Ratings

• Standard & Poor's Ratings Services believes that business diversification is an important risk mitigant, lessening both the possibility and the magnitude of an unexpected loss on a company's bottom-line and offering added protection to its creditors.
• All else being equal, ratings are typically higher for those banks with higher business diversity.
• Traditional measures of business diversification that are based on assets or revenues may not adequately reflect a company's business diversity; overlaying profit contribution by business segment should provide an additional insight into a company's business diversification.
• However, public disclosure of business segment operations is uneven, and banks have a significant degree of discretion in how business segments are defined, what activities are included, and how much disclosure is provided.
• As such, we believe segment analysis may provide an insight into a company's profit balance by line of business, but it does not necessarily provide a complete picture of its profit diversification by product, geography, and customer.
• Despite limitations on business segment disclosure, segment profit concentration analysis confirms that profits at large complex banks, including Citigroup Inc. and J.P. Morgan Chase & Co., are indeed more highly diversified than regional banks like Regions Financial Corp. and North Fork Bancorp. However, this analysis does not directly measure the overall profit benefit in relation to a diversified business model.
• Moreover, while PNC Financial Services Group, First Horizon, and Marshall & Isley Corp. rank highly in terms of revenue diversification, these companies' profits do not appear as highly diversified as measured by a profit concentration index.
• Success in retail banking as measured by pretax operating returns varies widely, with North Fork, BB&T Corp., Fifth Third Bancorp, and SunTrust Banks Inc. standing out with pretax operating margins higher than 50%, while National City Corp., Bank of New York Co. Inc., M&T Bank Corp., and KeyCorp at the lower end of the spectrum.
• Wholesale banking profitability, which includes investment banking, is widely dispersed among banks because of differences in the scale and scope of these operations.
• Segment profit analysis confirms that the significant reduction in credit costs in the past two years has been concentrated in the wholesale businesses (commercial and investment banking) rather than in the consumer business.
• Profitability of fee-based business like asset management and transaction services has been mostly stable during the same period.

Larger U.S. banks have strived to become true financial services conglomerates during the past decade, seeking differentiated business models that can allow for revenue diversification, enhanced cross-selling, and superior earnings performance longer term. In doing so, some banks have become more complex and geographically diverse organizations. They have reduced spread income dependence by adding fee-based businesses in the hope of capturing greater share of wallet and softening profit vulnerability, at least to some extent, to unexpected and volatile interest rate movements and the credit cycle. Still, we think that some fee-based activities like trading and capital markets activities in a perverse way may have in fact magnified profit volatility at some of these companies.

Importantly, Standard & Poor's considers business diversification as an inherent risk mitigant, lessening both the possibility and the magnitude of an unexpected loss on a company's bottom line. Monoline business companies are typically riskier than well-diversified financial institutions, all else being equal. To be sure, a well-diversified institution has a lower probability of significant losses in each of its businesses simultaneously, allowing for more consistent returns to shareholders and greater protection to creditors. Still, while a truly diversified entity is an ideal structure, we recognize that rapid expansion into unfamiliar activities or geographies, without adequate controls and supervision, can have undesirable consequences.

To date, commercial banks have shown mixed levels of success at integrating nonbank businesses (such as asset management or capital markets activities) to their traditional consumer and commercial banking platforms, and the lack of uniformity in line of business disclosure makes it even harder to properly assess differentiated performance. There is indeed a wide dispersion across banks regarding the relative contribution of different business activities, partly because banks define them differently. Moreover, today only a handful of organizations in the U.S. truly operate meaningfully diversified, multi-line, financial service businesses nationally or globally.

Business diversification typically has been measured through the balance sheet ("asset diversification" as measured by the loan-to-asset ratio or the reliance on loan-making activities) or the income statement ("revenue diversification" as measured by the proportion of noninterest income contribution to total revenues). Of course, lending activities may also include a fee component, which also limits the usefulness of the latter measure. Moreover, noninterest income is a heterogeneous category that comprises many different activities, including fiduciary income, service charges, trading revenue, and fees and other income. These broad categories have different profit drivers and associated expenses to them.

We argue that these measures do not accurately capture a company's diversity as it relates to profit generation. On the one hand, large complex banks have significant securitized or other off-balance-sheet assets that are not adequately captured in the loan-to-asset ratio, and profits or losses are increasingly being generated through off-balance-sheet arrangements. On the other hand, while nonbanking-related fee-based business such as asset management or capital markets activities may have an inherently stronger underlying revenue growth rate than traditional banking activities, these businesses are not asset-based at all. Moreover, while fee-based revenue growth may be strong, related operating expenses may actually limit these activities' profit contribution to a company's overall bottom-line.

Table 1 illustrates how 23 U.S.-based large complex and large regional banks rank according to revenue diversification. Interestingly, companies typically associated with a high level of business diversification such as Citigroup or J.P. Morgan rank below Mellon Financial Corp. Clearly, these indications are imperfect, indicating a level of fee income greater than interest income but not capturing the fact that it may be derived from only a few business lines.

