Diversification is a bedrock principle in modern finance that tells us when risks are evenly spread out rather than concentrated, the total amount of risk is reduced and safety increases. Diversification is a financial principle that pervades modern life. People who save for retirement are advised to hold diversified portfolios of various financial assets so that no single asset can have an outsized impact on the value of their savings. As the old adage goes, it is not wise to put all of your eggs in one basket.
The same is true in banking. Banks that spread their risks evenly over multiple business activities are better diversified, less risky and contribute to a safe and sound financial system. In this post we use the results of the Federal Reserve’s stress tests to document that Financial Services Forum members are better diversified than other banks subject to the stress tests. We then further demonstrate that Forum members are better diversified than other banks using bank exposures to commercial real estate (CRE) loans as a case study. The CRE example is timely given recent concerns about the performance of commercial real estate loans in the pandemic because commercial spaces such as malls and restaurants are seeing less activity and fewer customers. The results of both analyses demonstrate that Financial Services Forum members are better diversified than other banks subject to the stress tests and contribute to a safe and sound financial system. Finally, the broadly diversified nature of Forum members contributes to a broad base of economic activity across multiple sectors that can support the economic recovery as we deal with the pandemic.
Using the Stress Tests to Measure Diversification
Each year the Federal Reserve estimates losses that banks would suffer in a severely adverse economic scenario. More specifically, the Federal Reserve estimates losses in ten distinct business activity categories – seven loan categories (e.g. mortgage loans, commercial real estate loans, credit card loans, etc.), losses on investment securities (e.g. corporate bonds), losses on trading activities (e.g. derivatives), and a catch-all “other losses” category. The degree to which the stress test’s estimated losses are evenly spread across all ten of these categories provides a useful measure of diversification. As an example, a bank that has all of its losses concentrated in a single category, such as commercial real estate loans, would have an extremely concentrated and undiversified risk profile. In this case, if the CRE sector goes into rapid decline, the bank would be severely impacted. Alternatively, a bank that has its risk spread evenly over ten different activities would exhibit a much higher degree of diversification and would be less severely impacted by the same decline in the CRE sector.
A well-accepted quantitative measure of diversification is the Herfindahl-Hirschman Index (HHI). The HHI index ranges from 1,000 to 10,000 and reflects the sum of squared shares from each loss category. A bank with 100% of its losses concentrated in CRE would have an HHI of 10,000 (100×100=10,000) while a bank with 10% of its losses in each of the ten categories would exhibit a smaller HHI of 1,000 (10×10+10×10+10×10+…+10×10=1,000). Figure 1 below compares the weighted average HHI for Financial Services Forum members with that of all other banks subject to the stress tests from 2017 through 2020.
As shown in the Figure, Forum members are significantly better diversified than other banks subject to the stress tests, as the weighted average HHI index for other banks is typically about 50 percent larger than that of Forum members. This means that Forum members are engaged in a broader array of activities and are less severely impacted by poor performance in any single sector, such as commercial real estate. One timely example of the well-diversified nature of Forum members comes in the form of their significant underwriting activities. As we recently profiled, Forum members have contributed significantly to a large wave in security issuance by public companies as they have sought to raise funds to keep their doors open during the pandemic. The revenues earned through underwriting securities has helped buoy the financial results of Forum members as they deal with headwinds that have come with this pandemic.
Diversification Case Study: Commercial Real Estate Lending
The HHI results above are informative about diversification but can be difficult to picture because the index aggregates information from a wide array of activities. Focusing on bank exposures in a single sector, such as CRE lending, can be helpful to make the results in Figure 1 more concrete. In Figure 2, we report the weighted average proportion of stress test losses owing to CRE loans for Forum members and all other banks subject to the stress tests. We focus on CRE lending because CRE lending is often found to be an area where banks build up concentrated risk exposures and because the partial shutdown of the economy has renewed concerns about CRE lending due to the decline in economic activity.
As shown in Figure 2, CRE typically accounts for less than 10 percent of losses in the stress tests for Forum members on average. At the same time, CRE accounts for between roughly 15 to 20 percent of stress test losses for other banks on average. Accordingly, Forum members have less concentrated exposures to CRE lending and would be impacted less by a decline in the CRE sector than other banks.
Well-diversified banks are safer and support a sound financial system. Data from the Federal Reserve’s stress tests clearly demonstrate that Forum members are better diversified than other banks subject to the stress tests as they spread their risk more evenly across a wide range of activities. Both a general diversification analysis as well as an analysis focused on CRE lending demonstrate this empirical fact. Finally, an additional benefit of Forum members’ greater diversification is that they work to support the economy on multiple fronts – consumer lending, business lending, securities underwriting – ensuring that a broad swath of businesses and households benefit from the credit and financial services they provide. The breadth of Forum business activities contributes to broad-based economic activity that supports an even recovery as we deal with the challenges of this pandemic.