Fee-based income and macrohedging in Canadian banks
The Canadian banking system has experienced significant changes over the last two decades. Deregulations allowed banks to generate revenue from non-traditional activities, and today fee-based income is as equally important as net interest income. The main objective of this thesis is to investigate how fee-based income affects a bank’s earnings volatility and its exposure to interest rate risk. We conduct empirical analysis of the annual fee-based income earned by the six largest Canadian banks (Royal Bank of Canada, Toronto-Dominion Bank, Canadian Imperial Bank of Commerce, Bank of Montreal, Bank of Nova Scotia, and National Bank of Canada) over the period from 1990 to 2012 inclusive. This analysis shows that almost all kinds of fee-based income generated by Canadian banks are highly dependent on the performance of the Canadian economy. In particular, we notice that the Canadian Gross Domestic Product (GDP) and oil prices significantly affect the revenues generated through fee-based activities. We also find a high positive correlation between fee-based income and net interest income. Additionally, we find that trading activity generates the most volatile income stream and eventually increases the volatility of bank earnings. We construct a Monte Carlo simulation model to analyze bank income under different possible economic scenarios. The Monte Carlo model simulates different types of banks that are common not only in Canada, but also around the world. In addition to net interest income, these hypothetical banks can generate three categories of fee-based income: traditional income, basic non-traditional income, and advanced non-traditional income. We also account for the costs associated with fee-based income in our analysis. Through simulations we find that a small change in the term structure of interest rates leads to insignificant changes in income at any type of bank, eliminating the need to hedge against interest rate risk. Moreover, even when interest rates are expected to move dramatically, banks have optimal balance sheet structures that minimize interest rate risk and optimize the volatility of income. Banks with sub-optimal balance sheet structures need to hedge in order to avoid financial distress. We find that hedging works equally well when a bank hedges its entire net income or just the net interest income component. Moreover, some sources of fee-based income can serve as a good hedging tool against the interest rate risk because they provide a steady income stream that could serve as a cushion for earnings. For example, traditional income and basic non-traditional income decrease risk per unit of return and help banks to stabilize revenues. However, advanced non-traditional income increases earnings volatility and might even lead a bank to financial distress.
DegreeMaster of Science (M.Sc.)
DepartmentEdwards School of Business
SupervisorTannous, George; Mamun, Abdullah
CommitteeYu, Miaomiao; Fooladi, Iraj
Copyright DateMarch 2014
Interest rate risk