Fee income, widely embraced as a way to offset the decline and volatility of banks' traditional credit businesses, is undergoing a transformation of its own.

As they contribute an ever-growing portion of bank profits, fees are increasingly coming from more cyclical and risky activities.

In the first quarter, 39.7% of bank earnings were attributable to noninterest sources, continuing a long-term rise from 24.7% in 1984, according to the Federal Deposit Insurance Corp.

Though exact breakdowns are difficult to come by, it is clear that many of the gains have come from investment banking, trading, and brokerage activities. These are far more market-sensitive than the trust fees and service charges on deposits that historically typified noninterest income- sources responsible for just a third of all U.S. commercial banks' $106 billion of noninterest income last year, according to Federal Reserve data.

With their newfound focus on fees and the fact that not all may be created equal, bankers are undaunted in their quest to further tip the balance away from interest dependency.

They say they have shifted their attention from building fees per se to ensuring that they are in the right combination of fee-based businesses. They see net interest margins continuing to decline, forcing a new approach to earnings management with fees necessarily at its core.

"It's all in your business mix," said David Daberko, chairman and chief executive officer of National City Corp., Cleveland. "We have some things going extremely well right now and some are slow and will do better."

So a bank enjoying an uptick in mortgage or investment banking revenues in a bull market might want to invest in mortgage servicing and securities processing, which could be expected to generate fees through the next cycle.

An institution reaping fat fees from selling investments to consumers today might want to reinvest some of that into mutual fund processing.

Though bankers may disagree on the ideal mix of income sources, they are virtually unanimous in viewing fee-based growth as essential.

Given the rise of mutual funds and other nonbank products and competition, cheap deposits are much less available for funding assets in the old-fashioned way. Higher-cost funds coupled with competition from other loan sources have pushed down the net interest margin-the key ratio of profitability in bank intermediation. FDIC figures for federally insured banks put the net interest margin at 4.06% for the first quarter, compared with 4.22% a year earlier and 4.4%, on an annualized basis, in 1993.

"Deposit-gathering-a source of one-third to one-half of net interest income-is in secular decline," said Mr. Daberko. "At best it can grow 1% to 2% a year. You've got to get into other businesses-both lending and fee businesses."

Such businesses may promise higher margins, but at the price of higher risks.

Potentially lucrative credit products like leases, other asset-based loans, and subprime loans expose banks to higher loss rates than their traditional secured loans. Fee-income drivers such as trading, investment banking, and brokerage are tied to the vagaries of capital markets.

"Nobody said these businesses are not going to be volatile," said Edward E. Furash, chairman of Furash & Co., a Washington-based consulting firm. "The challenge is picking the right mix."

Mr. Furash has firm ideas about that mix.

He recommends that the largest banks derive 30% of earnings from traditional deposit-based businesses, including charges for checking accounts and automated teller machine use. This category is difficult to grow, he said, because it involves "socking it to the consumer."

Another 10% to 15% of the earnings should come from more volatile, markets-driven businesses such as investment banking and trading. Though potentially highly profitable, Mr. Furash pointed out, these activities must be subjected to rigorous risk controls.

The remaining 55% to 60%, Mr. Furash said, should come from "specialty intermediation"-such as specialized consumer finance-and from "fee-based operating businesses" such as investment management. These are attractive because they can be funded in the capital markets, not by deposits.

Banks that cannot make the grade themselves in what Mr. Furash called that "third box" have to go out and acquire "pieces of a big (nonbank) business," he said. That was the rationale behind KeyCorp's agreement to acquire McDonald & Company Securities or Citicorp's merger deal with Travelers Group.

Raphael Soifer, a bank analyst at Brown Brothers Harriman, is typically bullish on fees as an income source but more skeptical on the question of mix.

"There is some benefit to diversification, but at the end of the day market sensitivity is market sensitivity," Mr. Soifer said. "You can't always predict market-sensitive income."

Still, the analyst said he was glad to see how fees propelled recent earnings growth at the larger banks-even if much of it may have been volatile. "At this point in the cycle, loan growth would be a harbinger of credit problems to come," he said.

As Mr. Soifer sees it, brokerage and other market-sensitive businesses are less volatile than lending-at least over the long run. An unforeseen event like the Asian crisis can wipe out a bank's capital markets revenue in the blink of an eye, but it could be years before deteriorating asset quality depresses interest income.

Mr. Soifer said about 75% of fluctuations in bank earnings are due to credit quality. He contrasted 1990, when the industry was depressed and earnings were negligible, with recent quarters that have seen consistent shattering of profit records.

"That reflects an improvement in asset quality," he said. "Lending is extremely volatile, but not in the short term."

Lending is still responsible for the vast majority of banking industry profits. The FDIC said the aggregate net interest income was $44.3 billion in the first quarter, up 5.2% from a year earlier. Noninterest income increased much faster-18.8%-but it stood at $29.2 billion.

A report in the June Federal Reserve Bulletin showed that except for a 1.8% increase in noninterest income in 1994 this growth statistic has been in or near double digits throughout the 1990s.

Interest income was flat or declined from 1990 through 1993, and then the economic expansion turned that around. Last year interest income was up 7.9%, noninterest income 11%. But in dollar terms, interest income rose by almost $25 billion, to $338.2 billion; noninterest income increased $10.5 billion, to $105.8 billion.

Even as they stress fee strategies, many bankers "don't want to do that at the expense of the basic business of banking, which is still lending and deposit taking," said Stephen Hansel, president and CEO of Hibernia Corp., New Orleans.

"The goal is to help position the company to take what the market gives us," he said. "We want to be in the way of any kind of opportunity that's out there."

To that end, Mr. Hansel said, he has remade Hibernia from a company that six years ago was dependent on middle-market commercial lending to one that competes also in small-business and retail lending. "We've gone to a three- legged stool from a one-legged stool," he said.

On the fee side, Mr. Hansel said, Hibernia has recently benefited from upticks in mortgage banking and brokerage work but realizes that such riches might be fleeting. He is looking into building the insurance and cash management businesses to provide more stable, annuity-like income.

Is there a dark side to the passion for fees?

"Most recently, there has probably been an overstatement of growth in fee income," said Mr. Daberko of National City. "In mortgage banking, refinancings and low interest rates are astounding. Our fee income grew 30% in the first half of the year and more than doubled in mortgages. That will be cyclical. That will go down."

"Some of the largest banks have hurt themselves and the industry by cutting rates to the extent they have for syndicated loans for a fee," added Mr. Hansel. "They are more interested in the fee from the syndication than the spread on the credit."

To avoid sacrificing spread for fees, Susannah Swihart, chief financial officer of BankBoston Corp., said bankers should take a customer-based rather than transaction-based view of their businesses.

"These should not be secondary or peripheral businesses," she said. "They should be core and important and customer-oriented. You want to build deeper and more profitable relationships with the customer."

At BankBoston, fee income of $103 million was responsible for 21% of total revenues in the second quarter, up from 11% a year earlier. Most of the growth came in investment banking, Latin American money management, U.S. investment management, and electronic banking.

"These businesses are more stable than lending businesses but only some of them are 'annuities,'" Ms. Swihart said. "They can't be brought in and left alone."

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