Author Information : Anna Chernobai, Syracuse University
Ali Ozdagli, Federal Reserve Bank of Boston
Jianlin Wang, University of California at Berkeley
Year of Publication : Journal of Monetary Economics (2021)
Summary of Findings : As U.S. banks are becoming more complex in their business activities, their operational risk (such as internal fraud and market malpractices) also increases.
Research Questions : 1) When banking institutions are growing bigger and more complex, are they managing their risks better or are their risks growing bigger too?
2) After the financial deregulation in late 1990s, how did the level of risk change for banks and insurance firms that got deregulated compared to other nonbank financial institutions that were not subject to the deregulations?
3) Is the elevated operational risk post-deregulation a result of strategic risk taking or managerial failure?
What we know : After the financial deregulation in late 1990s (that culminated in the Gramm-Leach-Bliley Act of 1999), U.S. bank holding companies began expanding aggressively into nonbanking activities. Two big areas are securities underwriting and dealing, and insurance underwriting. This increased business diversification made bank holding companies more complex, in the sense that they began operating in a wider range of activities that lie outside of the traditional business of banking.
Some studies have documented benefits to banks from diversification such as improved short-term performance, higher market share, and greater political power.
Regulators are concerned that such increased business diversification made bank holding companies more complex, and that potential benefits of the diversification are offset by potential risk management weaknesses.
Novel Findings : This study uses pre- and post-deregulation periods to examine the effects of bank complexity on their operational risk and finds that the frequency and the severity of operational risk events increased significantly with bank complexity. This trend is driven by the newly established securities underwriting and dealing activities.
Another novel finding is that operational risk increased not only in the new nonbanking business lines of banks, but also within the traditional core (banking) business line. This points to the systemic nature of operational risk. This evidence also suggests that managerial failure offsets the potential benefits from any strategic risk taking.
Novel Methodology : We use a new methodology to study the effects of business complexity on risk management, that is robust to confounding effects. We utilize the 1990s deregulation period as a so-called natural experiment that serves as an external shock to banks' complexity. This experiment allows us to identify the causal effect of increased complexity on the quality of risk management.
Implications for Practice : Some recent studies document negative externalities of operational risk events affecting other financial firms. These externalities imply that the higher levels of operational risk that we observe post-deregulations are not socially optimal.
Implications for Policy: At the heart of current regulatory debates lies the tradeoff between potential diversification benefits and potential risk management weaknesses arising from increased complexity that can result in losses for both the financial sector and taxpayers. This study highlights that any apparent benefit of diversification may come at the expense of increased risk that is not immediately evident. Our results also suggest that operational risk externalities are more likely to originate from more complex bank holding companies. Accordingly, they may warrant more stringent regulatory requirements for operational risk. Therefore, our results support the recent inclusion of operational risk events in the Comprehensive Capital Analysis and Review (CCAR) framework of the Federal Reserve for the stress-testing of systemically important financial institutions.
Implications on Research: This paper focuses on the complexity of banks. The term complexity can be related to very different concepts, such as business diversification, geographic diversification, and network interconnectedness. While our paper focuses on business complexity, we hope this study jump-starts new scholarly research on the interaction between other sources of complexity and risk management in the financial sector.
Full Citations : Anna Chernobai, Ali Ozdagli, and Jianlin Wang. "Business Complexity and Risk Management: Evidence from Operational Risk Events in U.S. Bank Holding Companies." Journal of Monetary Economics: 117, pp. 418-440, 2021.
Abstract : Recent regulatory proposals tie a financial institution's systemic importance to its complexity. However, little is known about how complexity affects banks' risk management. Using the 1996–1999 deregulations of U.S. banks' nonbanking activities as a natural experiment, we show that banks' business complexity increases their operational risk. This result is driven by banks that had been constrained by regulations, compared with other banks and also with nonbank financial institutions that were never subject to these regulations. We provide evidence that managerial failure underlying these events offsets benefits of strategic risk taking.