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• the market's Herfindahl-Hirschman
Index,
• the number of banks and thrifts in
the community where the bank is
headquartered, and
• the percentage of deposits held by
thrifts in the market.
We then used standard statistical
procedures to test the importance of these
variables, jointly and individually, in
explaining earnings of the high-and
low-profit banks. These variables together
explained about one quarter of the
variability in their earnings (table 4)_ As
far as the relative contribution of
individual variables is concerned, we
found bank ownership, local competition,
asset allocation and deposit composition
to be key determinants of bank earnings.
Banks that were not affiliated with bank
holding companies earned higher profits.
Some bankers believe this occurs because
independent banks provide more
personalized services and can react more
rapidly to local changes than institutions
belonging to larger organizations.
Local competition, as measured by the
number of banks and thrifts in the
community where the banks are headquartered, affected bank earnings. Banks
operating in communities with fewer
banking alternatives faced less vigorous

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Address Correction Requested:

Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
P.O. Box 6387, Cleveland, OH 44101.

Federal Reserve Bank of Cleveland
Table 4 - Regression Results for
Bank Earnings
Return on
Assets
Deposit size
Bank ownership
Deposit composition
Asset allocation
Household income growth in market
HHI in market
Number of banks and thrifts in
head office community
Deposit held by thrifts in market
Adjusted

1. Significant

Negative!
Positive"
NegativeNegative
Negative
NegativeNegative

0.26

R2

2. Significant

Positive

at 5 percent
at 1 percent

level.
level.

competition and were able to earn higher
profits. The high earners maintained a
larger portion of demand deposits and
savings deposits with interest rate
ceilings that reduced interest expenses.
In addition, these banks made fewer loans
(or more investments), which lowered
non-interest expenses and kept loan
losses down.
When other variables were taken into
account, some individual factors became
insignificant in explaining high - and
low-profit bank earnings. These factors
included bank size, market growth, market
concentration, and the share of deposits
held by thrifts in the market.

Conclusion
Caution should be exercised in
attempting to draw any general conclusions about the factors that determine
bank earnings because our findings are
based only upon the most- and leastprofitable banks in four states and
cover only one year. Nevertheless, many
differences were found between the two
groups of banks.
Such factors as bank size and market
concentration are not significant in
explaining the variability in earnings
among the high- and low-profit banks
when other factors are taken into account.
What seemed to matter most was ownership,
local competition, asset structure and
deposit composition. The return on assets
was higher at banks that were unaffiliated
with bank holding companies, that
operated in communities with fewer banks
and thrifts, that held less expensive
deposits and that extended fewer loans.
These factors, along with superior
management, helped banks in this category
hold down operating expenses and generate
higher revenues.
No evidence was found to support the
notion that small independent banks cannot
do well in a deregulated environment.
Regardless of size, banks with good
management are likely to continue to
perform well.

BULK RATE
U.S. Postage Paid
Cleveland,OH
Permit No. 385

November 15,1985
ISSN 0428· 1276

ECONOMIC
COMMENTARY
Much concern has been expressed in
financial circles about bank earnings,
credit and interest-rate risks, and bank
failures over the last few years. Since
1981, the number of bank failures has
escalated because many institutions have
been saddled with an increasing volume
of bad loans and other problems.
Deregulation has played a role in these
problems by intensifying competition,
thereby increasing the difficulty for banks
to enhance earnings. Adequate profits,
of course, are necessary to allow banks to
grow, particularly smaller institutions
that have limited access to equity markets.
Numerous studies have examined bank
earnings to isolate factors that account
for differences among banks in profits.'
Findings generally reveal that the most
important factor determining bank
profitability is management's control over
expenses, especially non-interest
expenses. Other factors, such as bank size
and market concentration, had little or
no effect on bank earnings. All these
studies, however, have been based on
bank earnings prior to enactment of most
rate deregulation.
The introduction of money market
deposit accounts (MMDAs) in December
1982 and Super NOWs in January 1983
changed the method of competition and
greatly altered the balance sheets of
depository institutions. The absence of
rate ceilings on MMDAs and Super NOWs
enabled depository institutions to compete
with each other and with money market
mutual funds on the basis of rates.
Competitive pressure caused banks and
thrifts to pay higher rates; depositors
reacted by shifting funds to those highpaying accounts. Institutions that
traditionally held a high concentration of
low-cost savings deposits were probably
affected the most by deposit rate
deregulation.
Paul R. Watro is an economist at the Federal Reserve
Bank 0/ Cleveland. The author would like to thank
Larry Vozar and Steve Reutschi lor their assistance.
The views stated herein are those 0/ the author
and not necessarily those 0/ the Federal Reserve
Bank 0/ Cleveland or 0/ the Board 0/ Governors 0/
the Federal Reserve System.

