In his exploration of the impact of banks engaging in such noncore banking activities as securitizations and investment banking, the author finds that these nontraditional activities increase banks’ profitability and risk profiles.
What’s Inside?
The author conducts a battery of tests to examine the idea that banks that diversify to engage in noncore banking activities improve their profitability and reduce the volatility of such profitability. He posits that the US Gramm–Leach–Bliley Act of 1999, which introduced banking regulations that enabled banks to conduct both commercial and investment banking activities, gave rise to banks conducting business beyond their core activities. It also increased the likelihood of systemic failures, which highlights the ineffectiveness of banking regulations at the time. Previous literature on this topic is divided between stipulations that it is necessary for banks to diversify to increase profits, allocate capital efficiently, and enjoy scale economies and stipulations that such diversification increases risks and agency-related problems.
How Is This Research Useful to Practitioners?
When analyzing banks, practitioners ought to be cognizant of the sensitivity of banks to both core and noncore activities. The author’s findings raise the importance of thorough, holistic analysis.
How Did the Author Conduct This Research?
With a sample of more than 1,500 US-based full-service financial institutions, the author runs a series of regressions to assess how a bank’s introduction of noncore banking activities can affect its return on assets (ROA) and insolvency risk (IR). ROA and IR serve as proxies for profitability and risk, respectively.
The results of the panel tests support the hypothesis that nontraditional banking increases a bank’s risk profile, particularly considering that such a bank is also likely to assume leverage and reallocate capital from long-term, goal-oriented activities to engage in noncore initiatives. Unsurprisingly, this behavior intensifies during financial crises, further driving up risk. The author also tested the integrity of the results by examining their sensitivity to bank size, activity (investment and/or commercial banks), and various definitions of profitability and risk. These integrity tests validate the hypothesis.
Abstractor’s Viewpoint
Banking has moved far beyond mere deposit taking and lending. Although regulators have worked to discourage nontraditional banking activities to reduce the potential for bank failures and systemic risk after the recent financial crisis, history appears to be repeating itself as banks slowly resume these activities. Investors, regulators, and everyone else in the financial services industry should take note. Perhaps regulators need to consider using more “carrots” to induce positive behavior rather than wielding the proverbial “stick” that punishes hazardous behavior.