Why Banks Want to Be Complex

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The quasi collapse of the global financial system during the crisis of 2007-2009 has triggered an extensive debate about the role of large complex banks. On the one hand, banks are seen as “too complex to fail”, and researchers and policy makers argue that the main danger is that financial institutions and markets are becoming “too big to understand” or “too complex to depict”, and therefore need to shrink and be simplified. On the other hand, bankers argue that caps on bank size are inefficient because both size and complexity help banks diversify risks and innovate to create additional profit opportunities. Some studies suggest that there are significant economies of scale even for the largest banks (e.g., Hughes and Mester, 2013). The following questions arise from this debate: Is it size or complexity? Is complexity good or bad for individual banks and/or the financial system? In a new study Liu, Norden and Spargoli (2015) address these questions by investigating how complexity relates to individual bank performance and systemic risk, controlling for bank size. They find that more complex banks exhibit better performance, i.e., higher profitability and market share and lower risk. They also find an inversely U-shaped relation between bank complexity and systemic risk. The evidence provides an explanation why banks want to be complex.

The authors acknowledge that there is no general definition of bank complexity. They borrow from the international economics literature and measure bank complexity using the dimensions “diversification” (number of bank activities) and “diversity” (with ubiquity of bank activities in the system as inverse proxy). A bank is more diversified when it performs many different activities and/or when it engages more in activities that are relatively sophisticated and/or innovative, making the bank more diverse relative to the other banks in the system. The authors compute complexity for each bank and year, using U.S. bank holding company data covering the period 1986-2013.

In the first part of the analysis Liu, Norden and Spargoli show that more complex banks exhibit a significantly higher profitability, a significantly lower default risk, and a significantly higher market share than less complex banks. The reason is that more complex banks perform a large number of sophisticated and innovative activities. Because the latter cannot be easily and immediately copied, these activities allow banks to differentiate themselves from their competitors. Such strategy creates value and, at least in the short term, monopoly power.

In the second part of the analysis, the authors find an inversely U-shaped relation between complexity and systemic risk. Interestingly, banks with intermediate complexity are the ones that contribute the most to systemic risk, whereas the low and high complexity banks exhibit a lower impact. These results are surprising because they are not consistent with the conventional wisdom. The latter suggests that higher bank complexity should be monotonically positively related to systemic risk since more complex banks tend to be more interconnected and more difficult to resolve than less complex banks.

The evidence provided by Liu, Norden and Spargoli challenges the view that high bank complexity is per se bad and is consistent with recent theoretical models (e.g., Wagner 2011) showing that diversity in the financial system is critical for financial stability.

REFERENCES

Hughes, J., Mester, L., 2013. Who said large banks don’t experience scale economies? Evidence from a risk-return-driven cost function. Journal of Financial Intermediation 22, 559-585.

Liu, H., Norden, L., Spargoli, 2015. Why banks want to be complex. AEA/AFE 2016 Meetings Paper, November 2015.

Wagner, W., 2011. Systemic Liquidation Risk and the Diversity-Diversification Trade‐Off. Journal of Finance 66, 1141-1175.

The preceding post comes to us from Dr Frank Hong Liu, Senior Lecturer in Accounting and Finance at University of Glasgow, Lars Norden, Professor of Banking and Finance at the Brazilian School of Public and Business Administration, and Fabrizio Spargoli, Assistant Professor at Rotterdam School of Management at Erasmus University.  The post is based on their article, which is entitled “Why Banks Want to Be Complex” and available here.