If You Thought Diversified Revenue Makes Banks Safer, Read This

It may sound great when a bank talks about diversified revenue streams. But what if that diversification only served to make the bank riskier? 

We may be tempted to lump the big banks together in our minds: Bank of America (NYSE: BAC  ) , Goldman Sachs (NYSE: GS  ) , Citigroup (NYSE: C  ) -- a bank's a bank, right? Not exactly. These banks have significant differences their business strategies and revenue sources. In particular, banks face highly variable shares of non-interest income, which can have an enormous impact on the risks you face as an investor. 

The trend toward diversification
The repeal of the Glass-Steagall Act in 1999 is regarded by some as the herald of a new era of increasing bank integration and diversification. The new rules allowed commercial banks to take on investment banking activities and vice versa for the first time since 1933. The result? Banks began actively pursuing different business avenues and increasing the revenue share of non-interest producing activities such as customer fees, trading, money management, and other services.

At first blush, it seems like having a diverse base of income sources would be a good thing. We all know about the benefits of diversification in our portfolios, so why wouldn't diversification be a positive for a bank? Unfortunately, things are not always as they appear. 

The dark side of diversification 
Research into bank performance indicates that diversified income doesn't necessarily mean reduced risk. For example, Kevin Stiroh, now a Senior Vice President at the Federal Reserve Bank of New York, found over a decade ago that non-interest income tends to be more volatile than interest income -- especially when it comes from trading. 

Stiroh found that there is a "dark side to diversification": higher shares of non-interest income tend to increase risk and actually decrease profits for banks. Not only that, but he found that interest income and non-interest income correlate more strongly over time, possibly, he suspects, due to cross-selling to bank customers. Non-trading activities, especially those outside of trading, are also more correlated with GDP than interest income, meaning that a shift toward non-interest income tends to make banks more exposed to the economy in general, rather than less.

In other words, "diversified income" doesn't really mean diversified, and tends to produce higher risk without necessarily generating a higher reward. 

Where to go from here
When deciding whether to invest in a particular bank, you might want to take a look at the income statement and note the percentage of income coming from non-interest sources -- and find out what those sources are. Here's what it looked like for Goldman Sachs, Citigroup, and Bank of America in 2013 versus 2007.

Source: S&P Capital IQ.

At the very least, this will help you to distinguish between an investment bank like Goldman Sachs, and retail and commercial banking entities like Citigroup and Bank of America.

For any Bank of America investor, I find it particularly interesting that it's moved in the opposite direction with its noninterest income versus the other two. Much of that is due to the crisis-era acquisition of the investment bank and brokerage Merrill Lynch. But Bank of America investors will nonetheless want to keep an eye on whether that has the potential to make the bank's results more volatile.

Looking more closely at non-interest income can help you understand the bank's strategy, which can help you better assess where and how it could fit into your portfolio -- and whether you're willing to shoulder the risks. If you think the traders at your bank are top-notch, then maybe that high proportion of trading revenue isn't so bad. But if you're counting on your bank to be solidly profitable without too much volatility, you might want to look elsewhere.  

Understanding that diversification doesn't necessarily mean reduced risk when it comes to bank income sources can help you better assess the long term risks and potential profitability of your investment.

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