Don’t Put All Your Eggs in One Basket: Diversification and Large Banks

28 Jan 2019
Read Time 3 mins
Categories :
Bank Size

Recently, the Federal Reserve issued its inaugural financial stability report.  The report highlights the strength of the US banking system and cites increases in capital, liquidity, and long-term funding as clear indicators of a more resilient banking sector.  Further, as discussed in a recent blog post by our CEO, Kevin Fromer, Forum Members are a primary contributor to these sources of enhanced financial stability as they have contributed $270 billion in Tier 1 capital, nearly $1.5 trillion in high-quality liquid assets, and have substantially increased their sources of stable and long-term funding.

In this post, we explore another important feature of large banks that enhances their resiliency and financial stability – asset diversification.  The ability of large banks to engage in a wide array of financial activities spreads out risk and provides a degree of protection from lackluster results in any single business or activity.  The risk-reducing benefits of diversification, or “spreading your eggs across many baskets,” is a bedrock principle of modern finance that is as relevant to the asset allocation of large banks as it is to personal financial decisions such as diversifying retirement savings between equities and bonds.

Table 1 below provides a snapshot of the asset allocation of the banking system over the 2010-2018 timeframe.  The table provides a percentage breakdown of bank asset holdings across six important categories: cash and securities, federal funds (bank reserves), real estate loans, all other loans (e.g., auto loans, credit card loans, business loans), trading assets (capital market instruments that banks hold to fulfill client needs), and a residual category that encompasses all other bank asset holdings (e.g., fixed assets such as buildings and real estate).  Table 1 shows the average asset allocation among Forum members and all other bank holding companies (BHCs) with total assets below $250 billion over the 2010-2018 period.

Source: Federal Reserve Y9-C, available at https://www.ffiec.gov/nicpubweb/nicweb/HCSGreaterThan10B.aspx

 

The final row of Table 1 shows a simple and informative measure of diversification – the Herfindahl Index, or HI.  The HI is computed by summing the squared asset percentage from each asset category.  A completely undiversified bank that held all of its eggs in one basket would show a 100% weighting in a single asset category and would have an HI value of 10,000.  A bank that evenly spreads its assets across each of the six categories with an asset weighting of roughly 17% per category would have an HI value of roughly 1,667.  Accordingly, banks with lower HI index values are better diversified and more resilient to adverse shocks to any single asset category.

As can be seen in the bottom row of Table 1, Forum members are significantly better diversified than other BHCs.  The more equal allocation of assets across asset categories for Forum members depicted in Table 1 indicates that Forum members are better diversified and more resilient to an adverse shock to any specific asset category.

As a specific example, it is worth noting that relative to other BHCs, Forum members have a smaller asset weighting in real estate loans and larger asset weightings in bank reserves and trading assets.  That means Forum members would likely be less impacted by an adverse shock to real estate prices given their smaller weighting in real estate loans.  Moreover, real estate is one of the least liquid asset types, and therefore can be difficult to adjust in response to adverse shocks.

Figure 1 demonstrates that the improved diversification of Forum members relative to other BHCs depicted in Table 1 is a consistent feature of the data over a long period of time.  Figure 1 shows the average HI index for Forum members and the average HI index for all BHCs with total assets below $250 billion since 2010.  As the figure clearly shows, Forum members have exhibited substantially lower HI index values, and are better diversified, than other BHCs.  It also is interesting to note that Forum members have been improving their degree of diversification since 2010 as the average Forum member HI index has steadily trended down from roughly 2,300 to 1,700 between 2010 and 2018.  Accordingly, at the same time that Forum members have increased capital, stockpiled liquid assets, and increased long-term funding, they have also improved their resilience through better diversification.

Source: Federal Reserve Y9-C, available at https://www.ffiec.gov/nicpubweb/nicweb/HCSGreaterThan10B.aspx

 

Diversification is a key risk-management tool that can be used to improve resiliency for individual banks and for the overall financial system.

Forum members are well-diversified and have improved their diversification in the past several years.  In addition, better diversification implies that Forum members allocate resources more evenly to a wider array of business lines, which improves their ability to serve the wide-ranging needs of businesses households and communities throughout the U.S.  Accordingly, the significant diversification of Forum members enhances financial stability and improves their ability to meet the financial needs of their customers.

 

 

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