Capital buffers, business models and the probability of bank distress: a dynamic panel investigation

Abstract

PurposeThis paper aims to improve the debate linking the business models of banks to their riskiness by checking if diversification exerts different impacts on the probability of bank distress depending on the level of capital buffers.Design/methodology/approachThe paper focuses on a sample of listed bank holding companies observed between 2007:Q3 and 2022:Q4. The authors use three subindexes of bank diversification. The authors estimate a dynamic model specification using a system generalized method of moments with robust standard errors and consistent estimators under heteroskedasticity and autocorrelation within a panel. Sensitivity and robustness checks are performed.FindingsAsset and income diversification increase the probability of distress in low-capitalized banks during normal periods (excluding periods of crises and high uncertainty). Concerning crisis periods, a marginal increase in asset diversification during the global financial crisis (GFC) and the COVID-19 pandemic crisis induces a more important increase in the probability of failure of well-capitalized banks relative to low-capitalized ones. Contrary to the results obtained for the GFC period, well-capitalized banks were found to pursue more careful funding diversification in reaction to the sudden increase of uncertainty during the Russia–Ukraine war.Research limitations/implicationsPrudential supervision should concentrate on well-capitalized banks to encompass unexpected excessive risk-taking during crisis periods. Regulatory requirements should constrain fragile banks to avoid pursuing assets and income diversification strategies that increase earnings volatility.Originality/valueThe main originality of this paper is to consider the interaction between three different dimensions of bank diversification and capital regulation during stable and unstable periods using the marginal effect analysis. Moreover, this paper uses, initially, the GFC as the reference crisis period to study the impact of capital buffers and diversification interactions on the probability of bank distress. Then, the authors extend the observation period until 2022:Q4 to include two additional major events, namely, the COVID-19 pandemic and the Russia-Ukraine war.