile/lnternet Banking, and the like.
Non-lnterest Income, or fee-based income, came from non-traditional activities/services provided by banks wherein these activities differ per bank in order to establish some sort of “competitive advantage” against their competition. 1. 1 . 1. Banking Activities Engaged by Banks in RP Among the different classification of banks in the Philippines, it is Universal and Commercial banks’ services that are being availed of by most Filipinos since these banks cover Page 1 the basic banking services that are not limited to a certain market only.
Aside from the Traditional Deposit-Loan activities that earn the usual Interest Income, banks have also engaged in investment and trading activities in order to gain more profit that maintain the reserves in case a decrease in interest rate occurs due to the changes in macroeconomic factors that also happen to be relatively correlated with the Interest Rates. 1. 1. 2. Revenue Diversification: Reducing Risk for Bank Capital? risk such as credit risk, and interest risk. This is used in managing asset portfolios in order to minimize losses or even offset it with profitable assets.
In Banking, after the introduction of Financial Liberalization, wherein deregulation of banks have been granted, amount of competition among banks have grown until it reached the point that these banks had to differentiate the products and services they offer other than the traditional Loans and Deposits. This is where Non-Traditional Banking Activities come in. Non-Traditional Banking Activities are activities or services offered by banks at a given fee, therefore generating Non-lnterest Income.
And now that banks have a simultaneous generation of Interest and Non-lnterest Income, Revenue Diversification is done. 1. 2. Problem Statement What are the effects of Non-Traditional Banking Activities on Revenue Diversification of Universal and Commercial Banks in the Philippines from 2008-2012? Page 2 1. 3. Objectives a. ) To identify the different banking products and services offered in the Philippines that are classified as Non-Traditional Banking Activities b. ) To determine whether Non-Traditional Banking Activities have positive or negative effect/s on Revenue Diversification of Banks c.
To be able to recommend on which banks services will be able to take advantage of the use of Non-Traditional Banking Activities/Non-lnterest Income. 1. 4. Hypothesis HO: Non-Traditional Banking Activities (such as fee-based services and trading services) don’t have any significant effect on banks’ revenue diversification which, in theory, should reduce risk of insolvency. HI : Non-Traditional Banking Activities (such as fee-based services and trading services) have a significant effect on banks’ revenue diversification which, in theory, should reduce risk of insolvency. . 5. Assumptions of the Study This study will assume that revenue diversification is the diversification of noninterest income. According to historical data of interest rates in the Philippines by tradingeconomics. com, it appears that interest rates are relatively stable. With the help of the data presented by tradingeconomics. com, this study will now assume that interest income is stable. As for data to be collected, this study shall assume that the financial statements reported to the SEC and Osiris database are true and not adjusted in bad faith.
With regards to the Page 3 sample, it will be assumed that the top ten universal and commercial banks Philippines. 1. 6. Significance of the Study This study is a follow-up on the study made by Nguyen (2010) as wherein Dr. Nguyen recommended an intra-country application of their study, of which the country would be the Philippines. This study will also determine whether Non-Traditional Banking Activities have a significant contribution on the revenue diversification of Universal and Commercial banks in the Philippines.
At the end of this study, results gathered by the researcher will be used for recommendation on whether banks in the Philippines should focus on Non-Traditional Banking Activities or the Traditional Interest Income-earning Activities. The results of this study will be useful for Bank Managers, and Bank Regulators. Bank Managers This study is relevant for Bank Managers because the results of this study will determine whether or not Bank Managers would encourage their staff to exert more efforts in showcasing bank products and services other than deposits and loans.
Marketing strategies per branch or the bank in general can help bring in more clients that will either avail trading services or engage in trusts with the bank. Or it can also tell Bank Managers to help their branches refocus on the traditional deposits and oans, depending on whether this study will generate a positive or negative outcome. Page 4 Bank Regulators Bank regulators will benefit from this study because they can either increase or decrease the level of deregulation of banks as well as the capital requirements of banks depending on the results of this study. . 7. Scope and Limitations The study will focus on the top 10 publicly listed Universal and Commercial Banks in the Philippines from 2008-2012 as listed by philpad. com (2012) because of the services these banks offer as well as the availability of data to the public. The esearcher will take the gathered data as it is recorded, and will disregard the effects of the Global Financial Crisis in the list of factors influencing the revenue diversification of banks as well as the utilization of non-traditional banking activities. . Review of Related Literature Banks have evolved over the centuries, and for the past decades, banks in the Philippines have Joined in the bandwagon when it comes to modernization of banking. Some of these developments include the use of ATMs, internet and mobile banking, and express deposits. These are additional services offered by the banks for convenient banking experience for their clients.
