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Are there diversification benefits of increasing noninterest

income in the Chinese banking industry?
Li Li
a
, Yu Zhang
b
a
School of Management, Marist College, Poughkeepsie, NY 12601, USA
b
China Merchants Bank New York Branch, New York, NY 10022, USA
a r t i c l e i n f o a b s t r a c t
Article history:
Received 3 August 2010
Received in revised form 2 September 2013
Accepted 17 October 2013
Available online 25 October 2013
This paper assesses the potential diversificationbenefits of the increasing reliance onnontraditional
business activities based ondata fromthe Chinese banking industry in1986–2008. At the aggregate
level, there are diversification benefits of the increase in noninterest income. However, noninterest
income has higher volatility and cyclicality than net interest income, and the marginal benefit of
diversification decreases with the increase in noninterest income. At the bank level, the correlation
coefficients of the growth rates of net interest income and noninterest income are mostly negative,
which also suggests that there are diversification benefits of increasing the noninterest income.
However, further model analysis indicates that the effect of the noninterest income share on the
Chinese banking industry's revenue and risk is not significant. Overall, our findings suggest that
noninterest income diversifies bank revenue, but increased reliance on noninterest income may
worsen the risk/return trade-off for the Chinese banking industry.
© 2013 Elsevier B.V. All rights reserved.
JEL classification:
G21
G32
Keywords:
Net interest income
Noninterest income
Income diversification
Bank risk
1. Introduction
Over the years, traditional interest income has been the main source of revenue for Chinese commercial banks. However, the
Chinese banking industry has been steadily shifting away from traditional sources of revenue and toward the multiple-revenue
structure of both net interest income and noninterest income. This shift is a result of interest rate liberalization, financial
disintermediation, obvious trends in banking comprehensive operation, and the implementation of a more stringent financial
supervision policy. Fig. 1 shows the changes in noninterest income and its share of net operating revenue (defined as net interest
income plus noninterest income) from 1986 to 2008.
Fig. 1 shows that the absolute scale of the noninterest income of the Chinese banking industry has grown since the 1980s, but
the relative contribution of noninterest income to the net operating revenue has experienced some fluctuations. Overall, the share
increased from the 1980s (14.97% in 1986) to the mid-1990s (30.23% in 1996) before decreasing again (16.99% in 1999). It
increased again in the first few years of the 2000s (27.34% in 2004) and then decreased after 2004 (20.76% in 2008). Furthermore,
the average share of noninterest income during 2000–2008 was higher than that during 1986–1999 (22.17% vs. 18.9%), which
revealed the increasing tendency of noninterest income in the Chinese banking industry. Moreover, small banks had a radically
fluctuating share of noninterest income, from 15.21% (1992) up to 48.39% (1997), down to 39.64% (1998), up to 47.22% (1999).,
and then down to 14.13% (2008).
The obvious decreasing trend of the proportion of noninterest income of small banks after 1999 was mainly attributed to the
interest rate regulation for deposits and loans. The adjustment of benchmark interest rates, including those for deposits and loans,
by the central bank (The People's Bank of China) can directly affect the net interest income of commercial banks, especially small
banks, which are more sensitive to interest rate adjustments because of their small size and high liberalization. The benchmark
Journal of Empirical Finance 24 (2013) 151–165
E-mail addresses: lyanlin2010@gmail.com (L. Li), zhyu@vip.sohu.net (Y. Zhang).
0927-5398/$ – see front matter © 2013 Elsevier B.V. All rights reserved.
http://dx.doi.org/10.1016/j.jempfin.2013.10.004
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Journal of Empirical Finance
j our nal homepage: www. el sevi er . com/ l ocat e/ j empf i n
interest spread in China gradually increased but was at a low level in the 1990s. In the ten-year period from 1990 to 1999, the
one-, three, and five-year benchmark interest spreads were 1.55%, 1.47%, and 1.41%, respectively. However, the benchmark
interest spread has remained high since the turn of the century. In the seven-year period from 2002 to 2008, the one-, three-, and
five-year benchmark interest spreads were 3.33%, 2.32%, and 2.09%, respectively. These trends can be attributed to the Chinese
government's strict control of the interest spread to reduce the cost borne by state-owned enterprises during the 1980s and early
1990s to ensure the success of the economic system reform in China. In 1994, the Chinese government began to drive the reform
of the state-owned specialized bank, and the profit-maximum goal became the major goal of bank operation. After this shift, the
interest spread gradually increased. During 2002 to 2007 in particular, to cool down the overheated economy, the Chinese
government raised the benchmark deposit and lending rates ten times, and the interest spread became very high. Fig. 2 shows the
changes of benchmark interest spread from 1988 to 2008 in China.
As the benchmark interest rates spread remained low in the 1990s, the scale of net interest income was relatively small, and
although the scale of noninterest income was moderate, its share was relatively high. After 2000, as a result of the high
benchmark interest spread, the net interest income of commercial banks increased substantially. Although the absolute scale of
noninterest income increased compared with that in 1990s, the proportion of noninterest income in the net operating revenue
continued to decline. That is, the small scale of net interest income led to the high proportion of noninterest income in
small banks in the 1990s. In contrast, although the share of noninterest income decreased in the 21st century due to financial
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Non-interest Income's share of All Banks
Non-interest Income's share of Large Banks
Non-interest Income's share of Small Banks
Note: (1) Large banks are those banks with assets greater than ¥3 trillion (in 2000 RMB), including the Industrial
and Commercial Bank of China (ICBC), Agricultural Bank of China (ABC), Bank of China (BOC), China
Construction Bank (CCB), and Bank of Communication (BOCOM). Small banks are those banks with assets
below ¥3 trillion, including the China Merchants Bank (CMB), China Industrial Bank (CIB), China Minsheng
Bank Corp., Ltd. (CMBC), Shenzhen Development Bank (SDB), China CITIC Bank (CNCB), Hua Xia Bank
(HXB), Shanghai Pudong Development Bank (SPDB), Guangdong Development Bank (GDB), China Everbright
Bank (CEB), and Evergrowing Bank (EB). (2) Net operating income = Net interest income + non-interest income.
(3) Due to data completion restrictions, the data sets for medium and small banks begin in 1992.
Source: "China's Financial Statistics Yearbook, 1986-2007" and the 2008 Annual Report of each banks.
Fig. 1. Changes in non-interest income and their shares in net operating revenue (1986–2008). Note: (1) Large banks are those banks with assets greater
than ¥3 trillion (in 2000 RMB), including the Industrial and Commercial Bank of China (ICBC), Agricultural Bank of China (ABC), Bank of China (BOC), China
Construction Bank (CCB), and Bank of Communication (BOCOM). Small banks are those banks with assets below ¥3 trillion, including the China Merchants Bank
(CMB), China Industrial Bank (CIB), China Minsheng Bank Corp., Ltd. (CMBC), Shenzhen Development Bank (SDB), China CITIC Bank (CNCB), Hua Xia Bank (HXB),
Shanghai Pudong Development Bank (SPDB), Guangdong Development Bank (GDB), China Everbright Bank (CEB), and Evergrowing Bank (EB). (2) Net operating
income = Net interest income + non-interest income. (3) Due to data completion restrictions, the data sets for medium and small banks begin in 1992. Source:
“China's Financial Statistics Yearbook, 1986–2007” and the 2008 Annual Report of each bank.
152 L. Li, Y. Zhang / Journal of Empirical Finance 24 (2013) 151–165
liberalization, Chinese commercial banks gradually adjusted the revenue structure, and increasing the proportion of noninterest
income had become a common consensus among domestic commercial banks. Meanwhile, with the supervising commitment to
Basel II, these domestic commercial banks struggled with expanding the business scale under such stringent capital requirements.
As nontraditional activities that generate noninterest income reduced capital requirements under Basel II, it is not surprising that
commercial banks increasingly shifted toward noninterest income under the capital constraints. In addition, there was also a
sense that this shift could lower the volatility of bank profit and revenue and reduce risk. One potential mechanism is that
noninterest income may depend less on overall business conditions than traditional interest income, such that increased reliance
on noninterest income reduces the cyclical variation in bank profits and revenue. Furthermore, according to the standard portfolio
theory, if noninterest income and net interest income are negatively or weakly correlated, expanded product lines and
cross-selling opportunities associated with growing noninterest income may offer traditional diversification benefits for a bank's
