Product Mix and Earnings Volatility at Commercial Banks: Evidence from a Degree of Leverage Model

Abstract

We construct a degree-of-total-leverage framework to test whether and how shifts in product mix affect earnings volatility at 472 U.S. commercial banks between 1988 and 1995. Our framework, which accounts for cost and revenue synergies not captured in most previous studies, conceptually links earnings volatility to revenue volatility, expense fixity, and product mix. We find that replacing traditional lending activities with fee-based activities - an ongoing trend that may be strengthened by recent financial modernization - is associated with both higher revenue volatility and higher total leverage, which in this framework implies higher earnings volatility.

Keywords: Commercial banks, degree of total leverage, earnings volatility, fee-based actitivities, product mix.

JEL Classification: G21, G32, D24.