In this Economic Commentary, we
examine bank profitability and identify
institutional, operational and locational
differences between the most-and
least-profitable banks. We find significant differences in both expenses and
revenues between high and low earners,
and identify some of the contributing
factors to earnings differences.
Sample Selection and Method Used
The sample of banks used in this study
was selected from four states - Ohio,
Pennsylvania, Kentucky and West Virginia
- and included all those institutions that
earned more than two cents per dollar of
assets and all those institutions that failed
to earn a profit in 1983.2 There were 84
high earners and 79 low earners. The
average high earner earned 2.44 cents per
dollar of assets while the average low
earner lost 1.48 cents per dollar of assets.
Within the group of high earners, 34 were
in Kentucky, 21 in West Virginia, 12 in
Ohio, and 17 in Pennsylvania. Among the
low earners, 34 were in Kentucky, 11 in
West Virginia, 23 in Ohio, and 11 in
Pennsy Ivania.
For each of the high-and low-earning
banks, we gathered data on the size,
ownership, competition, market conditions,
operations, asset holdings, deposit
composition, revenues, and expenses
(see tables 1, 2 and 3). Some of these
factors are under the direct control of bank
management; others are not. Nevertheless,
each of these factors could have an
important influence on bank profits. For
each of these variables, we calculated
an average value for the high earners and
an average value for the low earners.

1. Some of these studies include Donald R. Fraser,
"The Determinants
of Bank Profits: An Analysis
of Extremes," The Financial Review, 1976, pp.
69-87; John A. Haslem, "A Statistical Analysis of
The Relative Profitability of Commercial Banks,"
Journal 0/ Finance, vol. 23, no. 1 (March 1968),
pp. 167·76; Myron L. Kwast and John T. Rose,
"Pricing, Operating Efficiency, and Profitability
Among Large Commercial Banks," Journal 0/

Bank Earnings:
Comparing the
Extremes
by Paul R. Watro

Using standard statistical methods, we
next tested to see if the averages were
different between the two groups of banks.
We have designated each result according
to whether or not the averages are
statistically different at various levels of
significance. A 1 percent level of significance means that the probability that the
difference is due to random chance is
less than 1 percent.
Findings
The average values for the high-and
low-profit banks and the statistical
differences between them are given in
tables 1 through 3.
The impact of institution size on bank
earnings has important implications for
public policy. With the current wave of
technological change and deregulation in
the financial service industry, much
concern has been expressed about the
survival of small independent banks. Yet,
small independent institutions have not
only survived, but many have continued
to outperform larger institutions. In this
study, high-earning banks were found to
be much smaller than low-earning banks.
Two-thirds of the high earners did not
operate any branch offices and fewer of
them belonged to a bank holding company
(table 1). The average deposit size of
the higher earners was only $29.8 million,
compared to $141.6 million for the low
earners. None of the high earners had
deposits over $200 million and two- thirds
of them had deposits under $25 million.
In contrast, 10 percent of the low earners
had deposits over $200 million and half
of them had deposits under $25 million.
We found that the degree of competition
is likely to alter bank earnings. Banks
operating in areas where competition is

Banking and Finance, vol. 6, no. 2 (j une 1982),
pp. 233·54; Marvin M. Phaup, Ir., "Characteristics
of High Performance
Banks 1969·1975," Economic
Review, Federal Reserve Bank of Cleveland, Fall
1976, pp. 12-22; and Larry D. Wall, "Why Are
Some Banks More Profitable?" Economic Review,
Federal Reserve Bank of Atlanta, vol. 68, no. 9
(September
1983), pp. 42-8.

Expenses and Revenues
Table 1- Size, Ownership, Competition, and Growth
High Earners

-111.82
-4.03
-34.83
-11.11

141.6
5.7
69.0
27.8

11.1
18.9
84.5
77.4
3257
2714
17.9

Local structure
Number of banks
Number of banks and thrifts
Bank's share of bank deposits (percent)
Bank's share of bank & thrift deposits (percent)
Community deposits held by thrifts (percent)
Market growth (percent change from 1978 to 1983)
Population
Household income
Per capita income

SOURCES:

Difference

29.8
1.7
34.2
16.7

Deposit size ($ million)
Number of offices
Single office (percent)
Member of bank holding company (percent)
Market structure
Number of banks
Number of banks and thrifts
Four-bank concentration
ratio (percent)
Four-bank & thrift concentration ratio (percent)
HHI (banks)
HHI (banks & thrifts)
Market deposits held by thrifts (percent)

1. Significant
2. Significant
3. Significant

Low Earners

13.7
25.6
82.9
72.4
2870
2175
25.0

-2.6
-6.7
1.6
5.0
387
5391
-7.13

1.5
1.7
83.8
78.9
6.8

2.5
3.9
59.2
50.7
18.7

-1.03
-2.23
24.63
28.23
-11.93

4.7
44.6
52.4

5.1
39.6
49.8

-0.4
5.01
2.6

at 10 percent level.
at 5 percent level.
at 1 percent level.
Federal

Reserve

System

Board of Governors,

and Survey

of Buying

Power.