revenue portfolio. However, revenues from fee-based activities might be more volatile than interest income because the
customer–bank relationship is stronger in the traditional lending business; for many of the new fee-based activities, it is easier
for customers to switch to another bank. Furthermore, expanding into fee-based services can considerably increase fixed costs
(e.g., by investments in technology and human resources), whereas if a lending relationship is already established, the only cost of
an additional loan is the bank's interest expenses. Finally, in contrast to the lending business, fee-based activities require less
regulatory capital, which suggests a higher degree of financial leverage and therefore leads to higher earnings volatility (DeYoung
and Roland, 2001).
Does noninterest income reduce bank risk with certainty? This question is a topic of considerable importance to both
commercial banks in terms of operating strategies and regulators of noninterest income business. This paper uses Chinese
banking industry data to examine this topic in depth. Section 2 presents a literature review on the risk and return effects of
noninterest income by bank. Section 3 presents the descriptive statistical analysis of the data. Section 4 examines the volatility
and cyclicality of bank revenue at the aggregate level. Section 5 examines the existence of diversification benefits based on the
correlation between growth rates of net interest income and noninterest income at the bank level. Section 6 tests the effects of
noninterest income on bank risk and return at the bank level. Section 7 summarizes our findings.
2. Literature review
An earlier work has tended to assert that noninterest income can increase a bank's profitability and stabilize bank revenue and
that diversification benefits can reduce bank risk. Eisemann (1976) and Brewer (1989) find substantial benefits of diversification
into non-bank activities. Canals (1993) concludes that the increased revenues obtained fromnewbusiness units have contributed
significantly to improving bank performance in recent years. Gallo et al. (1996) find that a high proportion of mutual fund assets
managed relative to the total assets of bank holding companies over the period 1987–94 was associated with substantially
increased profitability for bank holding companies (BHCs) and risk reduction. Radecki (1999) notes the importance of payment
revenues to the banking industry, especially BHCs, generating approximately 7% more revenue for the companies. Regarding the
bank's risk, Boyd and Graham (1988) and Boyd et al. (1993) simulate mergers between bank holding companies and nonbank
financial firms and conclude that mergers between bank holding companies and life insurance firms would likely reduce the risk
of bankruptcy. Lown et al. (2000) also conclude that life insurance companies are the merger candidates with the greatest
potential to reduce risk. Kwast (1989) finds limited diversification benefits as a result of the expanded bank securities powers
from 1976 to 1985. Rose (1989) finds that the observed cash-flow correlation between banking and financial-service lines was
small and positive, implying some diversification benefits. Templeton and Severiens (1992) examine market data for 54 bank
holding companies from 1979 to 1986 and conclude that diversification (measured as the share of market value not attributed to
bank assets) is associated with a lower variance of shareholder returns. Santomero and Chung (1992) use option pricing
techniques to simulate the volatility of asset returns fromcombinations of 123 bank holding companies and 62 non-bank financial
firms and conclude that bank expansion into nonbanking businesses reduces risk in general. Saunders and Walters (1994) find
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One Year Three Years Five Years
Source: The People’s Bank of China
Fig. 2. Benchmark interest rate spread in China from 1988 to 2008. Source: The People's Bank of China.
153 L. Li, Y. Zhang / Journal of Empirical Finance 24 (2013) 151–165
that the expansion of banks' activities reduces risk, with simulations indicating that the main risk-reduction gains arise from
insurance rather than securities activities. Gallo et al. (1996) find that a high proportion of mutual fund assets managed relative to
the total assets of bank holding companies over the period 1987–94 was associated with substantially increased profitability
for bank holding companies and risk reduction. Smith et al. (2003a) find that the increased importance of noninterest income
stabilized profits in the European banking industry by examining the banking systems of EU countries for the years 1994–98.
Smith et al. (2003b) likewise empirically confirm that European banks are able to seek diversification benefits through combining
interest and non-interest income activities, and they conclude that non-interest activities potentially stabilize bank earnings.
Lepetit et al. (2008) find a negative correlation between interest margin and non-interest income in the case of 602 European
banks during the period 1996–2002. Chiorazzo et al. (2008) identify a positive relationship between diversification and
non-interest income activity and risk-adjusted performance for Italian banks between 1993 and 2003.
However, with the increasing scale of noninterest income and further research on commercial banks, the viewpoint that
noninterest income can stabilize bank profits and diversify the risks has come into question. Rosen et al. (1989) focus on 319
banks involved in real estate activities from1980 to1985 and conclude that shifts toward high levels of real estate investment will
likely increase risk. DeYoung and Roland (2001) examine the link between bank profitability, volatility, and different revenue
shares for 472 large commercial banks from 1988 to 1995 and conclude that increased fee-based activities increase the volatility
of bank revenue, but they find no evidence of diversification benefits. Acharya et al. (2002) use bank-level data for Italian banks
from 1993 to1999 and conclude that diversification of bank assets (within the loan portfolio) does not typically improve
performance or reduce risk. Stiroh (2004) examines the effects of noninterest income on U.S. bank holding companies and finds
that increased reliance on noninterest income, especially trading income, leads to higher risks and reduced diversification
benefits. Stiroh (2006) further find that an increased noninterest revenue was not accompanied by higher share market returns
but was accompanied by increased market risk (beta, total volatility, and idiosyncratic volatility). DeYoung and Rice (2004) find
that increases in noninterest income are accompanied by increased variability in profits and a worsening in bank risk-return
trade-off. Esho et al. (2005) showthat for a sample of Australian Credit Unions, the return on assets (ROA) is negatively associated
with the increment of transaction fees and that risk increases with the higher revenue share of this income source. Stiroh and
Rumble (2006) and Mercieca et al. (2007) show that the banks' financial stability, measured by Z-scores, is negatively affected by
reliance on non-interest income. Baele et al. (2007) find that European banks with higher levels of noninterest income have
higher expected returns, as measured by Tobin's Q, but also have higher beta risk. They also conclude that overexposure to
noninterest income increases bank risk. Busch and Kick (2009) analyze the impacts of noninterest income on financial
performance and the risk profile of German banks between 1995 and 2007. They find that for all German universal banks,
risk-adjusted returns on equity and total assets are positively affected by higher fee income activities but that commercial banks
with higher fee-generating activities incur higher risk.
It is difficult to find domestic literature on the relationship between noninterest income and Chinese banking industry risks,
indicating how little attention this topic has received from Chinese scholars. One such study is that of Zhou and Wang (2008),
who examine the volatility relationship between the noninterest income and net operating revenue of commercial banks from
1999 to 2006 fromthe perspective of portfolio theory and find that the volatility of the net operating revenue is negatively related
to volatility, whereas the noninterest activities are positively related to volatility.
3. Sample, data, and methodology
Considering the data availability, this paper uses annual data for 15 Chinese commercial banks from 1986 to 2008. At the end
of 2008, the assets of these 15 commercial banks represented 65.15% of the total of the Chinese banking industry. All of these
banks are listed companies except the Agricultural Bank of China, Guangdong Development Bank, China Everbright Bank, and
Evergrowing Bank. All data come from China's Financial Statistics Yearbook and the 2008 Annual Report of each bank. These data
are deflated with the GDP deflator based on constant price in 2000 to eliminate the impacts of inflation.
In China, there is no specified and clear agreement on the concepts and scopes of noninterest income, so the disclosures of
these commercial banks differed. In general, all of the income, except traditional interest income, can be classified as noninterest
income. For convenience, this paper breaks noninterest income down into four components: fee and commission income,
exchange gains, investment revenue, and other income.
1
Table 1 shows the breakdown of major sources of bank revenue for three
