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.
|Date of creation:||1999|
|Date of revision:|
|Contact details of provider:|| Postal: P.O. Box 834, 230 South LaSalle Street, Chicago, Illinois 60690-0834|
Web page: http://www.chicagofed.org/
More information through EDIRC
|Order Information:|| Web: http://www.chicagofed.org/webpages/publications/print_publication_order_form.cfm Email: |
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Simon Kwan, 1998.
"Securities activities by commercial banking firms' Section 20 subsidiaries: risk, return and diversification benefits,"
Working Papers in Applied Economic Theory
98-10, Federal Reserve Bank of San Francisco.
- Simon H. Kwan, 1998. "Securities activities by commercial banking firms' section 20 subsidiaries: risk, return, and diversification benefits," Proceedings 609, Federal Reserve Bank of Chicago.
- Franklin R. Edwards & Frederic S. Mishkin, 1995.
"The decline of traditional banking: implications for financial stability and regulatory policy,"
Economic Policy Review,
Federal Reserve Bank of New York, issue Jul, pages 27-45.
- Franklin R. Edwards & Frederic S. Mishkin, 1995. "The Decline of Traditional Banking: Implications for Financial Stabilityand Regulatory Policy," NBER Working Papers 4993, National Bureau of Economic Research, Inc.
- John H. Boyd & Stanley L. Graham, 1991. "Investigating the banking consolidation trend," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Spr, pages 3-15.
- Robert DeYoung, 1994. "Fee-based services and cost efficiency in commercial banks," Proceedings 47, Federal Reserve Bank of Chicago.
- Allen N. Berger & Anil K. Kashyap & Joseph M. Scalise, 1995.
"The Transformation of the U.S. Banking Industry: What a Long, Strange Trips It's Been,"
Brookings Papers on Economic Activity,
Economic Studies Program, The Brookings Institution, vol. 26(2), pages 55-218.
- Allen N. Berger & Anil K. Kashyap & Joseph Scalise, 1995. "The Transformation of the U.S. Banking Industry: What a Long, Strange Trip It's Been," Center for Financial Institutions Working Papers 96-06, Wharton School Center for Financial Institutions, University of Pennsylvania.
- Mandelker, Gershon N. & Rhee, S. Ghon, 1984. "The Impact of the Degrees of Operating and Financial Leverage on Systematic Risk of Common Stock," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 19(01), pages 45-57, March.
- Rebecca S. Demsetz & Philip E. Strahan, 1995. "Diversification, size, and risk at bank holding companies," Research Paper 9506, Federal Reserve Bank of New York.
- David B. Humphrey, 1990. "Why do estimates of bank scale economies differ?," Economic Review, Federal Reserve Bank of Richmond, issue Sep, pages 38-50.
- George G. Kaufman & Larry R. Mote, 1994. "Is banking a declining industry? A historical perspective," Economic Perspectives, Federal Reserve Bank of Chicago, issue May, pages 2-21.
- Kenneth Spong, 2000.
"Banking regulation : its purposes, implementation, and effects,"
Federal Reserve Bank of Kansas City, number 2000bria.
- Kenneth Spong, 1994. "Banking regulation : its purpose, implementation, and effects," Monograph, Federal Reserve Bank of Kansas City, number 1994bria.
- Rodney N. Johnson & David R. Meinster, 1974. "Bank Holding Companies: Diversification Opportunities in Nonbank Activities," Eastern Economic Journal, Eastern Economic Association, vol. 1(4), pages 316-323, October.
- Allen N. Berger & David B. Humphrey, 1990.
"Measurement and efficiency issues in commercial banking,"
Finance and Economics Discussion Series
151, Board of Governors of the Federal Reserve System (U.S.).
- Allen N. Berger & David B. Humphrey, 1992. "Measurement and Efficiency Issues in Commercial Banking," NBER Chapters, in: Output Measurement in the Service Sectors, pages 245-300 National Bureau of Economic Research, Inc.
- Gallo, John G. & Apilado, Vincent P. & Kolari, James W., 1996. "Commercial bank mutual fund activities: Implications for bank risk and profitability," Journal of Banking & Finance, Elsevier, vol. 20(10), pages 1775-1791, December.
- Keeley, Michael C, 1990. "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review, American Economic Association, vol. 80(5), pages 1183-1200, December.
- Kwast, Myron L., 1989. "The impact of underwriting and dealing on bank returns and risks," Journal of Banking & Finance, Elsevier, vol. 13(1), pages 101-125, March.
- Boyd, John H. & Graham, Stanley L. & Hewitt, R. Shawn, 1993. "Bank holding company mergers with nonbank financial firms: Effects on the risk of failure," Journal of Banking & Finance, Elsevier, vol. 17(1), pages 43-63, February.
- Eisenbeis, Robert A & Harris, Robert S & Lakonishok, Josef, 1984. " Benefits of Bank Diversification: The Evidence from Shareholder Returns," Journal of Finance, American Finance Association, vol. 39(3), pages 881-92, July.
- Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
- Lord, Richard A, 1998. "Properties of Time-Series Estimates of Degree of Leverage Measures," The Financial Review, Eastern Finance Association, vol. 33(2), pages 69-83, May.
- John H. Boyd & Mark Gertler, 1995.
"Are Banks Dead? Or Are the Reports Greatly Exaggerated?,"
NBER Working Papers
5045, National Bureau of Economic Research, Inc.
- John H. Boyd & Mark Gertler, 1994. "Are banks dead? Or are the reports greatly exaggerated?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Sum, pages 2-23.
- John H. Boyd & Mark Gertler, 1994. "Are banks dead? or, are the reports greatly exaggerated?," Proceedings 25, Federal Reserve Bank of Chicago.
- John H. Boyd & Mark Gertler, 1994. "Are banks dead? or, are the reports greatly exaggerated?," Working Papers 531, Federal Reserve Bank of Minneapolis.
- Larry D. Wall & Alan K. Reichert & Sunil Mohanty, 1993. "Deregulation and the opportunities for commercial bank diversification," Economic Review, Federal Reserve Bank of Atlanta, issue Sep, pages 1-25.
- John H. Boyd & Stanley L. Graham, 1986. "Risk, regulation, and bank holding company expansion into nonbanking," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Spr, pages 2-17.
When requesting a correction, please mention this item's handle: RePEc:fip:fedhwp:wp-99-6. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Bernie Flores)
If references are entirely missing, you can add them using this form.