Banks' Non-Interest Income And Systemic Risk

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FDIC/JFSR - 11th Annual Bank Research ConferenceBanks’ Non-Interest Income and Systemic RiskMarkus Brunnermeier, Princeton UniversityGang (Nathan) Dong, Rutgers UniversityDarius Palia, Rutgers University

FDIC/JFSR - 11th Annual Bank Research ConferenceMotivation (1) Recent crisis shows large risk spillovers from one bank toanother increasing systemic risk Two types of banking activitieso Deposit taking and lending Bernanke 1983, Fama 1985, Diamond 1984, James 1987, Gorton andPennachi 1990, Calomiris and Kahn 1991, and Kashyap, Rajan, and Stein2002 Bank lending channel for transmission of monetary policyBernanke and Blinder 1988, Stein 1988, Kashyap, Stein and Wilcox 1993o Other activities (non-interest income) Trading income Investment banking and venture capital income Others: fiduciary income, deposit services charges, credit card fees

FDIC/JFSR - 11th Annual Bank Research ConferenceNon-interest to interest income ratio

FDIC/JFSR - 11th Annual Bank Research ConferenceNon-interest to interest income ratio

FDIC/JFSR - 11th Annual Bank Research ConferenceMotivation (2) Philip Angelides, Chairman of Financial Crisis Inquiry Commission– These banks have become trading operations It's the centre oftheir business Paul Volcker, Statement before the US Senate’s Committee onBanking, Housing, & Urban Affairs– “The basic point is that there has been, and remains, a strongpublic interest in providing a “safety net” – in particular, depositinsurance and the provision of liquidity in emergencies – forcommercial banks carrying out essential services. There is not,however, a similar rationale for public funds – taxpayer funds –protecting and supporting essentially proprietary and speculativeactivities”

FDIC/JFSR - 11th Annual Bank Research ConferenceResearch Questions Are non-conventional banking activities (non-interestincome) associated with higher or lower systemic risk? What is the economic magnitude of the specific nonconventional banking activity (trading and venturebanking) on systemic risk? Is there a relationship in the levels of pre-crisis noninterest income and the bank’s stock returns earnedduring the crisis?

FDIC/JFSR - 11th Annual Bank Research ConferenceBottom line in advance We find that systemic risk is higher for banks with ahigher non-interest income to interest income ratio. Ones.d. shock to this ratio increases its systemic riskcontribution by 11.6% when measured by CoVaR and5.4% when SES Glamour banks, high leverage banks, and larger bankscontributed more to systemic risk Both trading income and investment banking/venturecapital income to be equally significantly related tosystemic risk Banks with higher trading income one-year before therecession earned lower returns during the recessionperiod

FDIC/JFSR - 11th Annual Bank Research ConferenceRelated Literature (1) Systemic risk measures– Adrian and Brunnermeier (‘08): CoVaR difference between the CoVaR conditional on a bank being in distress andthe CoVaR conditional on a bank operating in its median state– Acharya, Pedersen, Philippon,& Richardson (‘10): SES systemic expected shortfall which is the expected amount a bank isundercapitalized in a systemic event in which the entire financial system isundercapitalized– Allen, Bali and Tang (‘10):CATFIN measure principal components of the 1% VaR and expected shortfall, using estimatesof the generalized Pareto distribution, skewed generalized error distribution,and a non-parametric distribution

FDIC/JFSR - 11th Annual Bank Research ConferenceRelated Literature (2) Non-interest income on bank’s risk– Stiroh (2004) and Fraser, Madura, and Weigand (2002) finds thatnon-interest income is associated with more volatile bank returns– DeYoung and Roland (2001) find fee-based activities areassociated with increased revenue and earnings variability– Stiroh (2006) finds that non-interest income has a larger effect onindividual bank risk in the post-2000 period

FDIC/JFSR - 11th Annual Bank Research ConferenceSystemic Risk: CoVaR Value at Risk (VaRi ) measures bank i’s worst expected loss at q%confidence level over a given time interval (q 1%)Probability ( Ri VaRqi ) q CoVaRsystem i measures the VaR of financial system conditional uponbank i being in distress Percentage of asset value that entire financial system might lose withprobability q conditional on that the asset loss of bank i is at its VaRiProbability(Rsystem CoVaRqsystemi Ri VaRqi ) q

FDIC/JFSR - 11th Annual Bank Research ConferenceSystemic Risk: CoVaR CoVaRsystem i,median measures the VaR of financial system conditionalupon bank i being in its median state Percentage of asset value that entire financial system might lose withprobability q conditional on that the asset return of bank i is at itsmedian levelProbability( R system CoVaRqsystem i ,median Ri mediani ) q Bank i’s systemic risk is the difference between the financialsystem’s VaR conditional on bank in distress (CoVaRsystem i), andthe financial system’s VaR conditional on bank operating in itsmedian state (CoVaRsystem i,median) CoVaRqi CoVaRqsystem i CoVaRqsystem i ,median

