Diversification and Risk Exposures at Large Banks: Evidence from the FDIC’s 2019 Risk Review

22 Nov 2019
Read Time 3 mins
Categories :
Value of Large Financial Institutions

A key benefit of large banks to the economy is their ability to diversify risks and avoid “putting all of their eggs in one basket.”  Diversification is a fundamental principal of modern risk management and we have documented in a previous post that large banks such as Financial Services Forum members, are well-diversified.  The broad diversification of large banks helps to ensure that no single risk dominates a bank’s risk profile, which enhances their safety and stability.  In this post, we review evidence from the FDIC’s 2019 Risk Review that further supports the view that large banks are well-diversified.

The 2019 Risk Review broadly describes an array of risks facing the more than 5,000 banks in the United States, including rising financial market volatility, risks in the energy sector, and risks in corporate lending.  Much of the discussion is appropriately high level and overarching, but the report does provide specific and quantitative evidence on the presence of concentrated risks in three specific areas: agriculture, commercial real estate (CRE), and residential housing.  The FDIC defines a bank’s risk as “concentrated” if its exposure to the risk exceeds 300% of total capital.  As an example, if a bank with $100 in total capital held $350 in commercial real estate loans, the FDIC would identify the bank as having a high concentration of CRE lending because $350/$100=350%.  While there is no immutable law that makes an exposure of 300% “concentrated” as opposed to, say, 350% or 250%, the FDIC’s analysis is concrete and transparent and can be used to systematically identify banks with more- versus less-concentrated risk exposures.

Table 1 below reproduces the FDIC’s analysis on concentrated risk exposures from the 2019 Risk Review and adds information on the risk exposure of Financial Services Forum members.

Table 1: Risk Concentrations Among U.S. Banks and Financial Service Forum Members

AgricultureCommercial Real EstateResidential Housing
% of all banks with exposure
>300% Capital (%)
82612
% of Forum members with exposure
>300% Capital (%)
000

Sources: 2019 FDIC Risk Review, FR Y-9C

As shown in the table, among all U.S. banks there are a non-trivial fraction of banks showing a high concentration to one or more of the identified risk factors.  No Forum member, however, exhibits a concentrated risk exposure in excess of 300% of capital to any of the identified risk factors.  The absence of a concentrated exposure is a good indicator of the broad diversification of Forum members.

While Table 1 does show that Forum members do not maintain any concentrated exposures to the three risk factors quantified in the FDIC’s report, the results should not be taken to mean that Forum members do not take any risk.  Rather, Forum members are engaged in a wide array of varying business lines that serve the economy and effectively spreads the risks they do take over multiple sectors.  As a result, no single source of risk dominates and overall risk is reduced.  Further, the specific and quantitative analysis of concentrated risks provided by the FDIC offers concrete evidence that demonstrates the well-diversified nature of large banks.  The broad diversification of Forum members enhances their safety and improves their ability to serve customers, businesses and households during both good times and bad.                    

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