Bank Income Diversification, Asset Correlation and Systemic Risk

• Author: Pei‐Fen Chen,Jhih‐Hong Zeng,Chien‐Chiang Lee
• Date: 01 March 2020
• Published date: 01 March 2020
• DOI: http://doi.org/10.1111/saje.12235

© 2019 Economic Society of South Africa

South African Journal of Economics Vol. 88:1 March 2020

doi: 10.1111/saje.12235

71

BANK INCOME DIVERSIFICATION, ASSET CORRELATION

AND SYSTEMIC RISK

CHIEN-CHIANG LEE†, PEI-FEN CHEN‡,* AND JHIH-HONG ZENG§

Abstract

This paper explores whether the asset correlations among the non-interest activities of banks are

the key causes for enhancing the bank diversification-systemic risk nexus. Our empirical evidence

indicates that banks’ income diversification significantly raises systemic risk. After removing

those banks with high asset correlations, the effect of individual banks’ diversification on banking

systemic risk turns insignificant or even inverse. The results show that high asset correlations

among banks could introduce bank failures, thereby leading to higher systemic risk in the financial

sector.

JEL Classification: E25, G11, G21, K20

Keywords: Banking industry, systemic risk, income diversification, financial crisis, asset correlation,

financial liberalisation

1. INTRODUCTION

The relationship between banks’ income diversification and the systemic risk has been an

ongoing debate in the literature. Over the past few decades, the loosening of bank regu-

lations throughout most of the world has spurred banks to engage in a greater amount of

non-traditional activities (Hsieh et al., 2013; Lee et al., 2014).1 Although banks may be

more profitable via these non-interest-generating activities,2 the access to risky assets

might lead to higher risk exposures.

This article addresses the question on how banks’ systemic risk is affected by income

diversifications when there are high asset correlations across banks. Wagner (2010)

1 Lee et al. (2014) indicate that with the present trend of financial deregulation, banks have been

stimulated to establish new products with the purpose of meeting demand as a result increasing

competitiveness, promoting the scale of business, market development, and expanding liberalisa-

tion and diversification.

* Corresponding author: Institute of China and Asia-Pacific Studies, National Sun Yat-sen

University, No. 70, Lianhai Rd., Gushan Dist., Kaohsiung 80424, Taiwan. Tel: +886-7-5252000

ext. 5575, Fax: +886-7-5255571. E-mail: pfchen@mail.nsysu.edu.tw

† School of Economics and Management, Nanchang University

‡ Institute of China and Asia-Pacific Studies, National Sun Yat-sen University

§ Department of Finance, National Sun Yat-sen University

2 The non-interest generating activities make non-interest income for banks, which is regarded as

banks’ revenue diversification. These activities have becoming important income sources other

than the traditional deposit-lending functions of banks. In advanced economies, for example, the

US, non-interest income includes income from trading and securitisation, investment banking and

South African Journal

of Economics

72 South African Journal of Economics Vol. 88:1 March 2020

© 2019 Economic Society of South Africa

theoretically demonstrates that the diversification and bank similarities are connected

such that diversification can even be undesirable by exposing the banks to the same sys-

temic risks. He also shows that banks have incentives to choose correlated assets, which

may indicate a rising probability for a systemic crisis. Sanya and Wolfe (2011) argue that

income diversifications smooth out cyclical variations in profits if returns across bank

activities are not perfectly correlated. This is one of the first few articles to compare

the difference between the analyses with and without filtering out those banks with a

high correlation in return on assets (ROA) to one another. Understanding the influences

of asset correlation among banks to the relationship between income diversifications

and risks, particularly systemic risk, helps shed light on the strategic decisions of bank

managers.

The literature often argues that financial innovation in the form of creating new in-

struments and opening up new markets is desirable, because it creates opportunities for

diversification. However, the innovation of new instruments introduces different types of

risk itself, including systemic risk. Systemic risk involves a collection of interconnected

financial institutions that have beneficial business relationships through which illiquidity,

insolvency and losses can quickly propagate during periods of financial distress (Billio

et al., 2012).3 The probability of systemic risk correlates to the degree of bank diversifica-

tion. Tasca et al. (2014) model the impact of interactions among financial institutions via

their common asset holdings, generating the optimal diversification level within a system

context.

In spite of the unidentified relationship between banks’ income diversification and sys-

temic risk, it is becoming more important to realise whether individual banks’ extension

into non-traditional businesses could jeopardise market stability in the whole banking

industry. First, banks nowadays have much more exposure to risky assets as they promote

various non-interest products, thus raising the average level of market risk. Second, a

global financial crisis does not easily occur. The increasing holding of risky assets by

financial institutions raises the possibility. In fact, the occurrence of a financial crisis

usually relates to the herding effect (see, e.g. Laih and Liau, 2013) through many syn-

chronous failures in financial institutions or market participants. After financial market

regulation has been loosened, bank managers or policymakers may have less precise judg-

ment after their entry into new businesses. Without complete auxiliary policies, hidden

disadvantages may accumulate and burst forth one day. As we shall stress in this paper,

a high correlation in banks’ assets could lead to the simultaneous appearance of defaults

that then turn into a broader financial crisis. In other words, a high similarity among

banks’ assets/portfolios could be a strong determinant in the relationship between banks’

income diversification and the banking industry’s systemic risk.

3 Another way of saying the same thing is that systemic risk can be generally described as the

risk that a failing financial institution in a financial system causes the failure of other institutions

in the system, such that this failure cascades and encompasses the whole system (Tasca et al.,

2014).

advisory fees, brokerage commissions, venture capital, fiduciary services and gains on non-hedging

derivatives. (Brunnermeier et al., 2019) In this article, we assort the non-interest income sources as

trading income, commission and fee income and other operating income.