The Relationships Between Profitability, Capital, and Risk: Commercial vs. Saving/Mortgage Banks

Abstract

This study examines the relationships between capital, profitability, and risk in U.S. commercial banks versus saving/mortgage banks for the period q1/1995-q4/2006. Following Froot and Stein (1988), we distinguish between these two banking sectors by their loans portfolios: commercial banks extend larger and unique loans with unstable probability of default rates relatively to saving/mortgage banks. Based on this analysis, we hypothesize positive relation between risk and profitability in commercial banks and positive relation between risk and capital in saving/mortgage banks. Contrary to the current literature, which analyze only two out of the three variables: capital, profitability, and credit risk, our approach considers simultaneous analysis of the above three variables. The simultaneous analysis as well as the empirical results, provides an answer to the question, why in the sample period commercial banks were riskier than saving/mortgage banks while having similar capital level.

Keywords: Profitability, Capital, Risk, Commercial Banks, Mortgage Banks

JEL Classification: G21, G32, G12