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

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Abstract
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
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