less intense would be expected to earn
higher profits. Researchers have typically
used measures of market structure (the
number and size distribution of competitions) to gauge the competitiveness
of
market areas.'
Since there is no unambiguous measure
for market structure, several variables
were examined: the number of competitors,
the four-firm concentration ratio, the
Herfindahl- Hirschman Index (HHI) and
the percentage of deposits held by thrifts
in the market.' The four-firm concentration ratio indicates the market share held
by the four largest competitors in the
market. The HHI is a more comprehensive
measure of market structure, since it
takes into account both the number and
size distribution of all the competitors in
the market.' When a market has only
one institution, the HHI attains its maximum
value of 10,000. The value of HHI
declines with increases in the number of
competitors and as the competitors become
more equal in their share of market
deposits. The percentage of deposits held
by thrifts in the market is used as a
measure for thrift competition.
All of the above market structure variables
showed a tendency to influence bank
earnings, but only the HHI and thrift
competition had a significant impact on

profits. The high-earning banks operated
in more concentrated markets and in
areas where thrifts held a smaller share
of the deposits.
In addition to the competitive condition
in the overall banking markets, the
competitive environment in local communities might also alter bank earnings,
particularly for banks that do not operate
offices throughout the entire market.
Over one-half of the sample banks had
only one office; many others had offices
in only one community. The high-earning
banks were headquartered in communities
with fewer competitors, faced less thrift
competition, and held a larger share of the
local deposits than the low-earning banks.
Banks operating in expanding markets
enjoy a larger supply of potential new
deposit and loan customers. While economic
growth generally leads to higher profits,
it is unclear how growth would affect
average earnings per dollar of assets.
High earners operated in markets that
experienced significantly faster increases
in household incomes than markets where
the low-earning banks were located. No
material differences in other growth
measures were detected between the
markets of the two groups of banks.

2. Statistically, the banks whose return on average
assets was more than one standard deviation above
or below the mean profitability level were classified
as either high or low profit banks.

4. Thrift institutions include all savings and loan
associations and mutual savings banks that are
federally insured.

3. For the purpose of this study, banking markets
were approximated
by metropolitan statistical areas
and counties outside of urban areas.

5. The Herfindahl- Hirschman Index is calculated by
adding the squared market share of each competing
institution.

As a percentage of assets, both expenses
and revenues differed among the high -and
low-earning banks (table 2). Expense
differentials were the largest and most
widespread. The average expenses per
dollar of assets were less than nine
cents for the higher earners, compared
to over 12 cents for the low earners.
Given the level of interest rates,
interest costs of banks are determined by
the volume and mix of their liabilities.
The share of liabilities paying market rates
has risen substantially with deposit rate
deregulation, particularly at smaller
institutions. Banks that could maintain
more demand and rate ceiling deposits
would pay less interest than banks with
fewer demand and regulated deposits.
Although high-earning banks held about
the same percentage of demand deposits
as low-earning banks, they held a
significantly smaller share of time deposits
and large CDs, and a larger share of
savings deposits with rate ceilings. As a
result, interest expense was significantly
lower at the most profitable banks.
The non-interest costs of banks are
affected by the volume and composition of
assets and liabilities and the effectiveness
of controlling operating expenses. Some
assets, such as loans, are risky and more
expensive to make and to service compared
to investing in government securities.
Lenders also incur higher administrative
costs in extending certain types of credit,
such as consumer loans, which are much
smaller than business and real estate loans.
Banks that have invested relatively more
funds in branch offices and buildings and
that are open longer are likely to incur
higher non-interest expenses.
High-earning banks held a larger
share of their assets in securities and
smaller shares in loans and in offices and
equipment than low-earning banks. The
average highly profitable bank had 50.1
percent of total assets in securities
compared to 39.2 percent for the lowearnings group. The high earners not only
devoted a smaller percentage of funds to
loans, but also made different kinds of
loans than low earners. Specifically, higher
earners had more real-estate loans and
fewer commercial and industrial loans.
Higher earners maintained shorter banking
hours and were more cautious in extending
credit. Only 0.2 percent of the loans
outstanding at the high earners had to be
written off, compared with 3.5 percent of
the loans held by low earners.