sets of banks: all banks, large banks with assets greater than ¥3 trillion (in 2000 RMB), and small banks with assets below
¥3 trillion. The net operating revenue, net income, total assets, and number of banks for each sample are reported.
As shown in Table 1, the net interest income of Chinese commercial banks comprises the highest share of net operating
revenue, while the share of noninterest income has experienced an increase followed by a decrease, which has been analyzed in
the first section. The fee and commission income of all banks and large banks followed the same pattern as the share of
noninterest income. In contrast, the share of fee and commission income of small banks maintained stable growth from 3.3%
1
Bank financial statements were used to classify the noninterest income. Taking the Industrial and Commercial Bank of China 2008 annual report for example,
fee and commission income includes clearing, settlement and cash management, personal banking and private banking, investment banking, bank cards, public
financial management, asset custody, security and commitment, agency funds and trusts, etc. Exchange gains primarily include income from trading cash
instruments, off-balance contracts, and market-to-market changes in the carrying value of assets and liabilities. Investment revenue includes bonds held for
trading, bonds designated at fair value with profit and loss, bonds available for sale, and investment revenue in associates, among others. Any noninterest income
not listed above is classified as other income.
154 L. Li, Y. Zhang / Journal of Empirical Finance 24 (2013) 151–165
(1992) to 10.53% (2008). Although all four components of noninterest income showed variations in terms of the share of net
operating revenue in this period, the sum of fee and commission income and investment revenue represents the greatest share of
noninterest income for commercial banks. Exchange gains and other income comprised a small share of the net operating revenue
for all banks except small banks. Small banks had a higher proportion of other income in the 1990s, which may be attributed to
the absence of specific differentiation and the incorrect listing of most noninterest income as other income.
Stiroh (2004) assessed the potential diversification benefits from the shift toward noninterest income in the U.S. banking
industry at aggregate and bank levels. This paper uses this methodology with some modifications based on the specific conditions
in China. For example, because the relationship between the noninterest income's share of net operating revenue and
bank-specific correlation is not non-linear in the Chinese banking industry, we do not consider the non-linear relationship in the
regression model, unlike the methodology used by Stiroh (2004). In addition, the components of noninterest income and the
selected independent variables in the regression model are different from those in Stiroh's paper.
4. Aggregate fluctuations and cyclicality of bank revenue
This section examines the aggregate fluctuations and cyclicality of bank profits and revenue over the last two decades in China.
Fig. 3 shows the variations in growth rates of net interest income and noninterest income from 1987 to 2008. Noninterest income
is less volatile than net interest income (standard deviations of 0.22 and 0.26, respectively) in the 1990s but more volatile after
the turn of the century (standard deviations of 0.25 and 0.1, respectively). In the studied period of time, the growth rate of
noninterest income is much more volatile than that of net interest income (standard deviations of 0.23 and 0.21, respectively).
2
However, as the average growth rate of noninterest income is higher than the average growth rate of net interest income (18.3%
vs. 15.65%), the coefficient of variation (the ratio of the standard deviation to the mean) for noninterest income growth is smaller
than that for net interest income growth (1.25 vs. 1.31), indicating that net interest income has a higher risk. However, the
coefficient of variation of noninterest income is far higher than that of net interest income (0.98 vs. 0.53
3
) during the period of
2000–2008, indicating that noninterest income has a higher risk. The growth rate of net interest income was more volatile in the
1990s than in the 2000s because of the large variation of the benchmark interest spread from 1987 to 1999. Using the one-year
benchmark interest spread for example, the difference between the maximum and the minimum was 0.54% (3.6% vs. 3.06%) in
2000–08 but 3.6% (3.6% vs. 0) in 1987–99. Because the net interest income growth is mainly affected by benchmark interest
spread, the large variation of the benchmark interest spread will lead to a higher volatility for the net interest income growth.
The shaded areas in Fig. 3 indicate the recession periods of the Chinese economy due to the shocks of the Southeast Asian
financial crisis and the subprime mortgage crisis in 1997–99 and 2008, respectively. In 1997, 1998, 1999, 2008, and 2009, the
Chinese GDP growth rates were 9.3%, 7.8%, 7.6%, 9%, and 8.5%, respectively, and the growth rates of both net interest income and
noninterest income were also decreasing during the shaded time periods. Thus, the economic cycle seems to have an impact on
the revenue of the Chinese banking industry. Of course, this hypothesis needs to be further verified by model analysis.
2
F-tests are used to compare the volatility of net interest income growth and that of noninterest income growth and accept the null hypothesis of equal
standard deviations for a full period (p-value = 0.61), i.e., that there is no significant evidence indicating that the S.D. of the noninterest income growth is higher
than that of the net interest income growth.
3
F-tests are used to compare the volatility of net interest income growth to that of the noninterest income growth and reject the null hypothesis of equal
standard deviations for the period of 2000 to 2008 (p-value = 0.02).
Table 1
Commercial bank revenue structure and bank size.
All banks Large banks Small banks
1986 1996 2008 1986 1996 2008 1992 1997 2008
Percent of net operating revenue (%)
Net operating revenue 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00
Net interest income 85.03 69.77 79.24 85.03 70.44 77.67 84.79 51.61 85.87
Noninterest income 14.97 30.23 20.76 14.97 29.56 22.33 15.21 48.39 14.13
Fees and commission income 14.88 5.48 13.43 14.88 5.38 14.11 3.30 5.91 10.53
Exchange gains 0.00 2.17 3.23 0.00 2.20 3.71 0.00 2.50 1.17
Investment revenue 0.00 16.63 3.15 0.00 16.82 3.48 0.01 21.69 1.79
Other income 0.08 5.95 0.95 0.08 5.17 1.03 11.89 18.29 0.64
Year 2000 RMB (100 million)
Net income 340.17 281.36 3119.16 340.17 218.72 2500.40 19.07 72.50 618.76
Net operating revenue 548.98 2141.27 10385.03 548.98 2031.69 8403.34 20.83 162.45 1981.69
Total assets 26523.77 97638.41 307301.23 26523.77 92768.51 243495.70 1387.49 6005.87 63805.52
Number of banks 15 15 15 5 5 5 10 10 10
Notes: (1) Components of noninterest income do not add up exactly because of rounding; (2) net operating revenue is net interest income plus noninterest
income; (3) due to data availability limitations, the data set for small banks begins in 1992.
155 L. Li, Y. Zhang / Journal of Empirical Finance 24 (2013) 151–165
Fig. 4 presents the growth rates of the four components of noninterest income from1987 to 2008: fee and commission income,
exchange gains, investment revenue, and other income. In this period, the standard deviations of these four components were
0.35, 3.18, 2.16, and 2.05,
4
respectively. Clearly, among all of the components, exchange gains are the most volatile, while fee and
commission income is the least volatile. As shown in Fig. 4, both exchange gains and investment revenue peaked in 1994, whereas
other income peaked both in 1991 and 1993. We believe that this extreme phenomenon was due to the confused concepts of
these four components and to the deficient accounting principles at the beginning of the 1990s in China. With the listing of banks
and the issuance of Provisional Regulations Governing Commercial Banks' Intermediary Business by the Central Bank in 2002,
an agreement on the classification of the four components of noninterest income was gradually reached, although minor
discrepancies still exist among banks. Therefore, as we can see from Fig. 4, the components of noninterest income after 1995 are
not abnormal. Based on the enlarged image of the growth rates of the components of noninterest income from 1995 to 2008 in
Fig. 4, the exchange gains are still the most volatile component, and fee and commission income is still the least. The standard
deviations of fee and commission income, exchange gains, investment revenue, and other income during 1995–2008 are 0.44,
0.78, 0.52, and 0.75, respectively.
5
We can visually examine the volatility and cyclicality of bank revenue using the figures above. Next, we rigorously
demonstrate the volatility and cyclicality of bank revenue.
4.1. Aggregate volatility
To gauge how net interest income and noninterest income contribute to the volatility of bank revenue, it is useful to
conceptualize net operating revenue as a simple portfolio of two types of assets: those that generate net interest income and
those that generate noninterest income. It is difficult to identify the specific assets associated with each income class to calculate a
rate of return, so we modify the standard decomposition of portfolio return volatility into a decomposition of portfolio growth
volatility. The log growth rate is used, making the volatility of this portfolio