FDIC/JFSR - 11th Annual Bank Research ConferenceSystemic Risk: Quantile Regression Regress to qth quantile (50% quantile is median), not tomean

FDIC/JFSR - 11th Annual Bank Research ConferenceSystemic Risk: CoVaR 1% quantile regressionRti i i Z t 1 iRtsystem system i system i Z t 1 system i Rti 1 system i 50% quantile (median) regressionRti i ,median i ,median Z t 1 i ,median Macroeconomic factors (Zt-1): volatility, liquidity,change in risk-free rate, change in term structure,change in credit spread, equity market return and realestate return

FDIC/JFSR - 11th Annual Bank Research ConferenceSystemic Risk: CoVaR Predict bank i’s VaR and median asset return using thecoefficients and estimated in quantile regressionsVaRqi ,t ˆ i ˆ i Z t 1Rti ,median Rˆti ˆ i ,median ˆ i ,median Zt 1 Predict financial system’s CoVaR conditional on bank i indistressCoVaR system i Rˆ system ˆ system i ˆ system i Z ˆ system iVaR iq ,ttt 1q ,t

FDIC/JFSR - 11th Annual Bank Research ConferenceSystemic Risk: CoVaR Predict financial system’s CoVaR conditional on bank ioperating in median state i , mediansystem iˆ system i Z ˆ system i R i ,medianˆCoVaRqsystem ,tt 1t Bank i ’s systemic risk is the difference between financialsystem’s CoVaR if bank i is at risk and financial system’sCoVaR if bank i is in median state isystem i , median CoVaRqi ,t CoVaRqsystem CoVaR,tq ,t

FDIC/JFSR - 11th Annual Bank Research ConferenceSystemic Risk: SES Estimation Acharya, Pedersen, Philippon and Richardson (2010) proposethe Systemic Expected Shortfall (SES) measure to capture abank’s contribution to a systemic crisis due to its expecteddefault loss SES is the expected amount that a bank is undercapitalized ina future systemic event in which the overall financial system isundercapitalized Systemic crisis event is when aggregate banking capital attime t is less than the target capital Empirically define systemic crisis event as the 5% worst daysfor the aggregate equity return of the entire banking system Realized SES is the stock return of bank i during the systemiccrisis event

FDIC/JFSR - 11th Annual Bank Research ConferenceRegressions Non-interest income and systemic risk: Non-interest Income (N2I) components: trading,investment banking & venture capital and others Newey-West standard error estimates in pooledregression

FDIC/JFSR - 11th Annual Bank Research ConferenceData 1986-2008Quarterly intervals534 unique banksSIC codes 60-67 matched with FR Y-9C (no investment banks,brokerages, insurance companies, mutual funds)CRSP: Daily return Weekly returnCompustat: Financial variablesFR Y-9C: Noninterest Income, Interest Income, C&I loanFed NY: LIBOR, TreasuryFHFA: House price indexNBER: Economic cycle dates

FDIC/JFSR - 11th Annual Bank Research ConferenceEmpirical Results (1) Non-interest income and systemic risk– Glamour banks, highly leveraged, and larger banks

FDIC/JFSR - 11th Annual Bank Research ConferenceEmpirical Results (2) Trading income and investment banking & venture capitalincome predicts systemic risk– Similar magnitude for investment banking and venture capitalincome than for trading income

FDIC/JFSR - 11th Annual Bank Research ConferenceEmpirical Results (3) Bank’s return during the crisis on its pre-crisis firmcharacteristics

FDIC/JFSR - 11th Annual Bank Research ConferenceRobustness (1) Is it interest income?No

FDIC/JFSR - 11th Annual Bank Research ConferenceRobustness (2) Is it interest income?No

FDIC/JFSR - 11th Annual Bank Research ConferenceRobustness (3) Systemic risk contributions the real economy? Yes– Using CRSP market return as proxy for overall economy

FDIC/JFSR - 11th Annual Bank Research ConferenceRobustness (4) Systemic risk contributions the real economy? Yes– Using CRSP market return as proxy for overall economy

FDIC/JFSR - 11th Annual Bank Research ConferenceRobustness (5) Cross-sectional v. time-series?Cross-sectional

FDIC/JFSR - 11th Annual Bank Research ConferencePolicy and caveats Non-traditional income is associated with systemic risk Maybe charge a Pigovian tax/charge/premium which is countercyclical Sample is commercial banks, effect might be much larger if includeother financial institutions such as insurance companies, investmentbanks, investment companies Not saying it is causal in a structural equation sense Cannot differentiate proprietary trading from client requested tradingor market making Could change as have new crises (stationarity issue)

FDIC/JFSR - 11th Annual Bank Research Conference Motivation (1) Recent crisis shows large risk spillovers from one bank to another increasing systemic risk Two types of banking activities o Deposit taking and lending Berna

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