Table 2-Expenses,

Revenues and Operations
High earners

Expenses (percent of average assets)
Interest
Deposit cornpositiontpercent
of deposits)
Demand
Savings
NOWs and Automatic Transfer Savings Acet.
Other with rate ceilings
Time
Large CDs
Non-interest
(percent of average assets)
Asset composition (percent of assets)
U.S. Treasury & government agencies securities
State and local securities
Loans
Bank premises
Loan composition (percent of loans)
Business
Real estate
Consumer
Bad loan (percent of loans)
Banking hours (weekly)
Revenues (percent
Interest
Loans
Securities
Service fees

1. Significant
SOURCE:

of average

at 1 percent

Condition

Low earners

8.2
55

-4.11
-1.01

20.9
33.8
4.4
19.8
45.2
5.0
2.7

18.8
29.2
5.1
11.8
52.1
8.8
5.8

2.1
4.61
-0.7
8.01
-6.91
-3.81
-3.11

29.0
17.3
39.2
1.1

21.4
6.6
50.1
2.5

7.61
10.71
-10.91
-1.41

9.9
49.7
30.4
0.2
32.4

19.9
41.1
27.9
3.5
34.5

-10.01
8.61
2.5
-3.31
-2.]1

10.5
9.9
6.3
2.6
0.5

0.71
0.91
-1.21
2.31
-0.21

11.2
10.8
5.1
4.9
0.3

assets)

Difference

12.3
6.5

level.

and income reports

of banks and American

Despite the appearance of conservati ve
asset allocation, banks in the high-profit
group earned more revenue per dollar of
assets than the low-earning banks. High
earners generated more income from
securities, but less from loans and service
charges. These banks earn more income
from securities because they hold more
of them, even though they hold a relatively
larger share of state and local government
securities that pay lower yields than U. S.
government securities. They earn less
loan income because they extend fewer
and less risky loans.

Cap and Capital Position
Whether they make loans or invest in
securities, banks take on interest rate risk,
that is, the potential for loss due to rate
swings. To control for this risk, banks
use asset -liability management. The most
widely employed technique is gap
management," The difference between
rate-sensitive assets and rate-sensitive
liabilities for specific periods is known as
the "gap." Interest-sensitive
assets or
liabilities are those that mature, or are
repriced, within a designated time-frame.

6. Another method used is duration gap management,
which helps to insulate net worth from investment
risk. For a discussion of asset-liability
management,
see Karlyn Mitchell, "Interest Rate Risk Management
at Tenth District Banks," Economic Review.
Federal Reserve Bank of Kansas City, vol. 70, no. 5
(May 1985), pp. 3-19.

Bank Directory.

For example, a loan may have a stated
maturity of one year, but can be subject
to rate changes tied to the prime rate and
is, therefore, immediately sensitive to
interest rate changes. Similarly, rates paid
on money market deposit accounts generally
can change daily and are, therefore,
immediately sensitive to interest-rate
movements.
The interest-rate gap is positive when
rate-sensitive assets are greater than
rate-sensitive liabilities; the gap is negative
when rate-sensitive liabilities are greater
than rate-sensitive assets. When the gap
is zero, net interest income is fully insulated
from interest rate risk because the
maturity of rate-sensitive assets and
liabilities are in balance. Repricing these
assets and liabilities should cause them
to offset each other and to leave the net
interest margin unchanged.
Banks could improve earnings by taking
on more interest rate risk. When interest
rates are rising, a positive gap position
would enhance profit margins since higher
rates would apply to a larger share of

assets than liabilities. Likewise, a negative
gap would foster wider profit margins
when rates were declining. To take size
differences among the banks into account,
we expressed the gap as a percentage of
banks' total assets. Findings revealed that
both groups of banks kept their gap
position close to zero (table 3). Since no
Table 3-Gap

and Capital Position
High
earners

Low
earners

Difference

Gap'
(percent of assets)
Three months
or less
Six months
or less
One year or less
Capital (percent of)
Assets
Deposits

1. Gap

2.3

2. Significant

-2.1
0.1

-2.4
1.2

13.7
16.6

6.6
7.5

7.12
9.12

Rate-sensitive
liabilities

x 100

Total assets

at 1 percent

Condition

-3.3

-4.5
1.3

Rate-sensitive
assets

= ----------

SOURCE:

-1.0

level.

reports

of banks.

statistical differences were found, it can
be concluded that higher-earning
banks
did not have any more interest-rate
exposure than the low-earning banks.
As expected, the high earners were
well-capitalized
with a capital-to-assets
and capital-to-deposit
ratios more than
twice as great as the capital ratio for the
low earners. The low earners were forced
to use a portion of their capital to offset
losses incurred during the year. In contrast,
high earners were able to augment their
capital base through retained earnings.

