November 19, 2018 / 1:24 PM / 23 days ago

Increasing similarity in banking raises concern for systemic risk, U.S. Fed official warns

NEW YORK(Thomson Reuters Regulatory Intelligence) - A growing homogeneity in business models and strategies among U.S. large banks may worsen overall risk in the financial system, warned Kevin Stiroh, the head of supervision at New York Federal Reserve.

Euro and U.S. dollar banknotes are seen in this picture illustration taken in Prague January 23, 2013.

"If firms expand, diversify and become more similar, each might become safer individually. The industry, however, might not be any safer or more resilient. If all firms are effectively the same, they could become 'systemic as a herd' and susceptible to the same shocks in a way that leaves the aggregate provision of financial services more volatile," Stiroh said last week at the Financial Times U.S. Banking Forum(here).

Banks are considered individually safer and more resilient compared to a decade ago due to higher and better capital ratios, deeper liquidity pools, and better risk management practices as a result of regulatory policies implemented in the wake of the financial crisis.

The homogeneity risk within large banks is because they tend to respond in similar ways to changes in regulations, the interest rate environment, and the challenges of fintech.

LESS DISPERSION IN BALANCE SHEET AND INCOME STATEMENT CHARACTERISTICS

Though still in its preliminary stages, a research conducted by the New York Federal Reserve shows that large banks experienced convergence in the composition of their balance sheets both on the asset and liability sides in the decade following the financial crisis.

On the asset side, the convergence can be observed in broad measures such as ratios of loans to total assets and trading assets to total assets. On a more granular level, such convergence also is happening across loan categories like residential real estate, commercial real estate, commercial and industrial, or consumer loans as the composition of loan balances across banks.

On the liability side, a similar convergence can be observed as funding profiles have largely become less dependent on wholesale funding sources and shifted towards deposits for the majority of U.S. banks.

This is mostly due to how they react to regulatory changes.

“A bank with with a low-risk balance sheet where the leverage ratio currently is binding, but the risk-based capital ratio is not may have incentives to shift out of low-risk assets into higher-risk assets in order to optimize its balance sheet and the corresponding risk-adjusted return on equity,” said Stiroh.

Similarly, the definition of high-quality liquid assets — finalized after years of work among various regulatory bodies — has made certain asset types more desirable to have on balance sheet to satisfy key liquidity ratios like net stable funding ratio and liquidity coverage ratio.

Banks also displayed convergence in their income statements, with greater similarity of their earnings streams, in particular in the composition of revenue such as the share of net interest income in total net revenue.

OTHER AREAS OF CONVERGENCE

Beyond asset classes, the Fed research also reveals that equity returns for large banks show increasing similarity.

As such, “the propagation mechanisms for an industry with a set of similar firms with a wider range of activities may be very different from one where firm heterogeneity can offset and smooth the impact of shocks,” stated Stiroh.

SUPERVISORY RESPONSE

Stiroh urged supervisory vigilance to keep such increase in systemic risk in check.

“Supervisors and regulators should be concerned not just with the firm as an entity, but with the industry as a portfolio of firms where aggregate outcomes reflect both each firm’s individual contribution and correlation properties across firms,” he said.

Indeed, supervisors should continue to focus on enterprise risk management that reflects each business and the interdependencies among them, and exercise an industry-wide, macroprudential perspective to understand the impact of the continuing evolution of the U.S. financial industry.

The most efficient way for supervisors to do this, he said, would be through more emphasis on cross-firm, horizontal studies to better understand how the industry is evolving.

(Bora Yagiz, FRM is a New York-based Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence, specializing in risk.)

This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Nov. 8. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters

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