Banks' Non-Interest Income and Systemic Risk

Markus K. Brunnermeier, Gang (Nathan) Dong, Darius Palia
2012 Social Science Research Network  
This paper documents that banks with higher non-interest income (noncore activities like investment banking, venture capital and trading activities) have a higher contribution to systemic risk than traditional banking (deposit taking and lending). After decomposing total non-interest income into two components, trading income and investment banking and venture capital income, we find that both components are roughly equally related to systemic risk. These results are robust to endogeneity
more » ... o endogeneity concerns when we use a difference-in-difference approach with the Lehman bankruptcy proxying for an exogenous shock. We also find that banks with higher trading income one-year prior to the recession earned lower returns during the recession period. No such significant effect was found for investment banking and venture capital income. . 1 "These banks have become trading operations. ... It is the centre of their business." Phillip Angelides, Chairman, Financial Crisis Inquiry Commission 2 on an individual bank being in distress. More formally, ∆CoVaR is the difference between the CoVaR conditional on a bank being in distress and the CoVaR conditional on a bank operating in its median state. The second measure of systemic risk is SES or the Systemic Expected Shortfall measure of Acharya, Pedersen, Philippon, and Richardson (2010; from now on defined as APPR). APPR define SES to be the expected amount that a bank is undercapitalized in a systemic event in which the entire financial system is undercapitalized. Note that ∆CoVaR measures the externality a bank causes on the system, while SES focuses how much a bank is exposed to a potential systemic crisis. In this paper, we begin by estimating these two measures of systemic risk for all commercial banks for the period 1986 to 2008. We examine four primary issues: (1) Is there a relationship between systemic risk and a bank's non-interest income? (2) From 2001 onwards, banks were required to report detailed breakdowns of their non-interest income. We categorize such items into two sub-groups, namely, trading income, and investment banking/venture capital income, respectively. We examine if any sub-group has a significant effect on systemic risk. (3) We hence check if the above two results are driven by endogeneity concerns, namely that significant omitted variables are correlated with both non-interest income and systemic risk. (4) Finally, we examine if there is a relationship in the levels of pre-crisis non-interest income and the bank's stock returns earned during the crisis. Our results are the following: 1. Systemic risk is higher for banks with a higher non-interest income to interest income ratio. Specifically, a one standard deviation increase to a bank's non-interest income to interest income ratio increases its systemic risk contribution by 11.6% in ∆CoVaR and 5.4% in SES. This suggests that activities that are not traditionally linked with banks (such as deposit taking and lending) are associated with a larger contribution to systemic risk. 2. Glamour banks (those with a high market-to-book ratio) and more highly levered banks contributed more to systemic risk. Generally, larger banks contributed more than proportionally to systemic risk, which is consistent with the findings in AB. 3. After decomposing total non-interest income into two components, trading income and investment banking/venture income, we find that both components are roughly equally related to ex ante systemic risk. A one standard deviation increase to a bank's trading income increases its systemic risk contribution by 5% in ∆CoVaR and 3.5% in SES, whereas a one Brownlees, Christian, and Robert Engle, 2010, "Volatility, Correlation
doi:10.2139/ssrn.1786738 fatcat:doxe7pypkjce5augrg5cscwjmi