Table 1 Revenue Diversification
Rating	Bank holding company	Noninterest income-to-revenues (%; as of September 2005)	Rank
A+/Stable/--	Mellon Financial	89.8	1
A+/Stable/A-1	Bank of New York	72.0	2
A-/Stable/--	PNC Financial	65.2	3
A+/Stable/A-1	J.P. Morgan Chase	63.1	4
A-/Stable/--	First Horizon	59.3	5
A/Stable/A-1	Marshall & Ilsley	58.6	6
AA-/Stable/A-1+	Citigroup	52.1	7
A+/Stable/A-1	Wachovia	47.5	8
AA-/Stable/A-1+	Bank of America	46.6	9
A+/Stable/A-1	U.S. Bancorp	46.0	10
A+/Stable/A-1	Fifth Third	45.4	11
AA-/Stable/A-1+	Wells Fargo	44.1	12
A-/Stable/A-2	KeyCorp	42.0	13
A+/Stable/A-1	SunTrust	40.8	14
A/Stable/A-1	National City	40.5	15
BBB+/Stable/A-2	Huntington	40.3	16
A/Stable/--	Regions Financial	39.9	17
A/Positive/A-1	BB&T	39.4	18
A-/Stable/A-2	AmSouth	36.6	19
BBB+/Stable/A-2	Popular	34.9	20
A-/Stable/A-2	M & T Bank	34.3	21
A/Stable/A-1	Comerica	31.2	22
BBB+/Positive/A-2	North Fork	28.4	23
Source: Company reports.

We have taken a fresh look at the business segment financial information that banks have disclosed in their SEC filings in order to get a better yet still imperfect understanding of business diversification and drivers of profitability. Still, cross-company comparisons are imperfect given the limitations of this information:

Companies have a high degree of discretion in how business segments are defined, what activities are included, and how much disclosure is provided. To illustrate, some banks may include private client and wealth management or mortgage banking in their retail banks, while others may report it as a separate business line. Moreover, asset inclusion or equity allocation methods may differ markedly across banking organizations.

Segment financial information on a consistent basis exists at most for the past three years. Trend analysis is difficult because banks tend to reorganize activities from one business segment to another, acquire or dispose of businesses, or engage in merger activity.

Business segment data sometimes includes "normalized" loan loss provisions and includes excess provisioning at the parent or "other" segment levels. Likewise, Commercial Banking segments may show enhanced profitability in recent periods, but this could be related to reserve releases rather than core revenue growth.

We have identified 14 business segments as reported by U.S. banks, but not all banks disclose financial information on all these activities even if they do perform them (see Table 2). We have excluded parent company, inter-segment eliminations, and the "other" segment from segment earnings, given that these activities usually include discontinued operations, treasury and asset-liability activities, and other revenues and expenses at the corporate level.

Table 2 Business Segment Disclosure
	Retail banking	Commercial banking	Wholesale & investment banking	Asset & wealth management	Asset management	Private banking	Brokerage	Transaction services	Credit cards	Mortgage banking	Consumer finance	Insurance	Private (merchant) equity	Other
AmSouth Bancorp.	x	x		x
Bank of New York Co. Inc.	x		x					x
Bank of America Corp.	x	x	x	x
BB&T Corp.	x		x	x						x	x	x		x
Citigroup Inc.	x		x		x	x	x	x	x		x		x
Comerica Inc.	x	x		x
Commerce Bancorp Inc.	x
Fifth Third Bancorp	x	x		x				x
First Horizon National Corp.	x		x							x
Huntington Bancshares Inc.	x					x					x
J.P. Morgan Chase & Co.	x	x	x	x				x	x				x
KeyCorp	x		x	x
M & T Bank Corp.	x	x								x			x
Marshall & Ilsley Corp.	x													x
Mellon Financial Corp.		x			x	x		x						x
National City Corp.	x		x	x						x	x			x
North Fork Bancorp	x									x
Northern Trust Corp.						x		x
PNC Financial Services Group	x		x		x			x
Popular Inc.	x	x		x				x			x			x
Regions Financial Corp.	x	x	x							x		x
State Street Corp.					x			x						x
SunTrust Banks Inc.	x	x	x	x						x				x
U.S. Bancorp	x	x		x				x
Wachovia Corporation	x	x	x		x	x	x
Wells Fargo & Co.	x		x								x
"Other" includes discontinued operations or activities not included in the disclosed segments. Source: Company reports.

Because of the impracticality of looking at these 14 segments individually, we have combined these segments into four major businesses:

• Consumer, including retail banking, credit cards, mortgage banking, and consumer finance;
• Wholesale, including commercial banking and investment banking;
• Fiduciary activities, including private client and asset/wealth management; and
• Other, including transaction services, brokerage, insurance, and private equity.

The grouping is not perfect in that some banks may include commercial banking (mostly middle market and small business) with retail banking, while others include private client in retail banking. Still, we believe these four broad categories help investors gain some insight into how balanced these companies' business models may be. However, we are not able to capture how diversified the product or geography might be within each segment.

