The Impact of Revenue Diversity on Banking System Stability

Abstract

The dismantling of legal barriers to the integration of financial services is one of the recent, major developments in the banking industry. This led to an expansion of the variety of financial intermediaries and types of transactions. However, this trend may alter banks' risk-taking incentives and may affect overall banking sector stability. This paper analyzes how banks' divergent strategies toward specialization and diversification of financial activities affect their ability to shelter from adverse economic conditions. To this end, market-based measures of banks' extreme systematic risk are generated, using techniques developed for extreme value analysis. Extreme systematic risk captures the probability of a sharp decline in a bank's stock price conditional on a crash in a market index. Subsequently, the impact of (the correlation between) interest and non-interest income (and its components) on this risk measure is assessed. The estimation results reveal that the heterogeneity in extreme bank risk can partially be attributed to differences in banks' reliance on non-traditional banking activities. All non-interest generating activities increase banks' sensitivity to the market index during times of extreme equity market movements. In addition, smaller banks and well-capitalized banks are better able to withstand large adverse economic conditions. Furthermore, the effects are stronger during times of market turbulence compared to a situation of normal economic conditions. Overall, diversifying financial activities in one umbrella institution does not lead to a reduction of extreme banking risk, which may explain why financial conglomerates trade at a discount.