US Bank Holding Companies : Structure of Activities and Performance Through the Cycles

The development of market-based finance and amendments to regulation on bank powers have supported a larger involvement of US banks in financial activities over the last decades. Changes in the structure of income question risks though. Especially, with a performance perspective: does diversification beyond “traditional” banking result in actual diversification of earnings risks and superior risk-return profile? With the exception of financial leverage and trading, knowledge is inconclusive to date. Besides the restriction of proprietary financial activities, the Dodd-Frank Act (2010) also allows for preventive bank restructurings involving creditors. Scrutiny of banks' soundness increases. Together with the recent international Basel III Accord which, among others, will gradually raise costs of capital, banks therefore operate in a new framework. More than ever, profitability and performance over time are key issues in the definition of banks' business models.The paper proposes a new insight on performance by assessing the influence of the economy and financial markets on earnings. To date, such an influence is not explored beyond financial risks. We use granular data from a large panel of US Bank Holding Companies (BHC) and, consistently with the return of banks to more customer-centric activities, distinguish banking activities and investment services. We find significant and distinct influences of the economy and of financial markets as well as different cost elasticities associated with the two types of activities. We then adopt a multiple scenarios approach. After assessing the performance profile of banking activities on a stand-alone basis, we find that the addition of investment services to banking increases the expected volatility of ROE but actually improves the risk-return profile of BHC. Also, prudent interest rate mismatch strategies may reduce the expected volatility of ROE and further support risk-return. Deviations from historical volatilities and correlations of GDP growth, interest rates and stock markets may cause these benefits to vary. We however further show that the “overall uncertainty” of ROE barely increases with investment services and interest rate mismatch while ROE expectations rise