Back to the Basics in Banking? A Micro-Analysis of Banking System Stability

TLDR

The study examines how banks’ specialization versus diversification of financial activities affects their resilience to a banking sector crash. Using extreme‑value analysis, the authors compute a tail‑beta systemic risk metric and evaluate how the correlation between interest income and non‑interest income components influences this risk. They find that banks engaging in non‑interest activities have higher tail beta, that smaller and better‑capitalized banks fare better, that these effects intensify in turbulence, and that diversification under one umbrella does not enhance system stability, explaining conglomerates’ discount.

Abstract

This paper analyzes the relationship between banks' divergent strategies toward specialization and diversification of financial activities and their ability to withstand a banking sector crash. We first generate market-based measures of banks' systemic risk exposures using extreme value analysis. Systemic banking risk is measured as the tail beta, which equals the probability of a sharp decline in a bank's stock price conditional on a crash in a banking index. Subsequently, the impact of (the correlation between) interest income and the components of non-interest income on this risk measure is assessed. The heterogeneity in extreme bank risk is attributed to differences in the scope of non-traditional banking activities: non-interest generating activities increase banks' tail beta. In addition, smaller banks and better-capitalized banks are better able to withstand extremely adverse conditions. These relationships are stronger during turbulent times compared to normal economic conditions. Overall, diversifying financial activities under one umbrella institution does not improve banking system stability, which may explain why financial conglomerates trade at a discount.