The Relation Between Bank Portfolios and Earnings: An Econometric Analysis

Abstract

UMEROUS theories of commercial bank N behavior have been proposed. In all of them, some form of profit maximization has been posited, either explicitly or implicitly, as the motivating force. Therefore, the rates of return, positive and negative, which a bank realizes from its assets and liabilities are important determinants of a bank's portfolio composition. Conversely, the composition of a bank's portfolio is an important determinant of its profits.' The relevant rates of return on earning assets, of course, are not easily observed nominal rates; servicing and processing costs must be deducted. Similarly, the relevant rates for liabilities are not observable interest payments per dollar; servicing costs net of service charges to depositors must be added. The relevant rates of return are net rates, and to apply a theory of bank behavior it is necessary to have estimates of these net rates. The purpose of this paper is to provide empirical estimates of the net rates of return which banks realize on various elements of their portfolios. Regression methods are utilized to allocate revenue and cost among the elements of bank portfolios.2 Thus, given observations of a cross section of banks. least-squares regressions of net current operating income (and other variants of profit) on various assets and liabilities are computed. The coefficients are estimates of net rates of return. The first section of the paper explains the analytical framework underlying the study and describes the data. The second and third sections report applications of the model to different samples of banks. By far the richest set of data concerns member banks in the Tenth Federal Reserve District, which is analyzed in section II. In section III, data for Connecticut commercial banks are studied. The fourth section of the paper briefly compares the estimates of net rates of return at Tenth District and Connecticut banks.