Most Important Factors
Because we found many differing factors
between high and low earners, we wished
to know which of these variables were
most important in explaining the overall
earnings performance of banks. We
assumed that the level of bank earnings
depended upon the following factors:
• the deposit size of the bank,
• whether the bank was a member of a
bank holding company,
• the percentage of deposits held in
demand deposits and savings deposits
with rate ceilings,
• the percentage of assets allocated
to loans,
• household income growth in the market,

Expenses and Revenues
Table 1- Size, Ownership, Competition, and Growth
High Earners

-111.82
-4.03
-34.83
-11.11

141.6
5.7
69.0
27.8

11.1
18.9
84.5
77.4
3257
2714
17.9

Local structure
Number of banks
Number of banks and thrifts
Bank's share of bank deposits (percent)
Bank's share of bank & thrift deposits (percent)
Community deposits held by thrifts (percent)
Market growth (percent change from 1978 to 1983)
Population
Household income
Per capita income

SOURCES:

Difference

29.8
1.7
34.2
16.7

Deposit size ($ million)
Number of offices
Single office (percent)
Member of bank holding company (percent)
Market structure
Number of banks
Number of banks and thrifts
Four-bank concentration
ratio (percent)
Four-bank & thrift concentration ratio (percent)
HHI (banks)
HHI (banks & thrifts)
Market deposits held by thrifts (percent)

1. Significant
2. Significant
3. Significant

Low Earners

13.7
25.6
82.9
72.4
2870
2175
25.0

-2.6
-6.7
1.6
5.0
387
5391
-7.13

1.5
1.7
83.8
78.9
6.8

2.5
3.9
59.2
50.7
18.7

-1.03
-2.23
24.63
28.23
-11.93

4.7
44.6
52.4

5.1
39.6
49.8

-0.4
5.01
2.6

at 10 percent level.
at 5 percent level.
at 1 percent level.
Federal

Reserve

System

Board of Governors,

and Survey

of Buying

Power.

less intense would be expected to earn
higher profits. Researchers have typically
used measures of market structure (the
number and size distribution of competitions) to gauge the competitiveness
of
market areas.'
Since there is no unambiguous measure
for market structure, several variables
were examined: the number of competitors,
the four-firm concentration ratio, the
Herfindahl- Hirschman Index (HHI) and
the percentage of deposits held by thrifts
in the market.' The four-firm concentration ratio indicates the market share held
by the four largest competitors in the
market. The HHI is a more comprehensive
measure of market structure, since it
takes into account both the number and
size distribution of all the competitors in
the market.' When a market has only
one institution, the HHI attains its maximum
value of 10,000. The value of HHI
declines with increases in the number of
competitors and as the competitors become
more equal in their share of market
deposits. The percentage of deposits held
by thrifts in the market is used as a
measure for thrift competition.
All of the above market structure variables
showed a tendency to influence bank
earnings, but only the HHI and thrift
competition had a significant impact on

profits. The high-earning banks operated
in more concentrated markets and in
areas where thrifts held a smaller share
of the deposits.
In addition to the competitive condition
in the overall banking markets, the
competitive environment in local communities might also alter bank earnings,
particularly for banks that do not operate
offices throughout the entire market.
Over one-half of the sample banks had
only one office; many others had offices
in only one community. The high-earning
banks were headquartered in communities
with fewer competitors, faced less thrift
competition, and held a larger share of the
local deposits than the low-earning banks.
Banks operating in expanding markets
enjoy a larger supply of potential new
deposit and loan customers. While economic
growth generally leads to higher profits,
it is unclear how growth would affect
average earnings per dollar of assets.
High earners operated in markets that
experienced significantly faster increases
in household incomes than markets where
the low-earning banks were located. No
material differences in other growth
measures were detected between the
markets of the two groups of banks.

2. Statistically, the banks whose return on average
assets was more than one standard deviation above
or below the mean profitability level were classified
as either high or low profit banks.

4. Thrift institutions include all savings and loan
associations and mutual savings banks that are
federally insured.

3. For the purpose of this study, banking markets
were approximated
by metropolitan statistical areas
and counties outside of urban areas.

5. The Herfindahl- Hirschman Index is calculated by
adding the squared market share of each competing
institution.

As a percentage of assets, both expenses
and revenues differed among the high -and
low-earning banks (table 2). Expense
differentials were the largest and most
widespread. The average expenses per
dollar of assets were less than nine
cents for the higher earners, compared
to over 12 cents for the low earners.
Given the level of interest rates,
interest costs of banks are determined by
the volume and mix of their liabilities.
The share of liabilities paying market rates
has risen substantially with deposit rate
deregulation, particularly at smaller
institutions. Banks that could maintain
more demand and rate ceiling deposits
would pay less interest than banks with
fewer demand and regulated deposits.
Although high-earning banks held about
the same percentage of demand deposits
as low-earning banks, they held a
significantly smaller share of time deposits
and large CDs, and a larger share of
savings deposits with rate ceilings. As a
result, interest expense was significantly
lower at the most profitable banks.
The non-interest costs of banks are
affected by the volume and composition of
assets and liabilities and the effectiveness
of controlling operating expenses. Some
assets, such as loans, are risky and more
expensive to make and to service compared
to investing in government securities.
Lenders also incur higher administrative
costs in extending certain types of credit,
such as consumer loans, which are much
smaller than business and real estate loans.
Banks that have invested relatively more
funds in branch offices and buildings and
that are open longer are likely to incur
higher non-interest expenses.
High-earning banks held a larger
share of their assets in securities and
smaller shares in loans and in offices and
equipment than low-earning banks. The
average highly profitable bank had 50.1
percent of total assets in securities
compared to 39.2 percent for the lowearnings group. The high earners not only
devoted a smaller percentage of funds to
loans, but also made different kinds of
loans than low earners. Specifically, higher
earners had more real-estate loans and
fewer commercial and industrial loans.
Higher earners maintained shorter banking
hours and were more cautious in extending
credit. Only 0.2 percent of the loans
outstanding at the high earners had to be
written off, compared with 3.5 percent of
the loans held by low earners.

