Financial Stability Through Bank Diversification the Banking

Financial Stability Through Bank Diversification

The banking industry of the United States of America is witnessing a major shift in the revenue making procedures. The banks are now inclined towards generating income from non-interest-based sources such as fee income, service charges and trade revenue etcetera instead of the traditional process of loan making. Noninterest income has always played an influential role in the revenue generation of the banking system. It'd evident from the fact that by the year 2000 the noninterest income accounted for forty three percent of the total banking revenue which is a massive rise from the twenty five percent in the year 1984.[footnoteRef:2] (Stiroh, 2004) [2: Kevin Stiroh, 2004. "Diversification In Banking: Is Noninterest Income The Answer?" Journal of Money, Credit and Banking 36(5), 853-882]

According some scholars, the shift in the revenue generation process, on the one hand, has led towards an evident increase in the revenue of the banking system in the recent times and on the other hand, it has also led towards a reduction in the volatility of the profitability and revenue of the system and has also reduced the risk that is associated with the banking industry. This might be due to the reason that the channels of non-interest income depend less on the overall business conditions of the economy, whereas, the channels of interest income rely heavily on the overall business conditions of the economy. Therefore, an increased dependence on generating revenue through noninterest income channels has led towards a reduction in cyclical variations in the revenue generation of the banking system. [footnoteRef:3] (Stiroh, 2004) [3: Kevin Stiroh, 2004. "Diversification In Banking: Is Noninterest Income The Answer?" Journal of Money, Credit and Banking 36(5), 853-882]

In addition to that, the expanded product lines and the cross selling opportunities that are linked with the non-interest income channels offer the banks with efficient diversification benefits in relation to the revenue portfolio of the banks. In other words, the non-interest income has the ability to improve the risk/return tradeoff of the banks and to diversify the revenue portfolio of the banks. The ability of the non-interest income channels to reduce risk is given great importance by the individual banks and the supervisors and the regulators of the banking system as well. [footnoteRef:4] (Stiroh, 2004) [4: Kevin Stiroh, 2004. "Diversification In Banking: Is Noninterest Income The Answer?" Journal of Money, Credit and Banking 36(5), 853-882]

Characteristics That Enables the Banks to Stay Stable during Financial Crisis

The financial crisis that began in the year 2007 and intensified in the year 2008 affected all the banks in a negative manner and led towards the dissolution of a number of banks. As the housing bubble burst it forced a number of banks to write of loans amounting to millions of dollars. The factors that led towards the development and creation of the housing bubble are as follows;[footnoteRef:5] (Brunnermeier, 2009) [5: Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008." Journal of Economic Perspectives 23, 77-100]

The economy of the United States of America was experiencing low interest rates as there was a large inflow of investment from foreign countries and the Federal Reserve had also opted for a lax policy.[footnoteRef:6] (Brunnermeier, 2009) [6: Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008." Journal of Economic Perspectives 23, 77-100]

The Asian countries were continuously investing in the U.S. securities in order to peg the exchange rate at a level that would be export friendly. In addition to that, they also aimed at reducing the continuous depreciation of their currencies in relation to the U.S. Dollar.[footnoteRef:7] (Brunnermeier, 2009) [7: Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008." Journal of Economic Perspectives 23, 77-100]

The traditional banking system went under transformation and was converted to an 'originate and distribute' system. In this system the loans were being pooled, and then they were divided into small portions and were then sold through the process of securitization. [footnoteRef:8](Brunnermeier, 2009) [8: Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008." Journal of Economic Perspectives 23, 77-100]

The Federal Reserve was concerned about the deflationary period that might have followed the bursting of internet bubble and hence did not pay much attention to the development of housing bubble and as a result no counter strategy was designed against the development and creation of housing bubble.[footnoteRef:9] (Brunnermeier, 2009) [9: Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008." Journal of Economic Perspectives 23, 77-100]

When the pre-crisis balance sheets of a number of banks analyzed the following facts were being identified; [footnoteRef:10] (Ratnovski and Huang, 2009) [10: Lev Ratnovski and Rocco Huang, 2009."Why are Canadian Banks More Resilient?" Working paper, IMF.]

Capital ratios have an influential impact on the ability of banks to resist financial shocks. The banks that have a better capital structure have the ability to sustain losses in an efficient manner without going insolvent. They can also have an access to sufficient funding when the market is uncertain about the value of their assets.[footnoteRef:11] (Ratnovski and Huang, 2009) [11: Lev Ratnovski and Rocco Huang, 2009."Why are Canadian Banks More Resilient?" Working paper, IMF.]