For decades, banks have expanded from simple deposit-loan transaction, they have engaged into other profit-generating activities that not only generate income for their firms, but also provide further use the terms Traditional Banking Activities (TBAs) to refer to the banks usual Deposit-Loan transactions that earn Interest Income (and incur Interest Expense) and Non- Page 5 Traditional Banking Activities (NTBAs) to refer to other banking activities that are not DepositLoan transactions that earn Non-lnterest Income (and incur Other Expenses).
Like most countries (if not all), the banks in the Philippines have classified and reported their income using two (2) main categories: Net Interest Income and Other Income (or Non-lnterest Income), which were also recognized by prior studies. 2. 1. Banks Banks are the most common and accessible among financial intermediaries. These institutions serve as a bridge connecting people who wish to save their excess money and people who need to spend money for different reasons.
And for centuries, banks offer their main services of keeping deposits and lending out loans. Being a financial ntermediary, their access and ability to distribute money is highly regulated by the government, specifically the Central Bank. Over the years, banks have developed and expanded its services from the standard Deposit and Loans to Brokerage and Trading. However, these services are only available to specific banks depending on the services they offer, as well as their target client market.
Classifications of these banks are as follows: Universal Banks Commercial Banks Savings Banks Rural Banks Cooperative Banks Page 6 most common ones are universal and commercial because they have the most pdated set of services that are most accommodating to the needs and wants of his/ her client. 2. 2. Classifications of Banks According to Section 3 and other sections of the General Banking Law of 2000 there are four (6) main types of banks in the Philippines (Circular No. 271 dated 8 January 2001): Thrift banks, Commercial banks, Universal banks, Rural banks, Cooperative banks and Islamic banks.
Thrift banks, defined by the BSP, are “… savings and mortgage banks, private development banks, and stock savings and loans associations organized under existing laws. “(Thrift Banks Act of 1995, Sec. 3a). Commercial Banks, on the other hand, are banks that “… offer a full range of financial services, including checking, savings, lending, and most other services” (Kapoor et al, 2013). these possess the powers of Thrift bank but in addition to that, Commercial Banks may issue letters of credit, accept negotiable instruments, and negotiate evidences of debt and promissory notes.
Universal banks, according to Saunders and Cornett (2008), “… offer not Just investment banking services, but also commercial lending, foreign exchanges and custody and cash management services. ” of which covers most of the banking services available for clients. Rural banks are, as defined by the Philippines National Statistical Coordination Board (NSCB), are banks sponsored or assisted by the government, which are privately managed, that lend money to farmers and merchants in order to fund their livelihood in the rural areas such as purchasing agricultural equipment.
Cooperative Banks are banks owned and accommodated by the same group of people, usually of the same community or profession, and serves as the financing institution providing loans, accepting deposits and other financial services for the said page 7 group of people (icba. coop, n. d. ). Lastly, Islamic banks, as described by the Institute of Islamic Banking and Insurance, are banks that apply the principles of Shari’ah (Islamic rulings) through the development of Islamic economics. = (Islamic- banking. com, n. d. ).
Therefore, these banks practice the strict rules and principles of Islam, presumably based on the teachings of the Qur’an. As for the Philippines, banksphilippines. com (2012) as of 2012, there are 705 banks in the Philippines, thirty-seven (37) of which are Universal and Commercial Banks. The rest would include Thrift Banks, Rural banks, Cooperative Banks, Islamic banks and Quasi-Banking institutions. According to a forum from philpad. com (2012), the top players, as well as the top ten in the banking industry as categorized by assets are the following: 1.
BDO 2. Metrobank 4. Landbank 5. RCBC 6. Development Bank of the Philippines 7. Philippine National Bank 8. Chinabank 9. Unionbank 10. Security Bank (source: philpad. com) Page 8 2. 3. Deposits and Loans: Traditional Banking Activities For decades, banks have relied heavily on the traditional net interest income earned due to the constraints brought by banking regulations. There might have been the existence of Nonlnterest Income, but it was minimal because banks would try to void violations of the said regulations.
Banks have operated as financial intermediaries in terms of keeping deposits of savers and giving out loans to spenders and borrowers. Similar to other companies, banks earn from their operations. A summary of this basic operation of Traditional Banking Activity is given by economicshelp. com (2013), wherein Banks would take clients’ deposits and use these deposits to give out loans to other clients in different terms. In this process, banks would pay interest to its depositors and collect interest from its borrowers. The net of the interest would then become the main income of the bank.