σ
2
d lnOP
¼ a
2
σ
2
d lnNON
þ 1−a ð Þ
2
σ
2
d lnNET
þ2a 1−a ð ÞCov d lnNON; d lnNET ð Þ ð1Þ
where a = NON/(NET + NON) is the noninterest share of net operating revenue, (1 − a) is the net interest share, dlnNON is the
log growth rate of noninterest income, dlnNET is the log growth rate of net interest income, a
2
σ
d ln NON
2
is the contribution of
noninterest income to overall revenue volatility, and (1 − a)
2
σ
d ln NET
2
is the contribution of net interest income.
The standard portfolio theory implies that if the covariance between noninterest income growth and net interest income
growth is negative, the volatility of the operating revenue growth can be directly reduced. Even if the covariance is positive, the
standard deviation of the net operating revenue will be less than the sum of the weighted average of noninterest income and net
interest income as long as the covariance is not exactly one. Table 2 shows estimates for the components of Eq. (1) for two time
periods: 1987–99 and 2000–08. The first column presents the average shares of noninterest income (α) and net interest income
(1 − α), the second column presents the sample variance or covariance of the variables (σ
d ln OP
2
, σ
d ln NON
2
, σ
d ln NET
2
, and
Cov(d ln NON, d ln NET)), and the third column presents the contributions (share-weighted variances), as expressed by the
right-hand side of Eq. (1).
Table 2 shows that the variance of net operating revenue fell from 3.83 (1987–1999) to 0.91 (2000–2008), indicating a
decreased volatility of bank revenue. In these two time periods, the variance of net interest income declined substantially (from
4.82 to 0.71), that of noninterest income decreased slightly (from4.66 to 3.84), and the covariance between themfell significantly
(from 1.36 to 0.77), which implies that the entire decline in overall bank revenue volatility is due to these three components,
especially net interest income and the covariance.
4
F-tests reject the null hypothesis of equal standard deviations for all pairwise combinations of the four components of noninterest income except for
investment revenue and exchange gains (p-value = 0.2) and investment revenue and other income (p-value = 0.72).
5
F-tests reject the null hypothesis of equal standard deviations for all pairwise combinations of the four components of noninterest income except for
investment income and exchange gains (p-value = 0.16), exchange gains and other noninterest income (p-value = 0.9), fee and commission income and
investment income (p-value = 0.55), and investment income and other noninterest income (p-value = 0.2).
-40%
-20%
0%
20%
40%
60%
80%
1
9
8
7
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
Growth Rate of Net Interest Income Growth Rate of Noninterest Income
Fig. 3. Growth rate of net interest income and noninterest income (1987–2008).
156 L. Li, Y. Zhang / Journal of Empirical Finance 24 (2013) 151–165
We believe that the decline in net interest volatility after 2000 is mainly due to the stable benchmark interest spread and
macroeconomics. The decreased covariance of the net interest income growth and noninterest income growth indicates
diversification benefits from noninterest activities. One plausible explanation is that the share of noninterest income of the
Chinese banking industry is still low compared to that of the international banking industry, yielding diversification benefits.
In addition, although noninterest income volatility decreased from 1987–99 to 2000–08, the variance of the noninterest
income is far greater than the variance of net interest income in 2000–08 (3.84 vs. 0.71). Moreover, the contribution of
noninterest income to the overall revenue volatility decreases only slightly (from 0.2 to 0.19), which is a much smaller decrease
than that of net interest income (3.05 vs. 0.43), indicating that, as net interest income volatility decreases, noninterest income
may gradually replace net interest income as the main source of overall revenue volatility.
4.2. Aggregate cyclicality
This section further describes the cyclical properties of different types of bank revenue in China using the following regression
model:
d lnX
t
¼ α þ
X
5
τ¼1
β
t−τ
d lnX
t−τ
þ
X
5
τ¼0
ω
t−τ
d lnGDP
t−τ
þε
t
ð2Þ
where X
t
is some measure of bank income in period t. The bank income includes net income, net income plus provisions, net
interest income, net interest income less provision, noninterest income, and noninterest income less exchange gains. The GDP is
the real GDP based on the year 2000. The coefficient β reflects the impact of lagged bank income on contemporaneous bank
income, ω reflects the impact of contemporaneous and lagged GDP on contemporaneous bank income, and ε
t
is the residual.
Net income and net income plus provisions are measures of bank profits. The net income plus provisions is included because
there is some evidence that banks use loan loss provisions to smooth earnings over the cycle, and adding back provisions may
help us to better understand the cyclicality of bank earnings. Net interest income and net interest income less provisions are
-400%
0%
400%
800%
1200%
1600%
1
9
8
7
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
Fees and Commission Income Exchange Gains
Investment Revenue Other Income
-100%
-50%
0%
50%
100%
150%
200%
250%
300%
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
Fees and Commission Income Exchange Gains
Investment Revenue Other Income
Fig. 4. Growth rates of four components of noninterest income (1987–2008).
Table 2
Decomposition of variance of net operating revenue.
Average share Variance/covariance Contribution to variance
1987–1999
Net operating revenue 3.83
Net interest income 79.50 4.82 3.05
Noninterest income 20.50 4.66 0.20
Net interest/noninterest 1.36 0.22
2000–2008
Net operating revenue 0.91
Net interest income 77.70 0.71 0.43
Noninterest income 22.30 3.84 0.19
Net interest/noninterest 0.77 0.13
Notes: (1) All data in this table are multiplied by a factor of 100; (2) contributions do not exactly add up because the shares change through the sub-periods.
157 L. Li, Y. Zhang / Journal of Empirical Finance 24 (2013) 151–165
indicators of traditional banking activities, and subtracting provisions may provide a more accurate measure of the return to
traditional lending activities, as it accounts for expected defaults. Noninterest income and noninterest income less exchange gains
measure nontraditional activities in the form of noninterest income, subtracting exchange gains because the volatility of
exchange gains is largest in the four components of noninterest income, allowing the cyclicality of the other three components of
noninterest income to be further examined.
Table 3 shows estimates of Eq. (2). From column 1, the contemporaneous and lagged GDP coefficients are jointly significant at
the 5% level (p-value = 0.039), indicating that a significant linear relationship exists between net interest income growth and
GDP growth. Adding back provisions in column 2 weakens the significance (p-value = 0.247), suggesting that income smoothing
does not exist in the Chinese banking industry. We further examine the other two components of net operating revenue, namely,
the growth rates of net interest income and noninterest income. Column 3 shows that the contemporaneous and lagged GDP
coefficients are not jointly significant (p-value = 0.816), indicating that there is no significant relationship between net interest
income growth and GDP growth. Column 4 shows a higher p-value (p-value = 0.535) between the contemporaneous and lagged
GDP coefficients, but this value is still not significant. Thus, despite our consideration of the provisions, net interest income is
barely affected by the macroeconomic fluctuations. Column 5 shows that the contemporaneous and lagged GDP coefficients are
jointly significant at the 10% level (p-value = 0.057). Removing exchange gains from noninterest income in column 6 weakens
the link between contemporaneous and lagged GDP, which implies that macroeconomic fluctuations are more likely to affect the
exchange gains than the other three components of noninterest income. According to these regressions, noninterest income
shows a more obvious cyclicality than net interest income. That is, an increase in noninterest income may extend, rather than
smooth, the impact of macroeconomic fluctuations on bank revenue.
A second way to address this issue is using a simple vector autoregression (VAR) framework. Fig. 5 shows the impulse
response function from a VAR with GDP, net interest income, and noninterest income from 1987 to 2008. The VAR is estimated in
log-levels for real GDP, real net interest income, and real noninterest income in a trend. The impulse response function shows
how a shock in GDP propagates through the system and affects net interest income and noninterest income. Neither net interest
income nor noninterest income exhibits a response in the first quarter. Net interest income continues to show no response to an
innovation in GDP after the first quarter. However, noninterest income shows a significant positive response in the second
quarter, but then declines sharply and becomes negative.
Table 3
Link between aggregate bank income growth and GDP growth.
Dependent variable (X
t
)
Bank profits Traditional revenue Non-traditional revenue
Net
income
Net income
plus provisions
Net interest
income
Net interest income
less provisions
Noninterest
income
Noninterest income
less exchange gains
X
t − 1
0.268
(1.167)
0.400
(1.005)
−0.484
(−1.005)
−0.215
(−0.479)
−0.574

