Differences Among Banks are More Important than Their Common Risks in Explaining Banking Profits

Abstract

[Regulations following the Financial Crisis threaten to throw out the baby with the bathwater. The Evidence shows that Banks are profitable largely because of their differences. Federally encouraged mergers and other regulations that discourage these differences among banks may reduce the contribution of bank individuality to the financial system. Uniformity increases system risks.We measure differences among banks using financial statement value differences from sample means. Such differences test as “priced risks,” improving forecasts of financial institution stock returns. We find “differentness” carries greater weight in explaining recent long run financial institution returns than market excess returns within a CAPM framework. This result has important implications for financial-crisis-induced changes in financial regulation. If differentness is necessary to long run profits in banking, then different capital rules for different sorts of bank are more helpful than rules that encourage uniformity of behavior. Large retail banks and complex wholesale banks should be separate to protect depositors.