Abstract
This paper examines the implications of bank activity and short-term funding strategies for bank risk and return using an international sample of 1,334 banks in 101 countries leading up to the 2008 financial crisis. Expansion into noninterest income-generating activities such as trading increases the rate of return on assets, and it could offer some risk diversification benefits at very low levels. Nondeposit, wholesale funding in contrast lowers the rate of return on assets, while it can offer some risk reduction at commonly observed low levels of nondeposit funding. A sizable proportion of banks, however, attract most of their short-term funding in the form of nondeposits at a cost of enhanced bank fragility. Overall, banking strategies that rely prominently on generating noninterest income or attracting nondeposit funding are very risky, consistent with the demise of the US investment banking sector.
Highlights
The recent financial crisis has important implications for the feasibility of different banking models
A higher fee income or nondeposit funding share continue to increase bank risk, and while we find a positive impact of these variables on the rate of return, these findings are more subject to endogeneity concerns
We examine the relationships between the fee income and non-deposit funding shares on the one hand and bank risk and return on the other
Summary
The recent financial crisis has important implications for the feasibility of different banking models. To ward off a generalized bank liquidity crisis, authorities worldwide have taken the unprecedented steps of providing extensive liquidity, giving assurances to bank depositors and creditors in the form of guarantees on interbank lending and in some cases blanket guarantees. On the asset side, the crisis exposed weaknesses in different business models of banks. After the crisis, the U.S has come full circle, from the separation of commercial and investment banking through the Glass-Steagall Act of 1933, to the reintroduction of universal banking by way of the Gramm-Leach-Bliley in 1999, and, to the disappearance of large independent investment banks altogether in 2008
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