Now, this so- called “interest” is based on the interest rates offered by bank, in compliance with the Central Banks reserve requirements, which fluctuates based on the economic condition of the country. And as these banks develop over time, they have come up with the idea of interest, an amount charged to borrowers and paid to lenders. However, since loans and deposits don’t have an exact off-setting rate, the difference between the interest from loans and the interest of deposits is the so-called Net Interest Income earned by banks (Investopedia, 2013).
Interest rates are influenced by external factors in the economy. It is through the Monetary Policies dictated by the Central Bank that interest rates are adjusted depending on the Money Supply in circulation. If there is too much money in circulation, Contractionary Monetary Policy is implemented, raising Interest Rates in order to attract depositors while Expansionary Monetary Policy is implemented when Money Supply is low, in order to Page 9 discourage clients from depositing their money in banks.
Using the Philippine Benchmark Interest Rate graph from 2002-2012 reported by tradingeconomics. com, interest rates are relatively stable over time but had dramatic decreases when it hanges. Back in 2002, the Philippines had interest rates ranging from 6. 5% to 7. 5% Global Financial Crisis. These effects have greatly influenced the Banking Industry especially their income generation from interest. 2. 4. Non-Traditional Banking Activities Banks, like most companies, are also expense-incurring firms with the need to generate income in order to cover for these expenses.
Employees’ salaries, Equipment (ATM) maintenance, Delivery Costs, Security Expenses, and Transaction Costs are Just some of the many expenses that banks incur in order to provide convenience and good service to their clients. However, given the low interest rates in the economy, interest income alone seems to be insufficient to cover for these expenses, and Inflation rates haven’t been placed in the equation yet. Another source of income for banks is what we call Non-Traditional Banking Activities, activities and transactions that are not directly concerned with charging Loans or paying interest to depositors.
Stiroh (2002) classified Non-lnterest Income into four (4) main categories based on the activities engaged by banks. 2. 4. 1. Deposit – Loan: Traditional One of the most common activities operated by banks is mediating the lending- orrowing process of money between savers and spenders. However, in order to attract savers to open page 10 deposit accounts in their branches or safes, banks offer interest income for depositors, relative to how much and how long the money will be deposited in their account.
These terms are relatively important because the terms will be the determining factor in matching people’s deposits with borrower’s loans, depending on the capacity of the borrower to pay on time. In the Philippines, only a few people are able to deposit their money in their accounts because of either lack of nformation or the threat of loss from banks in case of robbery and the like. But surprisingly, according to a recent study, 80% (or 8 out of 10) Filipino households don’t have bank accounts. 2. 4. 2. Non-Traditional Banking Activities in the Philippines 2. 4. 2. 1.
Trading Aside from the lending operations performed by banks, banks have also covered the financial market such as the Foreign Exchange (FX) market, Stock market, and the Derivatives market. Trading Income, as described by Stiroh (2002), is income derived changes”. Banks added trading financial instruments as part of their products and ervices since banks have the expertise when it comes to managing risk, computing possible profits in holding to certain assets, and the like. Trading in the financial markets is highly volatile, which is why Banks engage in trading here because of the concept “high risk, high return”.
Now, given the wellcomputed chances of earning a relatively high profit in the financial market, banks are given the possibility of gaining enough funds to cover risks of the possible changes in interest rates as well as additional funds that can be used for investment and payment of expenses. In Banks Page 1 1 such as Bank of the Philippines Islands (BPI), existing clients need not open a new account to trade; rather, these clients can already use their existing accounts to trade. 2. 4. 2. 2. Other Services: ATMs, Fiduciary, etc.
Technological innovations continue to improve banking in the Philippines, all for the convenience of banking for clients. The relatively older examples of these innovations is the use of Automated Telling Machines (ATMs), the purpose of which is to provide an easy-access to money wherever the client may be, as long as there is the presence of ATMs in the area. Now, these ATMs are considered a long-term investment made by banks. In order to maintain this equipment, as well as the printing of receipts, fees are to be charged against the clients.
While banks would usually not charge the clients for using the banks ATMs, the most common fees charged are the instances wherein the client would withdraw their money from another banks ATM because not finding an ATM of one’s bank is inevitable. Services charge-, commission-, and bank fee-generating activities are also part of a banks set of activities because the clerical work and other menial work performed by bank employees are part of the anks non-interest expense that are being incurred regularly, therefore it must also be compensated as part of the banks regular operations.