Liquidity can also enable the banks to sustain massive financial crisis. Availability of a wide variety of liquid assets enables the banks to maintain positive cash flows and to cover the disruptions in the availability of funds, which usually prevail in the market during the financial crisis.[footnoteRef:12] (Ratnovski and Huang, 2009) [12: Lev Ratnovski and Rocco Huang, 2009."Why are Canadian Banks More Resilient?" Working paper, IMF.]

Banks having retail deposits have fundamentally sound funding structures as these deposits are sticky and are covered by deposit insurance. The inter-bank depositors are less likely to take out their deposits from the banks with sound funding structure during the financial crisis.[footnoteRef:13] (Ratnovski and Huang, 2009) [13: Lev Ratnovski and Rocco Huang, 2009."Why are Canadian Banks More Resilient?" Working paper, IMF.]

Money market wholesale funding, on the other hand, is less reliable. Such deposits are uninformed and can be disrupted easily on the basis of rumors that may prevail in the market. The banks that rely heavily on such deposits are likely to fail in times of a financial crisis.[footnoteRef:14] (Ratnovski and Huang, 2009) [14: Lev Ratnovski and Rocco Huang, 2009."Why are Canadian Banks More Resilient?" Working paper, IMF.]

Bank Diversification and Stability through Non-Interest Income

The relationship between non-interest income and financial stability has always been subjected to great debates and controversies. A number of studies have been conducted to find out the exact relationship between non-interest income and financial stability. This section of the paper reviews the recent trends and existing literature in relation to this issue.[footnoteRef:15] (Stiroh, 2004) [15: Kevin Stiroh, 2004. "Diversification In Banking: Is Noninterest Income The Answer?" Journal of Money, Credit and Banking 36(5), 853-882]

In the year 1992, the Templeton and Severiens conducted a study. In this study they analyzed the market data of 54 bank holding companies. This study concluded that diversification, in terms of market value's share and not the assets of the bank, led towards low degree of variance in the shareholder returns.[footnoteRef:16] (Stiroh, 2004) [16: Kevin Stiroh, 2004. "Diversification In Banking: Is Noninterest Income The Answer?" Journal of Money, Credit and Banking 36(5), 853-882]

In the year 2001, DeYoung and Roland conducted a study in which they examined the relationship between the degree of volatility, profitability and the revenue shares of four hundred and seventy two commercial banks. The data that was being studied in this research was taken from the time period ranging between the years 1988 and 1995. This study concluded that, fee-based revenues or revenue from all the sources other than deposits, loans, investments and activities related to trade, lead towards an increase in the volatility of earnings and revenues of the banks. All of the above discussed studies do not mention evident benefits of diversification.[footnoteRef:17] (Stiroh, 2004) [17: Kevin Stiroh, 2004. "Diversification In Banking: Is Noninterest Income The Answer?" Journal of Money, Credit and Banking 36(5), 853-882]

In the year 1992, Santomero and Chung conducted a study. In this study they used the option pricing techniques and with the help of these techniques the tried to adjust the volatility of the return of assets by using a combination of 123 bank holding companies and 62 non-banking financial firms. This study concluded that the expansion of banks into various forms of non-banking businesses leads toward a reduction in risk.[footnoteRef:18] (Stiroh, 2004) [18: Kevin Stiroh, 2004. "Diversification In Banking: Is Noninterest Income The Answer?" Journal of Money, Credit and Banking 36(5), 853-882]

It has been reported by a number of studies that in the era of 1990s the non-interest income was more volatile than the interest income and it also had a higher growth rate when compared to interest income. The reason behind this volatility was due to the problems and dramatic changes that the banking system confronted as a result of loans that were being given to the banks in developing countries and the real estate problems that prevailed in the business environment.[footnoteRef:19] (Stiroh, 2004) [19: Kevin Stiroh, 2004. "Diversification In Banking: Is Noninterest Income The Answer?" Journal of Money, Credit and Banking 36(5), 853-882]

In addition to that, recent studies that were being conducted to find out the relationship between noninterest income, financial stability and reduced risk reported that there is very little evidence about the fact that the shift to non-interest income provides the banking system with reduced risks and more stable earnings and revenues. [footnoteRef:20] (Stiroh, 2004) [20: Kevin Stiroh, 2004. "Diversification In Banking: Is Noninterest Income The Answer?" Journal of Money, Credit and Banking 36(5), 853-882]

In addition to that it has also been observed by a number of studies at the aggregate level that, as the banks have started to depend on the non-interest income, this increase in dependence has made this form of income more volatile than the traditional interest income. Trading income has been observed to be the most volatile form of non-interest income. Moreover, with the passage of time the correlation between the non-interest and interest income has also become high. [footnoteRef:21] (Stiroh, 2004) [21: Kevin Stiroh, 2004. "Diversification In Banking: Is Noninterest Income The Answer?" Journal of Money, Credit and Banking 36(5), 853-882]

