۱- Introduction

۲- Background, data, and suggestive evidence

۳- The repeal of the GSA as a natural experiment

۴- Evidence from the natural experiment

۵- Other robustness checks

۶- Conclusion

References

Abstract

Recent regulatory proposals tie a financial institution’s systemic importance to its complexity. However, little is known about how complexity affects banks’ risk management. Using the 1996–۱۹۹۹ deregulations of U.S. banks’ nonbanking activities as a natural experiment, we show that banks’ business complexity increases their operational risk. This result is driven by banks that had been constrained by regulations, compared with other banks and also with nonbank financial institutions that were never subject to these regulations. We provide evidence that managerial failure underlying these events offsets benefits of strategic risk taking.

Introduction

The recent financial crisis has catapulted the regulation of complex financial institutions to the center of policy debate. The business complexity of U.S. bank holding companies (BHCs) has increased significantly since late 1990s due to their aggressive expansion into nonbanking activities. This expansion has been driven primarily by the Gramm-Leach-Bliley Act (GLBA) of 1999, which removed the restrictions on business activities imposed under the Glass-Steagall Act (GSA) of 1933, including securities underwriting and trading. Using the passage of GLBA as a natural experiment, we find that banks’ increased complexity due to expansion into nonbanking activities has caused a deterioration of banks’ operational risk management. This effect is driven by BHCs that were particularly constrained by pre-GLBA regulations, i.e., those BHCs that dealt in bank-ineligible securities through their heavily regulated Section 20 investment banking subsidiaries. The term complexity can be related to different concepts (Cetorelli and Goldberg, 2014), including business diversification, geographic diversification, and network interconnectedness. We follow the guidelines provided by the Bank for International Settlements (BIS) and the Federal Reserve, which relate complexity to the activities of banks outside the traditional business of banking and strictly separate it from other measures, such as interconnectedness, geographic activity, and size (BCBS, 2014a; BGFRS, 2015).