Financial Stability Through Bank Diversification the Banking Essay

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.....