Financial diversity, risk and systemic stability

If we look at financial markets like the market for retail deposits, or the market for mortgages or business loans, they’re not controlled by one type of organisation. For example, the market for deposits in the UK has been characterised by three broad financial institutions - shareholder owned banks, or PLC banks, building societies and mutuals, owned by their members and customers, and the government owned National Savings & Investment Bank, formally the Post Office Savings Bank. We should, of course, add that the UK government now owns significant stakes in Lloyds TSB and the Royal Bank of Scotland.

We will put that issue of government ownership to one side, because while the government owns a controlling interest in two of Britain’s largest PLC banks, that together account for well over a third of the market, it has chosen not to exercise control, and leaves them to their own devices, ie, profit maximisation. However, the objective of building societies and mutuals is different. Their aim is to maximise the welfare of their members, their customers. In practise, this difference is significant.

Whereas the aim of the shareholder owned banks is to charge the highest interest rate possible on loans and to offer the lowest rate possible on deposits, in order to maximise their return for shareholders, the objective of the mutuals is to raise deposits and make loans, normally for mortgages, while making only a normal rate of return on their services. In other words, they don’t aim to maximise profit. Finally, the National Savings & Investment Bank has still a different objective - to encourage saving and to provide a source of funding for government.

If we model a market like the mortgage market or the market for deposits and savings, it would be wrong to assume one type of firm and one type of behaviour. We should recognise business diversity and recognise that the degree of diversity changes over time. Changes in bank regulation allowed building societies to convert to banks, and the share of the mutual sector fell, standing at around 20% today. To capture these changes, we need a robust measure of financial diversity. The measure we have devised, the Michie-Oughton D-Index, is based on a measure used by Simpson to measure biological diversity. And that article was published in Nature in 1949.

It looks at the different concentration of types of species, in our case different types of financial institution, and subtracts this from one to attain a diversity index. The D-Index shows that corporate diversity in financial services has been falling since 2000. There is both theoretical and empirical evidence that banks and building societies behave differently, and that corporate diversity has an impact on bank behaviour. However, there is still another problem caused by the loss of diversity in financial services, and that is financial instability. The demutualizations in the UK, prompted by the 1986 Building Societies Act, is one of several changes in regulation that change the financial landscape.

The distinction between firm diversification and corporate diversity is an important one, especially in banking, where there are a spillover effects from each individual bank’s risk to systemic risk. Full diversification within a firm reduces risk for that bank, but if all banks move in the same direction, this may lead to increased systemic risk. For any individual firm, risk is spread by diversification. Intuitively, this is equivalent to the argument ‘don’t put all your eggs in one basket’. It is also known as the fallacy of aggregation. What makes sense for an individual firm does not make sense for all firms when their behaviour is aggregated. Keynes’ theory of the downward multiplier is based on the fallacy of aggregation.

Keynes was writing during the last Great Depression in 1930s, and he pointed out that in a recession, it makes sense for each individual firm to cut its production and its employment. However, when all firms do this simultaneously, there is a fall in output and employment at the macroeconomic level that causes incomes to fall, leading to a further fall in demand, that necessitates our individual firm to make a further reduction in its production and output, with the process continuing into a downward spiral. While the initial cut in output and employment was rational from the perspective of an individual firm, when all firms reason in the same way, their actions are self-defeating and the economy tumbles into recession.

Turning back to financial diversity, by supplying a wider range of services or financial products, firms in the financial sector able to spread risk. However, for the industry as a whole, risk is spread by having different types of firms specialising in different activities. One of the trends that has emerged since Big Bang in the UK and the repeal of the Glass Steagall Act in the United States, is an increase in firm diversification, as banks were allowed to engage in a wider range of activities. This has led to banks becoming more similar as they each diversify into the same set of activities. A number of recent studies have highlighted the link between different aspects of diversity and the stability of financial systems.

For example, Haldane and May’s 2011 paper published in Nature analyses the sources of systemic risk in banking systems and identifies diversity across the financial sector as a key factor that promotes systemic stability. To quote them, “In the run up to the crisis and in the pursuit of diversification, banks’ balance sheets and risk management systems became increasingly homogeneous. For example, banks became increasingly reliant on wholesale funding on the liabilities side of the balance sheet, and managed the risks using the same Value At Risk models. This desire for diversification was individually irrational from a risk perspective. But it came at the expense of lower diversity across the system as a whole, thereby increasing systemic risk. Homogeneity bred fragility.”

A similar argument has been expressed by Goodhart and Wagner in 2012, who note that, again to quote, “The biggest institutions are now operating in the same global markets, undertake similar activities, and are exposed to the same funding risks. This lack of diversity is very costly for society. Similar institutions are likely to encounter problems at the same time. This makes systemic crisis, such as the crisis of 2007 to 2009, more likely.” And we are still feeling the effects of that crisis, as it has spread from the financial sector to the real side of economies.