The correlation between the interest and non-interest income is reported to have increased over the last decade. The correlation between service charges, fee and net interest income is higher than the correlation between trade income, fiduciary income and net interest income. In relation to risk and return, a number of studies have reported that, there is an evident negative relationship between the share of non-interest income and profit associated with a single unit of risk. Trading activities have been reported to be very unstable in nature, whereas, fiduciary income is stated to be more stable in nature and is associated with higher profits per unit of risk.[footnoteRef:22] (Stiroh, 2004) [22: Kevin Stiroh, 2004. "Diversification In Banking: Is Noninterest Income The Answer?" Journal of Money, Credit and Banking 36(5), 853-882]

It was also reported by a study that the European banks that opted for non-interest income were confronted with more risks when compared with the banks that used the traditional interest income channels for revenue generation. In addition to that, risk has also been observed to have a positive correlation with fee based activities. According to the recent studies, which were aimed at studying the relationship between diversification and the measures of performance and risk based on the market indicated that the banks that have higher share of non-interest income in their overall revenue are expected to perform well in the long run. But these studies also indicated that the effect of this better performance is not very evident due to high degree of systemic risk.[footnoteRef:23] (De Jonghe, 2010) [23: Olivier De Jonghe, 2010. Back To the Basics in Banking? A Micro-Analysis of Banking Stability. Journal of Financial Intermediation 19, 387-417.]

Banking system plays an important role in all the economies and contributes a lot to the stability of the financial system. The financial supervisors and regulators, therefore, spend a considerable amount of time in devising ways to ensure the stability of the banking system. It has been reported by a number of studies that the shift of the revenue generation systems of a bank to revenue streams other than interest streams leads towards an increase in the bank's beta and hence reduces the stability of the bank.[footnoteRef:24] (De Jonghe, 2010) [24: Olivier De Jonghe, 2010. Back To the Basics in Banking? A Micro-Analysis of Banking Stability. Journal of Financial Intermediation 19, 387-417.]

The above mentioned facts raise sufficient doubts about the thought that noninterest income leads toward increased stability of profits and revenues and hence reduces the risks. The studies conducted regarding this issue reported that though noninterest income stabilizes the operating income but it has been becoming more volatile than the net interest income and the correlation between these two forms of income has been growing since the last decade and is expected to grow more.[footnoteRef:25] (Stiroh, 2004) [25: Kevin Stiroh, 2004. "Diversification In Banking: Is Noninterest Income The Answer?" Journal of Money, Credit and Banking 36(5), 853-882]

Impact of Off Balance Sheet Activities on the Banking System

There has been a rapid increase in the off balance sheet activities of the banks in the recent years. The reason behind this rapid increase is the increase in the completion in the banking industry. This competition put substantial financial pressures on the banks. And the banks, in addition to the traditional on balance sheet activities, started using the off balance sheet activities and innovative financial methods to increase their financial strength.[footnoteRef:26] (Lozano-Vivas and Pasiouras, 2010) [26: Ana Lozano-Vivas, Fotios Pasiouras, 2010. "Bank Productivity Change and Off-balance-sheet Activities across Different Levels of Economic Development." Working Capital, Technical University of Crete.]

In the recent years, commercial banks have shifted from performing lending activities to some more innovative ways of generating revenue. This has led towards the use of off balance sheet activities, such as credit lines and contingent liabilities etcetera. These activities now cover a major portion of the balance sheets of the banks. The fact that whether these activities increase the productive efficiency and profitability of the banks or reduce these variables is still unclear.[footnoteRef:27] (Lozano-Vivas and Pasiouras, 2010) [27: Ana Lozano-Vivas, Fotios Pasiouras, 2010. "Bank Productivity Change and Off-balance-sheet Activities across Different Levels of Economic Development." Working Capital, Technical University of Crete.]

A research conducted by the Technical University of Crete that consisted of 752 banks from 87 countries stated that between the time period ranging between 1999 and 2006, the cost of the banks that did not include off balance sheet activities in their banking model increased by 9%, whereas, the costs of the banks that employed off balance sheet activities in their banking model increased by 9.19%. The study indicated that this increase was triggered mainly by the business conditions and not by cost productivity.[footnoteRef:28] (Lozano-Vivas and Pasiouras, 2010) [28: Ana Lozano-Vivas, Fotios Pasiouras, 2010. "Bank Productivity Change and Off-balance-sheet Activities across Different Levels of Economic Development." Working Capital, Technical University of Crete.]