The impact of revenue diversity on banking system stability

1. The impact of revenue diversity • on • banking system stability olivier.dejonghe@ugent.be

2. Do conglomerates create value? Non-financial corporations: no consensus • Discount: Lang and Stulz (JPE,1994), Berger and Ofek (JFE, 1995), Servaes (JF,1996) • No discount: Graham et al. (JF, 2002), Campa and Kedia (JF, 2002) • Benefit: Villalonga (JF, 2004) Financial conglomerates • No consensus either • Depends on method, measures, region e.g.: Laeven and Levine (JFE, 2007), Baele, De Jonghe and Vander Vennet (JBF, 2007), Mercieca, Schaeck and Wolfe (JBF, 2007) olivier.dejonghe@ugent.be

3. Riskiness of financial conglomerates Normal economic conditions • Volatility of accounting profits increases De Young and Roland (JFI, 2001); Stiroh (JMCB, 2004); Stiroh and Rumble (JBF, 2006) • Volatility of market returns increases Stiroh (JMCB, 2006) • Higher systematic risk exposures Baele, De Jonghe and Vander Vennet (JBF, 2007) Does functional diversification influence banking system stability? THIS PAPER: extreme systematic risk olivier.dejonghe@ugent.be

4. Banking system stability (1) Banking panics: sources • Business cycle induced panics • Rather than random events or self-fulfilling prophecies Gorton (OEP,1988), Allen and Gale (JF, 1998), Kaminsky and Reinhart (AER, 1999) (2) Banking panics: observations • Historically, bank run by depositors • Nowadays: (stock) market discipline equity market indicators of bank fragility • Flannery (JF, JMCB, JFSR), Gropp et al. (JMCB, 2006) • (1) And (2)  banks’ extreme systematic risk exposure olivier.dejonghe@ugent.be

5. Conditional crash probability • X is bank stock return • Y is return on a European market index • x and y are quantiles, corresponding to a low probability, p • Estimation method: semi-parametric extreme value analysis • Extreme systematic risk or tail beta Finance applications: • Poon, Rockinger and Tawn (RFS, 2004) • Straetmans, Verschoor and Wolff (JAE, 2008) • Hartmann, Straetmans and de Vries (NBER, 2006) olivier.dejonghe@ugent.be

6. Extreme systematic risk olivier.dejonghe@ugent.be

7. olivier.dejonghe@ugent.be

8. Does functional diversification increase bank stability? • 1) Revenue shares (in total operating income): • - Share of net interest income • - Share of net commission and fee income • - Share of net trading income • - Share of net other operating income • 2) Revenue Diversification • 3) Revenue correlation olivier.dejonghe@ugent.be

9. Drivers of extreme systematic risk: set-up • Dependent variable: Tail-beta bound within [0,1] • Generalized linear model • Independent variables: moving 6 year averages • Commercial banks + BHCs from EU15 • Time and country fixed effects • Standard errors clustered at country level olivier.dejonghe@ugent.be

10. The impact of revenue diversity on the Tail Beta olivier.dejonghe@ugent.be

11. Central versus tail dependence olivier.dejonghe@ugent.be

12. Additional results • Unbalanced panel data set • IPO, delisting, illiquid, M&A • No sample selection bias • Banking crises do not drive the results • Higher interest margin or loans-to-asset: Risk reduction • Set-up allows for interaction effects • E.g.: effect of changes in revenue composition is different for large vs small banks olivier.dejonghe@ugent.be

13. Conclusions: Revenue diversity and bank stability • Heterogeneity in systematic tail risk! • Financial conglomeration: a useful risk diversification device? • New revenue sources increase tail beta • Net interest margin lowers risk • However, depends on correlation of shocks to revenue types! • Can also be attributed to other bank characteristics • Bank size increases risk • Capital adequacy as a buffer and signal of soundness • Tail risk and its determinants contain additional info! olivier.dejonghe@ugent.be