A new paper from the International Monetary Fund analyzes the characteristics of a panel of over 400 international banks and finds what factors, beyond low levels of equity, influence a bank’s individual (idiosyncratic) risk and its contribution to systemic risk more broadly:
We analyze how bank profitability impacts financial stability from both theoretical and empirical perspectives. We first develop a theoretical model of the relationship between bank profitability and financial stability by exploring the role of non-interest income and retail-oriented business models. We then conduct panel regression analysis to examine the empirical determinants of bank risks and profitability, and how the level and the source of bank profitability affect risks for 431 publicly traded banks (U.S., advanced Europe, and GSIBs) from 2004 to 2017. Results reveal that profitability is negatively associated with both a bank’s contribution to systemic risk and its idiosyncratic risk, and an over-reliance on non-interest income, wholesale funding and leverage is associated with higher risks. Low competition is associated with low idiosyncratic risk but a high contribution to systemic risk. Lastly, the problem loans ratio and the cost-to-income ratio are found to be key factors that influence bank profitability. The paper’s findings suggest that policy makers should strive to better understand the source of bank profitability, especially where there is an over-reliance on market-based non-interest income, leverage, and wholesale funding. [Emphasis added]
These results are fairly intuitive, but the four conclusions merit some further elaboration.
The negative relationship between profitability and a bank’s idiosyncratic and contribution systemic risk comes mostly from the fact that high bank profits serve as an “equity buffer” and increase a bank’s charter value, giving them more “skin in the game” and reducing their tolerance for risk.
The second conclusion is straightforward with respect to leverage, while heavier reliance on non-interest income (NII) through securitization and investment banking exposes banks to risks that, although promising a higher return, also come with greater variance than a more straightforward borrow-short-and-lend-long model.
The third conclusion follows from the general logic of reduced competition: lower competition leads to higher profits in most markets, and banking is no exception. However, such a concentrated market structure can exacerbate “contagion effects” that are independent of a bank’s profitability.
The fourth and final conclusion, that “problem loans” and higher operating costs negatively impact profitability, is also straightforward. But as it relates to bank profitability and financial stability, it shows the deleterious effects of risky lending that, as the first conclusion shows, is not only bad for an individual bank’s bottom line but also bad for systematic risk.