In order to ensure a higher level of consistency, we have focused our profitability analysis on each segment's pretax operating profit. Chart 1 below shows banks' profit contribution from each segment. First Horizon, BB&T, Huntington Bancshares Inc., and Regions have the heaviest concentration to the consumer, while Wachovia Corp., M&T Bank Corp., Comerica Inc., and Mellon Financial Corp. have the least. Interestingly, Mellon also appears to have a better balance of businesses relative to other large banks in the U.S., even though we cannot conclude in a definite way that its business model is more diversified than others.

Digging deeper into business diversity, we have adapted the Herfindahl Index, which measures the degree of industry concentration, to measure the degree of profit concentration a company may have to a certain business segment. In this case, we measure the relative size of business segments in relationship to overall profitability by using a segment's profit contribution instead of a firm's market share. We define this profit concentration index as the sum of the squares of the profit shares of each individual business segment. As such, it can range from 0.0 to 1.0, and decreases indicate less concentration, whereas increases imply the opposite. A small index indicates a diversified company with no dominant business lines. The major benefit of this index is that it gives more weight to larger business segments. If all segments have an equal share the reciprocal of the index shows the number of segments in the company. When segments have unequal shares, the reciprocal of the index indicates the "equivalent" number of segments in the company.

In this regard, the profit concentration index helps to differentiate a company that is more diversified with a lower concentration index from one in which a single business segment represents a larger portion of profits. Clearly, the usefulness of this profit concentration index is constrained by the fact that not all companies disclose financial information for the same number or type of business segments. For instance, while Wells Fargo & Co. typically states that the company engages in 80 business activities, most are grouped under its retail bank, which accounts for more than 71% of the company's overall profits; the other two segments are its wholesale bank (23%) and its consumer finance company subsidiary (5%). Intra-company, however, this profit concentration index is useful to gauge whether a company has become more or less balanced in the past three years, especially following an acquisition. We note, however, that this measure of profit concentration does not address the benefits or lack thereof from business diversification.

We gain the following insights from the profit concentration index for 23 banks in the U.S. in Table 3:

The largest banks, including Citigroup and J.P. Morgan, are the most highly diversified organizations, while regional banks like Regions Financial and North Fork are the least. This ranking was not confirmed by the revenue-based measure.

The biggest improvement in business balance during the past two years has been attained by North Fork (with Greenpoint), Marshall & Isley, J.P. Morgan (with Bank One) and Bank of America Corp. (with FleetBoston). The latter two also reflect the recovery in their corporate and investment bank segments.

Profits at Regions Financial, First Horizon, and BB&T have become more concentrated during the same time period. In the latter two cases, we think this has occurred because of a higher reliance on mortgage banking.

Table 3 Business Segment Pretax Profit Concentration Index
	--Concentration index--
	2003	June 2005	Basis point change	Equivalent number of segments
Citigroup	0.166	0.140	(0.026)	7.2
J.P. Morgan Chase	0.267	0.198	(0.069)	5.0
Mellon	0.290	0.229	(0.061)	4.4
National City	0.263	0.242	(0.021)	4.1
Popular	0.258	0.263	0.006	3.8
Wachovia	0.269	0.268	(0.001)	3.7
SunTrust	0.293	0.275	(0.018)	3.6
Bank of America	0.384	0.305	(0.078)	3.3
U.S. Bancorp	0.300	0.309	0.010	3.2
PNC Financial	0.363	0.341	(0.022)	2.9
Fifth Third	0.453	0.408	(0.045)	2.5
MEDIAN	0.381	0.420	0.039	2.4
AmSouth	0.474	0.432	(0.042)	2.3
KeyCorp	0.421	0.505	0.084	2.0
Huntington	0.510	0.533	0.023	1.9
Bank of New York	0.514	0.542	0.028	1.8
Comerica	0.567	0.551	(0.016)	1.8
Wells Fargo	0.537	0.561	0.024	1.8
First Horizon	0.378	0.562	0.184	1.8
Marshall & Ilsley	0.699	0.604	(0.096)	1.7
BB&T	0.441	0.628	0.187	1.6
Regions	0.333	0.659	0.326	1.5
North Fork	0.879	0.676	(0.203)	1.5
Note: Sorted by ranking in 2005. North Fork 2004 and not 2003. Source: Company reports.

Bank profitability has generally improved during the past few years. Business segment profitability provides an insight as to which segments have contributed to this improved performance. Chart 3 illustrates profit performance for five major business segments. Commercial Banking and Wholesale & Investment Banking show the most improvement, as well as more volatility, which relates to lower loan loss provisioning needs and loan loss reserve releases during the past two years. While loan loss provisioning needs have also driven a portion of the increase in pretax operating margins in retail banking, efficiency gains have been equally important. Lastly, profitability of fee-based businesses like asset management and transaction services has been more stable, which we attribute to mostly lackluster equity markets during the past three years. Importantly, a high profitability level is typically associated with high efficiency (i.e., low cost-to-revenue ratio).