(−2.460)
−0.522

(−2.247)
X
t − 2
0.137
(0.703)
−0.081
(−0.160)
−0.246
(−0.303)
−0.761
(−1.083)
−0.166
(−0.746)
−0.181
(−0.766)
X
t − 3
0.193
(1.098)
0.190
(0.440)
0.076
(0.096)
−0.354
(−0.571)
−0.657
⁎⁎
(−2.848)
−0.662

(−2.496)
X
t − 4
0.816
⁎⁎
(3.979)
0.206
(0.570)
0.326
(0.355)
−0.443
(−0.605)
−0.716

(−2.476)
−0.540
(−1.834)
X
t − 5
−0.432
(−1.931)
0.256
(0.689)
0.510
(0.589)
−0.328
(−0.503)
−0.666
⁎⁎
(−2.584)
−0.742
⁎⁎
(−2.803)
GDP
t
−10.921
⁎⁎
(−3.106)
−12.235
(−1.780)
0.843
(0.069)
12.731
(1.355)
8.254

(2.264)
7.189

(1.610)
GDP
t − 1
−1.130
(−0.217)
9.628
(1.310)
1.069
(0.085)
−6.657
(−0.536)
9.500

(2.411)
10.905
(2.327)
GDP
t − 2
−4.029
(−0.935)
−12.115
(−1.268)
−0.910
(−0.060)
12.592
(0.849)
5.932
(1.476)
4.380
(0.895)
GDP
t−3
−5.128
(−1.138)
2.752
(0.237)
−1.865
(−0.247)
−5.155
(−0.642)
−2.652
(−0.762)
−3.461
(−0.804)
GDP
t − 4
8.297

(2.260)
5.812
(0.577)
0.508
(0.092)
2.820
(0.533)
9.335
⁎⁎
(3.273)
9.948
⁎⁎
(2.845)
GDP
t − 5
−9.458
⁎⁎
(−3.771)
−5.162
(−0.754)
−3.364
(−0.651)
1.094
(0.245)
−1.089
(−0.434)
−2.379
(−0.809)
Constant 2.172
(3.528)
1.137
(1.171)
0.441
(0.268)
−1.363
(−0.892)
−2.240
(−2.723)
−2.036

(−2.142)
Jt. sig. of lagged X 0.009 0.396 0.812 0.860 0.099 0.153
Jt. sig. of GDP and lagged GDP 0.039 0.247 0.816 0.535 0.057 0.087
Adjusted R
2
0.817 0.276 −0.591 −0.315 0.666 0.588
No. obs. 22 22 22 22 22 22
Notes: (1) t-value in parentheses; (2) Jt. sig. reports the p-values associated with the null hypothesis that the set of independent variables are jointly insignificant;
(3) ***, **, and * indicate statistical significance at the 99%, 95%, and 90% levels, respectively.
158 L. Li, Y. Zhang / Journal of Empirical Finance 24 (2013) 151–165
These results indicate that net interest income does not significantly respond to macroeconomic fluctuations, while
noninterest income responds significantly to changes in real output. Based on this analysis, we conclude that the main reason that
net interest income is not subject to macroeconomic fluctuations is government investment, which stimulates demand and spurs
economic growth during economic depressions in China. In addition, the government encourages banks to provide large-scale
credit to entity economy, especially the government financing platform. When the benchmark interest spread changes little,
traditional interest activities can ensure a steady growth, even during a recession. In contrast, noninterest income exhibits
cyclicality, being affected by some market factors. For instance, during economic depressions, the scarcity of funds and investment
channels will result in a decrease in noninterest income, while the availability of sufficient funds and investment channels during
economic booms will lead to an increase in noninterest income.
5. Bank-level correlation and diversification effect
The analysis above is based on the aggregate data and concludes that there are diversification benefits from increasing
noninterest income. However, based on a deeper assessment, the most direct way to examine the diversification effect of an asset
portfolio is to examine the correlation of each asset in the portfolio. To examine the diversification benefits from the increase
in noninterest income, this section examines the correlation between net interest income and noninterest income using
cross-sectional correlation and bank-specific correlation based on the bank-level data. The cross-sectional correlation measures
the correlation between the net interest income growth and noninterest income growth across banks at a point in time, whereas
bank-specific correlation measures the correlation between net interest income growth and noninterest income growth across
time for each bank.
5.1. Cross-sectional correlation
The cross-sectional correlation is defined as
6
ρ
t
¼ Corr d lnNET
i;t
; d lnNON
i;t