Table 2-Expenses,

Revenues and Operations
High earners

Expenses (percent of average assets)
Interest
Deposit cornpositiontpercent
of deposits)
Demand
Savings
NOWs and Automatic Transfer Savings Acet.
Other with rate ceilings
Time
Large CDs
Non-interest
(percent of average assets)
Asset composition (percent of assets)
U.S. Treasury & government agencies securities
State and local securities
Loans
Bank premises
Loan composition (percent of loans)
Business
Real estate
Consumer
Bad loan (percent of loans)
Banking hours (weekly)
Revenues (percent
Interest
Loans
Securities
Service fees

1. Significant
SOURCE:

of average

at 1 percent

Condition

Low earners

8.2
55

-4.11
-1.01

20.9
33.8
4.4
19.8
45.2
5.0
2.7

18.8
29.2
5.1
11.8
52.1
8.8
5.8

2.1
4.61
-0.7
8.01
-6.91
-3.81
-3.11

29.0
17.3
39.2
1.1

21.4
6.6
50.1
2.5

7.61
10.71
-10.91
-1.41

9.9
49.7
30.4
0.2
32.4

19.9
41.1
27.9
3.5
34.5

-10.01
8.61
2.5
-3.31
-2.]1

10.5
9.9
6.3
2.6
0.5

0.71
0.91
-1.21
2.31
-0.21

11.2
10.8
5.1
4.9
0.3

assets)

Difference

12.3
6.5

level.

and income reports

of banks and American

Despite the appearance of conservati ve
asset allocation, banks in the high-profit
group earned more revenue per dollar of
assets than the low-earning banks. High
earners generated more income from
securities, but less from loans and service
charges. These banks earn more income
from securities because they hold more
of them, even though they hold a relatively
larger share of state and local government
securities that pay lower yields than U. S.
government securities. They earn less
loan income because they extend fewer
and less risky loans.

Cap and Capital Position
Whether they make loans or invest in
securities, banks take on interest rate risk,
that is, the potential for loss due to rate
swings. To control for this risk, banks
use asset -liability management. The most
widely employed technique is gap
management," The difference between
rate-sensitive assets and rate-sensitive
liabilities for specific periods is known as
the "gap." Interest-sensitive
assets or
liabilities are those that mature, or are
repriced, within a designated time-frame.

6. Another method used is duration gap management,
which helps to insulate net worth from investment
risk. For a discussion of asset-liability
management,
see Karlyn Mitchell, "Interest Rate Risk Management
at Tenth District Banks," Economic Review.
Federal Reserve Bank of Kansas City, vol. 70, no. 5
(May 1985), pp. 3-19.

Bank Directory.

For example, a loan may have a stated
maturity of one year, but can be subject
to rate changes tied to the prime rate and
is, therefore, immediately sensitive to
interest rate changes. Similarly, rates paid
on money market deposit accounts generally
can change daily and are, therefore,
immediately sensitive to interest-rate
movements.
The interest-rate gap is positive when
rate-sensitive assets are greater than
rate-sensitive liabilities; the gap is negative
when rate-sensitive liabilities are greater
than rate-sensitive assets. When the gap
is zero, net interest income is fully insulated
from interest rate risk because the
maturity of rate-sensitive assets and
liabilities are in balance. Repricing these
assets and liabilities should cause them
to offset each other and to leave the net
interest margin unchanged.
Banks could improve earnings by taking
on more interest rate risk. When interest
rates are rising, a positive gap position
would enhance profit margins since higher
rates would apply to a larger share of

assets than liabilities. Likewise, a negative
gap would foster wider profit margins
when rates were declining. To take size
differences among the banks into account,
we expressed the gap as a percentage of
banks' total assets. Findings revealed that
both groups of banks kept their gap
position close to zero (table 3). Since no
Table 3-Gap

and Capital Position
High
earners

Low
earners

Difference

Gap'
(percent of assets)
Three months
or less
Six months
or less
One year or less
Capital (percent of)
Assets
Deposits

