Product mix and earnings volatility at commercial banks: evidence from a degree of leverage model

Commercial banks? lending and deposit-taking business has declined in recent years. Deregulation and new technology have eroded banks? comparative advantages and made it easier for nonbank competitors to enter these markets. In response, banks have shifted their sales mix toward noninterest income ? by selling ?nonbank? fee-based financial services such as mutual funds; by charging explicit fees for services that used to be ?bundled? together with deposit or loan products; and by adopting securitized lending practices which generate loan origination and servicing fees and reduce the need for deposit financing by moving loans off the books. The conventional wisdom in the banking industry is that earnings from fee-based products are more stable than loan-based earnings, and that fee-based activities reduce bank risk via diversification. However, there are reasons to doubt this conventional wisdom a priori. Compared to fees from nontraditional banking products (e.g., mutual fund sales, data processing services, mortgage servicing), revenue from traditional relationship lending activities may be relatively stable, because switching costs and information costs reduce the likelihood that either the borrower or the lender will terminate the relationship. Furthermore, traditional lending business may employ relatively low amounts of operating and/or financial leverage, which will dampen the impact of fluctuations in loan-based revenue on bank earnings. We test this conventional wisdom using data from 472 U.S. commercial banks between 1988 and 1995, and a new ?degree of total leverage? framework which conceptually links a bank?s earnings volatility to fluctuations in its revenues, to the fixity of its expenses, and to its product mix. Unlike previous studies that compare earnings streams of unrelated financial firms, we observe various mixes of financial services produced and marketed jointly within commercial banks. Thus, the evidence that we present reflects the impact of production synergies (economies of scope) and marketing synergies (cross-selling) not captured in previous studies. To implement this framework, we modify standard degree of leverage estimation methods to conform with the characteristics of commercial banks. Our results do not support the conventional wisdom. As the average bank tilts its product mix toward fee-based activities and away from traditional lending activities, we find that the bank?s revenue volatility; its degree of total leverage, and the level of its earnings all increase. The first two results imply increased earnings volatility (because earnings volatility is the product of revenue volatility and the degree of total leverage) and the third result implies a possible risk premium. These results have implications for bank regulators, who must set capital requirements at levels that balance the volatility of bank earnings against the probability of bank insolvency. These results also suggest another explanation for the shift toward fee-intensive product mixes: a belief by bank managers that increased earnings volatility will enhance shareholder value (or at least will increase the value of the managers? call options on their banks? stock). Our results have no direct implications for the expanded bank powers debate we examine only currently permissible fee-based activities, and these activities may have demand and production characteristics different from insurance underwriting, investment banking, or real estate brokerage.