The COVID-19 crisis is a reminder that resilient and powerful financial and banking systems are essential. In EU member states, the banking sector is the most important part of the financial system and the central source of finance for small and medium enterprises (SMEs), which make up around 99 percent of all EU companies. The question of which institutional structure makes banks resilient is thus more important than ever. However, there is little quantitative evidence about the role of institutional diversity in the stability of banks. The debate continues to be dominated by the question of whether market-based financial systems recovered faster after 2008 than bank-based ones (Beck, Demirgüc-Kunt & Singer 2013, Gambacorta et al. 2014, Langﬁeld & Pagano 2016).
One well-known adage instructs that you “should not put all your eggs in one basket.” Translated to the institutional structure of a banking system, one can expect that the system will be more stable when different types of banks coexist than when only one type of bank dictates the performance of the entire sector—if that type’s business model is in financial distress, all banks in the system are threatened simultaneously and in the same way (Haldane 2009, De Nederlandsche Bank N.V. 2015). The coexistence of different bank types reduces the risk of mutual infection and loss of financial stability in a crisis. As Haldane and May (2011) write, “excessive homogeneity within a financial system—all the banks doing the same thing—can minimize risk for each individual bank, but maximize the probability of the entire system collapsing.”
In our paper, we argue that the robustness of a diversified system should not only benefit the entire system, but also the individual bank. We predict that each bank will be more stable when the surrounding banking system is more institutionally diverse. For the investigation, we use a sample of banks from 22 EU member states. The observation period is 1998-2014 and includes almost 39,000 data points. The years 2007-2014 are of particular interest. They mark the period of the financial and economic crisis and the first peak of the debt crisis in the euro area. In order to identify the effect of bank diversity, we use established methods for estimating panel data sets (Beck, Jonghe & Schepens 2013, Hawkins & Baum 2014). The calibration of the indicator for bank stability and the model structure, in particular the selection of control variables, are largely based on the literature on bank competition and stability (e.g. Schaeck, Wolfe & Cihàk 2009, Schäfer, Siliverstovs & Terberger 2010, Köhler 2015). As is common practice, we measure the stability of the individual bank using the Z-Score (e.g. Leroy & Lucotte 2017, Goetz 2018).
To calibrate the main variable, Institutional diversity, we use the Shannon Index (Shannon 1948), an established entropy measure that has become known as an indicator of ecological diversity. The degree of diversity is also becoming increasingly popular in the economic context. Based on the traditional three-way division of the banking system into cooperative banks, commercial banks and savings banks, the index is calculated on the basis of the aggregated total assets of these three banking groups in the domestic banking sector. The more equally the respective market shares of the three groups are distributed, the larger the index value becomes. We also test the robustness of the findings by using the Gini-Simpson diversity index (Simpson 1949) (the Herfindahl Index, a more popular concentration measure, is the inverse of the Gini-Simpson index).
Furthermore, we consider the role of competition as a second impact channel that could mediate the link between diversity and stability. In fact, literature often equates high institutional diversity with intense competition. That may or may not be the case. It is well known that individual banks’ pricing leeway is limited in the face of high competition. However, if different types of banks serve different local markets and each have a strong market position, high diversity can certainly go hand in hand with considerable leeway in setting prices. In order to separate the diversity effect from the competitive effect, we include the Lerner Index, which provides a bank-specific measure of competition, as a control variable in the empirical estimation model (Lerner 1934, Gischer, Müller & Richter 2015). Another important control variable is non-interest income, which we use as an indicator of the extent of bank-internal diversification (e.g. Guerry & Wallmeier 2017). In addition to other bank-specific characteristics such as a bank’s total assets, our estimation model also contains a number of country indicators as control variables such as financial deepness (measured as private credit to the bank’s home-country’s GDP) and financial system size (measured as aggregated total assets of the domestic banking system to GDP).
Our main question is the impact of institutional diversity on bank stability in the event of a crisis. The finding here is quite clear for the crisis period 2007-2014: the higher the Shannon index (= diversity), the higher the Z-score (= bank stability). The coefficient of the Shannon index is highly statistically significant. Statistical significance, though weaker, also emerges for the second diversity indicator (Gini-Simpson Index) in the crisis period, so that the positive relationship between institutional diversity and bank stability can be considered robust.
In Germany, this finding coincides with anecdotal evidence from the period following Lehman Brothers’ insolvency in 2008. Local banks, mostly savings banks and cooperative banks, soon became anchors of stability in those turbulent times. Unlike major international banks, the business model of exclusively local savings banks and cooperative banks was largely unaffected by the liquidity drain in international money markets.
Our analysis of the relationship between institutional diversity and the volatility of the return on assets also provides insight on a plausible mechanism for the positive relationship between diversity and stability. We find a significant negative effect of the diversity indicator on the fluctuation range of the ROA for the crisis period. This smoothing effect increases the Z-Score.
Considering the entire observation period from 1998 to 2014, the statistically significant positive relationship between bank stability and diversity remains for the Shannon Index, but not for the alternative Gini-Simpson Index. Bank-internal diversification is negatively linked to bank stability both in the overall sample and especially for the crisis period, as is strong growth in banks’ assets. Yet another result from the literature is confirmed by our estimate: a higher Lerner index (= lower competition) has a significant positive impact on bank stability (e.g. Beck, Jonghe & Schepens 2013, Berger, Klapper & Turk-Ariss 2008). More results and explanations can be found in our paper.
The study complements the literature of institutional banking structure in several ways. Our results suggest that institutional diversity of business models in the banking sector matters. We provide the first quantitative evidence on the link between institutional diversity and bank stability in the Great Financial Crisis. Our findings imply that increasing and maintaining institutional diversity is a valuable precautionary buffer against the adverse consequences of crises and other external shocks. In contrast, increasing the concentration and uniformity in EU countries’ banking systems are not likely to contribute to higher resilience in European banking systems.
Christopher F. Baum is a Professor of Economics and Social Work and Chair of the Economics Department at Boston college.
Caterina Forti Grazzini is a PhD candidate at Freie Universität Berlin/DIW Graduate Center and a Graduate Programme participant at the European Central Bank.
Dorothea Schäfer is the Research Director of Financial Markets at the German Institute for Economic Research (DIW Berlin) and Adjunct Professor of Jönköping International Business School, Jönköping University.
This post is adapted from their paper, “Institutional Diversity in Domestic Banking Sectors and Bank Stability: A Cross-Country Study,” available on SSRN.
 Corresponding author.