1. Gap

2.3

2. Significant

-2.1
0.1

-2.4
1.2

13.7
16.6

6.6
7.5

7.12
9.12

Rate-sensitive
liabilities

x 100

Total assets

at 1 percent

Condition

-3.3

-4.5
1.3

Rate-sensitive
assets

= ----------

SOURCE:

-1.0

level.

reports

of banks.

statistical differences were found, it can
be concluded that higher-earning
banks
did not have any more interest-rate
exposure than the low-earning banks.
As expected, the high earners were
well-capitalized
with a capital-to-assets
and capital-to-deposit
ratios more than
twice as great as the capital ratio for the
low earners. The low earners were forced
to use a portion of their capital to offset
losses incurred during the year. In contrast,
high earners were able to augment their
capital base through retained earnings.

Most Important Factors
Because we found many differing factors
between high and low earners, we wished
to know which of these variables were
most important in explaining the overall
earnings performance of banks. We
assumed that the level of bank earnings
depended upon the following factors:
• the deposit size of the bank,
• whether the bank was a member of a
bank holding company,
• the percentage of deposits held in
demand deposits and savings deposits
with rate ceilings,
• the percentage of assets allocated
to loans,
• household income growth in the market,

• the market's Herfindahl-Hirschman
Index,
• the number of banks and thrifts in
the community where the bank is
headquartered, and
• the percentage of deposits held by
thrifts in the market.
We then used standard statistical
procedures to test the importance of these
variables, jointly and individually, in
explaining earnings of the high-and
low-profit banks. These variables together
explained about one quarter of the
variability in their earnings (table 4)_ As
far as the relative contribution of
individual variables is concerned, we
found bank ownership, local competition,
asset allocation and deposit composition
to be key determinants of bank earnings.
Banks that were not affiliated with bank
holding companies earned higher profits.
Some bankers believe this occurs because
independent banks provide more
personalized services and can react more
rapidly to local changes than institutions
belonging to larger organizations.
Local competition, as measured by the
number of banks and thrifts in the
community where the banks are headquartered, affected bank earnings. Banks
operating in communities with fewer
banking alternatives faced less vigorous

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101

Address Correction Requested:

Please send
corrected mailing label to the Federal Reserve
Bank of Cleveland, Research Department,
P.O. Box 6387, Cleveland, OH 44101.

Federal Reserve Bank of Cleveland
Table 4 - Regression Results for
Bank Earnings
Return on
Assets
Deposit size
Bank ownership
Deposit composition
Asset allocation
Household income growth in market
HHI in market
Number of banks and thrifts in
head office community
Deposit held by thrifts in market
Adjusted

1. Significant

Negative!
Positive"
NegativeNegative
Negative
NegativeNegative

0.26

R2

2. Significant

Positive

at 5 percent
at 1 percent

level.
level.

competition and were able to earn higher
profits. The high earners maintained a
larger portion of demand deposits and
savings deposits with interest rate
ceilings that reduced interest expenses.
In addition, these banks made fewer loans
(or more investments), which lowered
non-interest expenses and kept loan
losses down.
When other variables were taken into
account, some individual factors became
insignificant in explaining high - and
low-profit bank earnings. These factors
included bank size, market growth, market
concentration, and the share of deposits
held by thrifts in the market.

Conclusion
Caution should be exercised in
attempting to draw any general conclusions about the factors that determine
bank earnings because our findings are
based only upon the most- and leastprofitable banks in four states and
cover only one year. Nevertheless, many
differences were found between the two
groups of banks.
Such factors as bank size and market
concentration are not significant in
explaining the variability in earnings
among the high- and low-profit banks
when other factors are taken into account.
What seemed to matter most was ownership,
local competition, asset structure and
deposit composition. The return on assets
was higher at banks that were unaffiliated
with bank holding companies, that
operated in communities with fewer banks
and thrifts, that held less expensive
deposits and that extended fewer loans.
These factors, along with superior
management, helped banks in this category
hold down operating expenses and generate
higher revenues.
No evidence was found to support the
notion that small independent banks cannot
do well in a deregulated environment.
Regardless of size, banks with good
management are likely to continue to
perform well.