t
¼
X
n
i¼1
d lnNET
i;t
−E d lnNET
t
ð Þ

d lnNON
i;t
−E d lnNON
t
ð Þ
h i
X
n
i¼1
d lnNET
i;t
−E d lnNET
t
ð Þ

2
!
1=2
X
n
i¼1
d lnNON
i;t
−E d lnNON
t
ð Þ

2
!
1=2
ð3Þ
where ρ
t
is estimated for each year from 1987 to 2008. d ln NET
i,t
and d ln NON
i,t
are the growth rate of net interest income and
noninterest income, respectively, for bank i in year t. E(d ln NET
t
) and E(d ln NON
t
) are the average growth rate of the net interest
income and noninterest income, respectively, for all banks in year t.
The cross-sectional correlation is estimated separately for each year and describes the correlation between net interest income
and noninterest income across banks in a particular year. That is, it shows whether a bank with above average noninterest income
growth typically has above average net interest income growth. If noninterest income has a strong diversification effect on bank
revenue, then ρ
t
is expected to be negative. On the other hand, if ρ
t
is strongly positive, noninterest income provides little
diversification benefit for bank revenue.
We estimate ρ
t
for three sets of banks: all banks, large banks (assets greater than ¥3 trillion in 2000 RMB), and small
banks(assets less than ¥3 trillion in 2000 RMB). Fig. 6 plots the time series of cross-sectional correlations, ρ
t
, for the three sets of
banks. From Fig. 6, ρ
t
of all three sets of banks fluctuates between positive and negative. For all banks, the number of negative
years is 12, the number of positive years is 10, the average ρ
t
across all years is −0.064, and the mean ρ
t
is −0.008 between 1987
and 1999 and −0.144 between 2000 and 2008. The results indicate that noninterest income provides diversification benefits in
the Chinese banking industry. For large banks, the number of negative years is 12, the number of positive years is 10, the average
ρ
t
across all years is −0.1105, and the mean ρ
t
is −0.024 between 1987 and 1999 and −0.236 between 2000 and 2008. For small
6
This formula is cited from Stiroh (2004).
-.15
-.10
-.05
.00
.05
.10
.15
1 2 3 4 5 6 7 8 9 10
Response of Net Interest Income to Cholesky
One S.D. GDP Innovation
-.3
-.2
-.1
.0
.1
.2
.3
1 2 3 4 5 6 7 8 9 10
Response of Noninterest Income to Cholesky
One S.D. GDP Innovation
Fig. 5. Impulse response function of net interest income and noninterest income to an innovation in GDP.
159 L. Li, Y. Zhang / Journal of Empirical Finance 24 (2013) 151–165
banks, the number of negative years is 9, the number of positive years is 7, the average ρ
t
across all years is 0.008, and the mean ρ
t
is 0.027 between 1993 and 1999 and −0.006 between 2000 and 2008. The results showthat for both large banks and small banks,
noninterest income provides diversification benefits in the Chinese banking industry. It is worth noting that the estimate
indicates a greater diversification effect for large banks than small banks, which is due to the smaller contribution of noninterest
income to net operating income for large banks relative to small banks. The noninterest income to net operating income ratio is
27.74% for large banks and 28.57% for small banks. Furthermore, half of the ratios of noninterest income to net operating income
for small banks exceeded 30% during 1993–2008, compared to none of those of large banks. Therefore, for large banks,
noninterest income has a greater diversification effect. The results also indicate that as the noninterest income increases, the
marginal revenue brought about by diversification declines.
We further analyze the correlation between various components of noninterest income and net interest income. Fig. 7 plots ρ
t
between various components of noninterest income and net interest income. From Fig. 7, we observe that the correlation
between various components of noninterest income and net interest income fluctuates between negative and positive, showing
no regularity. The results, ranked from strongest to weakest, are exchange gains (mean of 0.071), fee and commission income
(0.023), other income (−0.0465), and investment revenue (−0.0629).
5.2. Bank-specific correlation
The bank-specific correlation defined as
7
ρ
i
¼ Corr d lnNET
i;t
; d lnNON
i;t


i
¼
X
T
t¼1
d lnNET
i;t
−E d lnNET
i
ð Þ

d lnNON
i;t
−E d lnNON
i
ð Þ
h i
X
T
t¼1
d lnNET
i;t
−E d lnNET
i
ð Þ

2
!
2
X
T
t¼1
d lnNON
i;t
−E d lnNON
i
ð Þ

2
!
2
ð4Þ
where ρ
i
is estimated for each bank during the examination period. d ln NET
i,t
and d ln NON
i,t
are the growth rates of net interest
income and noninterest income, respectively, for bank i in year t. E(d ln NET
i
) and E(d ln NON
i
) are the average growth rates of
net interest income and noninterest income, respectively, for bank i in all years.
The bank-specific correlation is estimated separately for each bank and describes the correlation between net interest income
and noninterest income over time for a particular bank. This is a relatively traditional method, as it directly measures whether the
noninterest income has diversification benefits. A negative correlation would suggest strong potential diversification benefits.
The calculation results based on Eq. (4) show that, for all banks, the average ρ
i
is −0.017, the median is 0.020, and the standard
deviation is 0.270. The mean is −0.005 for large banks and −0.023 for small banks. The results indicate that noninterest income
has evident diversification benefits in the Chinese banking industry, which is in agreement with the conclusion above.
Fig. 8 plots the distribution of ρ
i
. From Fig. 8, ρ
i
is distributed between −0.519 and 0.390 with a median of 0.020. For all banks,
the number of negative banks is 7, and the number of positive banks is 8. Although the numbers of both negative and positive
banks are almost the same, for the 7 negative banks, the absolute average value is far greater than that for the 8 positive banks
(0.252 vs. 0.188). As shown in Fig. 8, the distribution of negative ρ
i
is wider than that of positive ρ
i
.
We further analyze bank-specific correlation using the following regression model
8
:
ρ
i
¼ α þβ
1
ln A
i

þβ
2
D
A
!
þβ
3
d ln A
i
ð Þ þβ
4
NONSH
i
2
þ β
5
FEESH
i
þβ
6
EXCHSH
i
þβ
7
OTHERSH
i
þβ
8
MULTI
i
þε
i
ð5Þ
7
This formula is cited from Stiroh (2004).
8
When the noninterest income's share of the net operating revenue is 0 or 1, there is no relationship between noninterest income and net interest income

