Risky Mix

• Author: Ralph Chami, Connel Fullenkamp, Thomas Cosimano, and Céline Rochon

Risky Mix Finance & Development, March 2017, Vol. 54, No. 1

Ralph Chami, Connel Fullenkamp, Thomas Cosimano, and Céline Rochon

If financial institutions combine banking and nonbanking business there is potential for danger

The biggest banks in the world are not just banks—they’re financial supermarkets that can underwrite securities, manage mutual funds, and act as brokers in addition to lending money. Offering many different kinds of financial services increases the profits of these institutions—whether they are universal banks, in which the functions are all part of the bank, or are holding companies that own separate bank and nonbank providers.

But when all these activities are under one roof, many regulators believe that new risks are added that could endanger both the institution and the financial system. After the global financial crisis of 2008, regulators in a number of countries proposed rules to insulate traditional banking (taking deposits and making loans) from the risks associated with other financial services. For example, in the United States, the so-called Volcker Rule, which prohibits banks from engaging in proprietary trading (using their own money rather than trading for a client), was enacted as part of the Dodd-Frank Act in 2010. In Europe, regulators in both the United Kingdom and the European Union have proposed various types of ring-fencing—separating banks’ traditional functions from the rest of their operations.

These actions, however, are based more on a fear that something bad could happen than on experience. Poor lending decisions by banks and many nonbank lenders appear to have been the main cause of the crisis, rather than nontraditional activities such as proprietary trading. Nonetheless, it may be necessary to protect traditional banking from potential damage caused by banks’ other financial activities. This decision should be based on careful consideration of the risks involved in combining banking with other financial services in a single company.

Differing risksWe found an important distinction between the risks involved in traditional banking and the risks of other financial activities that helps explain why nontraditional activities may be dangerous for banks based on two categories of financial risk: slow moving and fast moving.

Slow-moving financial risks take time to build up and cause losses over long periods, possibly months or even years. Because they accumulate relatively slowly, these risks often give advance warning that a future loss may occur. Credit, or default, risk is the leading example of a slow-moving financial risk. Often, borrowers go through periods of declining sales or other income that indicate they will have trouble repaying their loans. This longish process gives a bank time to take steps to mitigate or even prevent damage from default. For example, banks can work with their customers to prevent default by temporarily reducing or postponing payments. And even if a borrower defaults, a bank has time to work with the customer to restructure the loan to minimize the loss.

Fast-moving risks evolve...