BULK RATE
U.S. Postage Paid
Cleveland,OH
Permit No. 385

November 15,1985
ISSN 0428· 1276

ECONOMIC
COMMENTARY
Much concern has been expressed in
financial circles about bank earnings,
credit and interest-rate risks, and bank
failures over the last few years. Since
1981, the number of bank failures has
escalated because many institutions have
been saddled with an increasing volume
of bad loans and other problems.
Deregulation has played a role in these
problems by intensifying competition,
thereby increasing the difficulty for banks
to enhance earnings. Adequate profits,
of course, are necessary to allow banks to
grow, particularly smaller institutions
that have limited access to equity markets.
Numerous studies have examined bank
earnings to isolate factors that account
for differences among banks in profits.'
Findings generally reveal that the most
important factor determining bank
profitability is management's control over
expenses, especially non-interest
expenses. Other factors, such as bank size
and market concentration, had little or
no effect on bank earnings. All these
studies, however, have been based on
bank earnings prior to enactment of most
rate deregulation.
The introduction of money market
deposit accounts (MMDAs) in December
1982 and Super NOWs in January 1983
changed the method of competition and
greatly altered the balance sheets of
depository institutions. The absence of
rate ceilings on MMDAs and Super NOWs
enabled depository institutions to compete
with each other and with money market
mutual funds on the basis of rates.
Competitive pressure caused banks and
thrifts to pay higher rates; depositors
reacted by shifting funds to those highpaying accounts. Institutions that
traditionally held a high concentration of
low-cost savings deposits were probably
affected the most by deposit rate
deregulation.
Paul R. Watro is an economist at the Federal Reserve
Bank 0/ Cleveland. The author would like to thank
Larry Vozar and Steve Reutschi lor their assistance.
The views stated herein are those 0/ the author
and not necessarily those 0/ the Federal Reserve
Bank 0/ Cleveland or 0/ the Board 0/ Governors 0/
the Federal Reserve System.

In this Economic Commentary, we
examine bank profitability and identify
institutional, operational and locational
differences between the most-and
least-profitable banks. We find significant differences in both expenses and
revenues between high and low earners,
and identify some of the contributing
factors to earnings differences.
Sample Selection and Method Used
The sample of banks used in this study
was selected from four states - Ohio,
Pennsylvania, Kentucky and West Virginia
- and included all those institutions that
earned more than two cents per dollar of
assets and all those institutions that failed
to earn a profit in 1983.2 There were 84
high earners and 79 low earners. The
average high earner earned 2.44 cents per
dollar of assets while the average low
earner lost 1.48 cents per dollar of assets.
Within the group of high earners, 34 were
in Kentucky, 21 in West Virginia, 12 in
Ohio, and 17 in Pennsylvania. Among the
low earners, 34 were in Kentucky, 11 in
West Virginia, 23 in Ohio, and 11 in
Pennsy Ivania.
For each of the high-and low-earning
banks, we gathered data on the size,
ownership, competition, market conditions,
operations, asset holdings, deposit
composition, revenues, and expenses
(see tables 1, 2 and 3). Some of these
factors are under the direct control of bank
management; others are not. Nevertheless,
each of these factors could have an
important influence on bank profits. For
each of these variables, we calculated
an average value for the high earners and
an average value for the low earners.

1. Some of these studies include Donald R. Fraser,
"The Determinants
of Bank Profits: An Analysis
of Extremes," The Financial Review, 1976, pp.
69-87; John A. Haslem, "A Statistical Analysis of
The Relative Profitability of Commercial Banks,"
Journal 0/ Finance, vol. 23, no. 1 (March 1968),
pp. 167·76; Myron L. Kwast and John T. Rose,
"Pricing, Operating Efficiency, and Profitability
Among Large Commercial Banks," Journal 0/

Bank Earnings:
Comparing the
Extremes
by Paul R. Watro

Using standard statistical methods, we
next tested to see if the averages were
different between the two groups of banks.
We have designated each result according
to whether or not the averages are
statistically different at various levels of
significance. A 1 percent level of significance means that the probability that the
difference is due to random chance is
less than 1 percent.
Findings
The average values for the high-and
low-profit banks and the statistical
differences between them are given in
tables 1 through 3.
The impact of institution size on bank
earnings has important implications for
public policy. With the current wave of
technological change and deregulation in
the financial service industry, much
concern has been expressed about the
survival of small independent banks. Yet,
small independent institutions have not
only survived, but many have continued
to outperform larger institutions. In this
study, high-earning banks were found to
be much smaller than low-earning banks.
Two-thirds of the high earners did not
operate any branch offices and fewer of
them belonged to a bank holding company
(table 1). The average deposit size of
the higher earners was only $29.8 million,
compared to $141.6 million for the low
earners. None of the high earners had
deposits over $200 million and two- thirds
of them had deposits under $25 million.
In contrast, 10 percent of the low earners
had deposits over $200 million and half
of them had deposits under $25 million.
We found that the degree of competition
is likely to alter bank earnings. Banks
operating in areas where competition is

Banking and Finance, vol. 6, no. 2 (j une 1982),
pp. 233·54; Marvin M. Phaup, Ir., "Characteristics
of High Performance
Banks 1969·1975," Economic
Review, Federal Reserve Bank of Cleveland, Fall
1976, pp. 12-22; and Larry D. Wall, "Why Are
Some Banks More Profitable?" Economic Review,
Federal Reserve Bank of Atlanta, vol. 68, no. 9
(September
1983), pp. 42-8.