Economics of Banking  735 between the interest income a bank earns from lending and the interest ex- pense it pays to borrow funds is its net interest income. For the regional retail banks in the United States and retail-focused universal banks such as Banco Santander and ING Group, net interest income is typically the biggest compo- nent of total net revenues. As we discuss later in this chapter, it is important to understand that not all of a bank’s net interest income creates value. Most banks have a maturity mismatch as a result of using short-term deposits as funding to back long- term loans and mortgages. In this case, the bank earns income from holding positions on different parts of the yield curve. Typically, deposits are a low- cost and predictable form of funding, so that borrowing for the short term costs a bank less than what it can earn from long-term lending. Yet it is unclear whether all of this income represents value creation. For example, the true value created from lending is measured by the difference between the rate that banks receive on their outstanding loans and their returns in the financial markets on loans with the same maturity (see the section on economic-spread analysis later in this chapter). Fee and Commission Income For services such as transaction advisory, underwriting and placement of se- curities, managing investment assets, securities brokerage, and many others, banks typically charge their customers a fee or commission. For investment banks (like Morgan Stanley and Goldman Sachs), such commissions and fees typically make up around half of total net revenues and around one-third or more for universal banks with large investment-banking activities (among them HSBC and Bank of America). Fee income is usually easier to understand than net interest income, as it is independent of financing. However, some forms of fee income are highly cyclical; examples include fees from underwrit- ing and transaction advisory services. Trading Income Over the past 30 years, proprietary trading emerged as a third main category of income for the banking sector as a whole. This can involve not only a wide variety of instruments traded on exchanges and over the counter, such as eq- uity stocks, bonds, and foreign exchange, but also more exotic products, such as credit default swaps and asset-backed debt obligations, traded mostly over the counter. Trading profits tend to be highly volatile: gains made over several years may be wiped out by large losses in a single year, as the credit crisis painfully illustrated. These activities have also attracted considerable attention in the wake of the crisis. In 2010, the United States adopted legislation preventing 736  Banks banks from engaging in proprietary trading for their own profit.3 This resulted in steeply lower overall trading income, as the law permits only trading re- lated to serving the bank’s customers. In Europe, restrictions on trading activi- ties also were adopted—for example, through the 2017 Markets in Financial Instruments Directive II (MiFID II). Trading income for European banks has sharply declined since 2008. Other Income Some banks also generate income from a range of nonbanking activities, in- cluding real estate development, minority investments in industrial compa- nies, and distribution of investment, insurance, and pension products and services for third parties. Typically, these activities make only small contribu- tions to overall income and are unrelated to the bank’s main banking activities. As Exhibit 38.1 shows for the European banking sector, the relative impor- tance of these four income sources has changed radically over past decades. European banks shifted away during the 1990s from interest income toward 3 The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act aimed to improve the stability of the U.S. financial system through increased regulation and supervision. For example, it established restrictions on proprietary trading by banks through the so-called Volcker Rule and new government agencies such as the Financial Stability Oversight Council. EXHIBIT 38.1  Income Sources for European Banks, 1988–2018 Income streams/total net revenues,1 % 0 1988 1990 1992 1994 1996 1998 2000 2002 2004 2012 2014 2016 2018 2006 20082 2010 Interest Commission Trading3 Other2 10 20 30 40 50 60 70 80 90 100 1 For 1988–2007, based on a sample of 113 EU banks, of which 109 were active in 2007. For 2008–2013, based on a sample of 211 EU banks active in 2013.   For 2014–2018, based on a sample of largest 80 EU banks in 2014. 2 Other income was negative from 2014 to 2017. 3 Trading income was –9% in 2008. Source: Bloomberg, Compustat, Datastream, CapitalIQ.