In the Philippines, there are approximately 12,700 ATMs in all over the country with around 10,900 coming from universal and commercial banks. Fiduciary businesses are also being accommodated by banks under the trust department in the Philippines. In the Philippines, only a few banks are being authorized by the Bangko Sentral ng Pilipinas (BSP). These activities would include managing investments and estimating risk for prospect investments. page 12 2. 5. Non-lnterest Income: Is it a Factor for Bank Stability? isk, and both sides have a common relation of the two factors but opposite sides of the given relationship: Revenue Diversification. If Finance, in general, views Diversification as a good thing (given the context of Asset Portfolio Diversification), there are others who view otherwise when it comes to Bank Revenue Diversification. When it comes to determining the effect of Non-lnterest Income on the Banks’ overall risk, two groups of studies that discuss whether or not Non-lnterest Income provide diversification benefits especially when it came to Risk
Reduction. In a study conducted by the group of Nguyen (201 1), Non-lnterest Income contributes to the Revenue Diversification of banks, therefore minimizing the risks of not earning income to be used for either investment to equipment or help preserve their clients’ deposits therefore preventing the banks from declaring bankruptcy due to the available funding banks will obtain after earning/gaining profit from Non- Traditional Banking Activities. The findings of Nguyen are being supported by Smith (2003).
However, in the study, it is said that Non-lnterest Income is not a stand-alone ource of income, rather, Non-lnterest Income and Interest income work simultaneously (Smith, 2003); therefore NIIs and Interest Income are not complementary as their correlation becomes closer and closer. In search of diversification benefits from Non-lnterest Income, Stiroh (2002) was able to prove that instead of reducing risk, NIIs actually add up to the riskiness in terms of Bank Stability because the nature of NIIs, specifically Trading Income, is highly volatile and is dependent on the demand and supply of the underlying assets involved in trade.
This theory is page 13 also supported by the studies of Bailey-Tapper (2010). Non-lnterest Income is volatile because its demand is also fluctuating based on the demands of the clients also dependent on the economic standing of the country, therefore, despite the chances of getting high returns, it does not help in maintaining stability of the banks’ income. Let’s say, a banks performs its Traditional Banking activities of Loans and Deposits, it is sure to earn Interest Income for every client it serves and it is constant throughout the year.
But add the generation of Non-lnterest Income, Total Income generated per period has become volatile since the generation of Nonlnterest Income is variable epending on its clients. And with volatility comes risk making the Banks Income unstable, which then defeats the purpose of Revenue Diversification. However, a common misconception was clarified in the work of De Young and Rice (2004).
While most studies would claim that non-interest income strictly come from nontraditional banking activities, De Young and Rice (2004) would claim that non-interest income is also generated from traditional banking activities such as deposits wherein checking fees, safe-keeping fees and cash management fees are also charged to the clients. But other than that, De Young and Rice (2004) support the claim of Stiroh (2002) that non-interest income activities are less stable than interest income. On the other hand, Smith (2003) thinks otherwise.
Their study shows that the mix of relatively high (or positive) and Stabilize bank profits via Revenue Diversification. With the contribution of Non-lnterest Income, Total Interest Income is not affected by the economic fluctuations of interest rates, therefore being more capable of generating new capital for the bank. Page 14 Given the arguments of the literatures above, the study will then test which concept s applicable in the Philippine setting and therefore determine which banking activities will be more profitable for the Universal and Commercial Banks in the page 15 2. . Literature Map Page 16 2. 7. Research Gap This study will follow the recommendations made by the group of Nguyen (2010) regarding the intra-country application of their paper by measuring the correlation of the use of Revenue Diversification with Bank Stability, Profitability, and Bank Market Power. This study will further discuss and identify whether it is Interest Income from Traditional Banking Activities or Non-lnterest Income from Non-Traditional Income Activities. 3. FRAMEWORKS 3. 1 .
Theoretical Framework In this study, banks will be illustrated in a market set-up using the point of view of the bank (excluding the concept of competition), which will consist of environment, stakeholders, strategies used, and measurement of success of the said strategies. For the market environment, Random Walk theory will be used in order to explain the volatility and uncertainty of the market. As for the stakeholders such as the banks investors and depositors, Modern Portfolio Theory shall be used in order to describe the preferences of the banks stakeholders when it came to choosing which nstitutions theyd place their money on.
In order to satisfy the stakeholders and to give assurance, the strategy of Diversification, specifically Revenue Diversification between interest and non-interest income, will used in order to theoretically reduce the risk of insolvency of banks. To measure the risk and return of these banks, the financial ratios on ROE and Profitability as well as solving for variance and standard deviation of income will be used. And finally, in order to measure for risks taken by the banks, with regards to total income, Sharpe Ratio will be used. page 17