i
= 0). Therefore, we expect that a non-linear relationship exists between the noninterest income's share of the net operating revenue and ρ
i
. Thus, we
consider both linear and non-linear relationships between the noninterest income's share of the net operating revenue and ρ
i
(using NONSH
2
as an independent
variable). However, the regression results do not reveal a significant inverted-U-shaped relationship between ρ
i
and NONSH
2
. Thus, we rule out NONSH
2
. The
cause of this result may be insufficient data.
-1.0
-0.5
0.0
0.5
1.0
1
9
8
7
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
All Banks Large Banks Small Banks
Fig. 6. Cross-sectional correlation between noninterest income growth and net interest income growth. Notes: The data set for small banks begins in 1993.
160 L. Li, Y. Zhang / Journal of Empirical Finance 24 (2013) 151–165
where i is bank i, A is the assets of the bank,
D
A
is the leverage ratio, d ln(A) is the annual asset growth rate, NONSH is the
noninterest income's share of the net operating revenue, FEESH is the fee and commission income's share of the noninterest
income, EXCHSH is the exchange gains' share of the noninterest income, and OTHERSH is the other income's share of the
noninterest income. All of the variables marked by an upper bar are averages.
9
MULTI is a dummy variable that equals either 1
(large banks) or 0 (non-large banks). The estimation results are presented in Table 4.
From Table 4, columns 1and 2, the coefficient of NONSH is positive and significant at a 95% confidence level, indicating that as
noninterest income increases, the correlation between net interest income and noninterest income increases, and the
diversification benefits decrease. That is, although the noninterest income has diversification benefits in the Chinese banking
industry at the present stage, with the increase in shares of noninterest income, the marginal revenue brought about by
diversification gradually declines. At the same time, the correlation between MULTI and ρ
i
is insignificant, indicating that large
banks do not have higher or lower ρ
i
than small banks. Furthermore, from column 2, the correlation between the components of
noninterest income and ρ
i
is not significant, showing that the individual components of noninterest income do not have a
significant impact on the correlation between net interest income and noninterest income. Moreover, the correlation between the
three control variables (ln(A),
D
A
, and d ln(A)) and ρ
i
is significant. Banks with higher A and d ln(A) show a higher correlation
between net interest income and noninterest income, while banks with higher
D
A
show a lower correlation.
We also estimate the correlation between net interest income and noninterest income for large banks and small banks using
Eq. (5). Because there are only five large banks, which is insufficient for regression, we only calculate the estimate for small banks.
From Table 4, columns 3 and 4, the only significant correlation is between d ln(A) and ρ
i
. The results differ from our expectations,
which is likely due to the insufficient data.
6. Noninterest income's impact on bank risk and return
After examining the diversification benefits using correlation analysis, we examine the link between noninterest income
growth and bank revenue and risk using models. We first graph the relationship between noninterest income shares and two
measures (bank performance and risk). We use the risk-adjusted returns (Sharp ratio) to measure the bank performance. The
Sharp ratio is the average return on equity (ROE) divided by the standard deviation of the ROE. The lower the Sharp ratio, the
worse the bank performance and the higher the risk. The Z-score (or Z) is the number of standard deviations below the mean by
which profits must fall to bankrupt the firm. Z is defined as
10
Z ¼
X
T
t¼1

t
= A
t
þA
t−1
ð Þ ½ Š
!
=T þ
X
T
t¼1
E
t
þ E
t−1
ð Þ= A
t
þA
t−1
ð Þ ½ Š
!
=T
( )

ROA
ð6Þ
where A
t
is the total assets in period t, π
t
is the net income after taxes in period t, E
t
is the total equity, and 2π
t
= A
t
þA
t−1
ð Þ is the
return on assets in year t. σ
ROA
is the estimated standard deviation of the return on assets. As the formula indicates, the higher the
mean rate of return on assets and the higher the ratio of equity to assets, the higher Z is. Hence, higher values of Z are associated
with lower probabilities of failure. The more volatile the asset returns, the lower the Z-score.
According to the noninterest income's share of operating revenue for all banks, we plot the curve of the Sharp ratio and Z-score
from small to large in Fig. 9. Based on Fig. 9, with an increasing proportion of noninterest income in the net operating income, the
Sharp ratio and Z-score do not exhibit an obvious increase or decrease, making it difficult to determine the impact of the share of
noninterest income on the bank performance and risk.
9
One must arbitrarily drop one of the four components of noninterest income to avoid perfect collinearity. Investment revenue was chosen because it has the
largest mean share of noninterest income.
10
This formula is cited from Lown et al. (2000).
-1.2
-0.8
-0.4
0.0
0.4
0.8
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
Fees and Commission Income Exchange Gains Investment Revenue Other Income
Fig. 7. Cross-sectional correlation between net interest income growth and growth in components of noninterest income.
161 L. Li, Y. Zhang / Journal of Empirical Finance 24 (2013) 151–165
Next, we establish an econometric model to analyze the impact of noninterest income on bank risk and return. The
model is
Y
i
¼ α þβ
1
ln A
i

þβ
2
D
A
!
þβ
3
d ln A
i
ð Þ þβ
4
NONSH
i
2
þ β
5
FEESH
i
þβ
6
EXCHSH
i
þβ
7
OTHERSH
i
þβ
8
MULTI
i
þε
i
ð7Þ
where i is bank i and Y
i
is the dependent variable, including the mean and standard deviation of net income growth, the mean and
standard deviation of ROE, the Sharp ratio, and the Z-score. The other variables are the same as those in Eq. (5). The estimation
results are shown in Table 5.
From Table 5, in all regression equations, we observe that the relationship between NONHS and the dependent variables is not
significant. That is, from a statistical perspective, the relationship between noninterest income growth and bank risk and return is
not significant. This finding may be a result of insufficient data. Nevertheless, it is enlightening to analyze the relationship
between NONHS and the dependent variables to some extent. Columns 1 and 2 suggest a positive relationship between NONHS
and the mean and standard deviation of net income growth, indicating that noninterest income growth induces net income
growth and an increase in the volatility of net income growth. Columns 3, 4, and 5 suggest a negative relationship between
NONHS and both the mean ROE and Sharp ratio and a positive relationship between NONHS and the standard deviation of ROE,
indicating that the noninterest income growth increases the volatility of the net income growth but not the average revenue. That
is, banks with high shares of noninterest income usually have lower risk-adjusted returns (lower profits per unit of risk). Column
6 suggests a positive relationship between NONHS and Z-score, indicating that noninterest income growth does not lead to bank
insolvency risk.
0.00
0.04
0.08
0.12
0.16
0.20
0.24
-1.00 -0.75 -0.50 -0.25 0.00 0.25 0.50 0.75 1.00
R
e
l
a
t
i
v
e

F
r
e
q
u
e
n
c
y
Rho
Fig. 8. Bank-specific correlation between noninterest income growth and net interest income growth.
Table 4
Determinants of correlation between net interest income growth and noninterest income growth.
All banks Small bank
Log assets (ln(A)) 0.287
⁎⁎⁎
(3.344)
0.310
⁎⁎
(2.534)
0.145
(0.793)
0.720
(1.581)
Debt/assets
D
A
À Á
15.465
⁎⁎
(3.625)
20.236
⁎⁎
(2.446)
15.873
(1.675)
24.325
(1.799)
Growth in assets (dln(A)) 3.051
⁎⁎⁎
(3.374)
3.663
⁎⁎⁎
(3.698)
3.342
⁎⁎
(2.886)
3.718
(2.217)
NONSH 1.743
⁎⁎
(2.912)
1.855
⁎⁎
(2.897) 0.517
(0.420)
4.103
(1.318)
FEESH −0.254
(−0.441)
−1.697
(−1.285)
EXCHSH 2.371
(1.743)
5.202
(1.247)
OTHERSH −0.168
(−0.476)
−0.221
(−0.369)
MULTI 0.194
(0.852)
0.416
(1.551)
Constant −2.859
⁎⁎⁎
(−3.470)
−3.104
⁎⁎
(−2.785)
−1.456
(−0.990)
−6.585
(−1.599)
Adjusted R
2
0.604 0.618 0.616 0.533
Jt. sig.: component shares
of noninterest income
0.417 0.632
No. obs. 15 15 10 10
Notes: (1) t-value in parentheses; (2) ***, **, and * indicate statistical significance at the 99%, 95%, and 90% levels, respectively; (3) Jt. sig. reports the p-values from
the F-test of the joint significance, where the hypothesis of the joint test is that the coefficient of the dependent variable is not significant.
162 L. Li, Y. Zhang / Journal of Empirical Finance 24 (2013) 151–165
Regarding the components of noninterest income, only other revenue is negatively correlated with the mean ROE and Sharp
ratio and positively correlated with the standard deviation of ROE, indicating that higher shares of other revenue lead to greater
volatility and lower returns. The higher the growth in assets is, the higher the growth in net income is. Additionally, the higher the
leverage (debt/assets) is, the lower the profits per unit of risk are.
Based on an analysis of Fig. 8 and Table 5, we can see that the impact of noninterest income on bank risk and return is not
significant. However, we should note that an increase in noninterest income may lead to an increase in volatility (higher risk) but
not higher returns. In other words, although noninterest income does not have a significant impact on the bank risk/return
trade-off from a statistical viewpoint, it may worsen the risk/return trade-off.
7. Conclusion
This paper explores the relationship between noninterest income growth and bank risks based on the data for the Chinese
banking industry from1986 to 2008. First, we examine the volatility and cyclicality of the sample data on an aggregate level. Next,
we examine the correlation between net interest income and noninterest income through cross-sectional correlation and
bank-specific correlation. Furthermore, we establish econometric models to analyze the impact of noninterest income on bank
risk and return.
At the aggregate level, in the Chinese banking industry, the net operating income's volatility tended to decline during 1986 and
2008. In particular, the volatility of net interest income, the volatility of noninterest income, and their covariance decrease.
-1
0
1
2
3
4
C
C
B
I
C
B
C
A
B
C
B
O
C
O
M
H
X
B
S
P
D
B
S
D
B
C
E
B
C
M
B
G
D
B
C
N
C
B
C
I
B
C
M
B
C
B
O
C
E
B
0
5
10
15
20
25
Sharp Ratio (Left Axis) Z-score (Right Axis)
Fig. 9. Relationship between risk measures and noninterest income share.
Table 5
Noninterest income shares as determinants of bank risk and return.
Dependent variable
Net income growth Return on equity (ROE) Z-score
Mean Std. dev. Mean Std. dev. Sharp ratio
Log assets (ln(A)) −0.017
(−0.226)
−0.045
(−0.249)
−0.080
(−0.559)
0.231
(0.365)
−0.119
(−0.249)
1.556
(0.384)
Debt/assets
D
A
À Á
−3.086
(−0.573)
11.532
(1.116)
−15.614
(−1.625)
58.324
(2.653)
−89.443
⁎⁎
(−3.658)
−365.782
(−1.557)
Growth in assets (dln(A)) 1.902
⁎⁎
(3.122)
1.315
(0.894)
−1.505
(−1.290)
7.342
(1.428)
−3.943
(−1.017)
−40.471
(−1.234)
NONSH 0.053
(0.133)
0.627
(0.660)
−0.770
(−1.022)
2.457
(0.740)
−3.280
(−1.309)
24.567
(1.159)
FEESH 0.040
(0.113)
−0.165
(−0.193)
−0.983
(−1.449)
4.313
(1.443)
−2.227
(−0.987)
−2.633
(−0.138)
EXCHSH −0.297
(−0.355)
−0.304
(−0.150)
0.456
(0.285)
−0.385
(−0.055)
−1.280
(−0.240)
−36.739
(−0.815)
OTHERSH −0.221
(−1.017)
0.107
(0.205)
−1.062
⁎⁎
(−2.557)
4.075

(2.227)
−3.518
⁎⁎
(−2.550)
−8.326
(−0.713)
MULTI 0.223
(1.349)
0.760
(1.909)
0.011
(0.036)
0.098
(0.071)
−2.015
(−1.920)
−6.841
(−0.770)
Constant −0.190
(−0.277)
0.810
(0.489)
1.158
(0.882)
−3.409
(−0.590)
2.543
(0.583)
−7.699
(−0.209)
Adjusted R
2
0.451 0.061 0.173 0.104 0.560 0.058
Jt. sig.: component shares of noninterest income 0.757 0.982 0.156 0.207 0.174 0.740
No. obs. 15 15 15 15 15 15
Notes: (1) t-value in parentheses; (2) ***, **, and * indicate statistical significance at the 99%, 95%, and 90% levels, respectively; (3) Jt. sig. reports the p-values from
the F-test of the joint significance, where the hypothesis of the joint test is that the coefficient of dependent variable is not significant.
163 L. Li, Y. Zhang / Journal of Empirical Finance 24 (2013) 151–165
However, the decrease in the volatility of the net operating income is mainly subject to the decrease of the net interest income
and the decrease of the covariance between the net interest income and noninterest income. The decline of the covariance
between the net interest income and noninterest income indicates that the development of noninterest income in the Chinese
banking industry will bring diversification benefits. Although the noninterest income volatility has declined compared to 1987–
1999, when the variance of noninterest income was less than that of net interest income, the variance of noninterest income was
much larger than the variance of net interest income during 2000–2008. Compared to the sharp decrease in the contribution of
the net interest income to the variance of the net operation income, the decrease in the contribution of noninterest income to the
variance of net operating income is not significant, indicating that as the volatility of net interest income decreases, noninterest
income may gradually replace net interest income as the main cause of the volatility of operating income. We also find that,
compared to the net interest income, noninterest income show obvious cyclicality. That is, an increase in noninterest income may
extend, rather than smooth, the impact of macroeconomic fluctuations on bank revenue. At the aggregate level, our conclusion is
different fromthe finding of Stiroh (2004). Although we also find that the declining volatility of net operating revenue reflects the
reduced volatility of net interest income, we report that it reflects the reduced covariance between net interest income and
noninterest income, which indicates to some extent that the development of noninterest income in the Chinese banking industry
will bring diversification benefits. Stiroh (2004) finds that the covariance between net interest income and noninterest income
increases during the sample period and concludes that at the aggregate level, the shift from traditional business activities to
nontraditional business activities does not bring diversification benefits in the U.S. banking industry.
At the bank level, the cross-sectional correlation and bank-specific correlation between net interest income and noninterest
income show that, in the Chinese banking industry, noninterest income growth has diversification benefits. However, with the
increase in shares of noninterest income, the marginal revenue brought about by diversification gradually declines. Further
analysis shows that the impact of noninterest income growth on bank risk and return is not significant. However, we should note
that an increase in noninterest income may lead to an increase in bank risk, albeit not with higher returns. At the bank level, our
conclusion is also different from the findings of Stiroh (2004). Stiroh (2004) reports that the growth rates of net interest income
and noninterest income become more correlated during a sample period; however, we find that the correlation between the two
growth rates becomes small, which reflects diversification benefits of the noninterest income growth in the Chinese banking
industry.
This study shows that in the Chinese banking industry, an increase in noninterest income has diversification benefits.
However, because noninterest income has higher volatility and cyclicality than net interest income, with the increase in shares of
noninterest income, the marginal revenue brought about by diversification gradually declines. Therefore, relying more on
noninterest income may worsen the risk/return trade-off.
Compared to the extant literature, our contribution is that there is a reasonable boundary of noninterest income growth.
Unreasonably higher shares of noninterest income may increase risks rather than bring profits. Only by considering the scale of
the bank's business development can we determine the optimal proportion of noninterest income.
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