Business Complexity and Risk Management: Evidence from Operational Risk Events in U.S. Bank Holding Companies 
The recent financial crisis has catapulted the regulation of large, complex financial institutions to the center of policy debate. Although regulators have recently proposed complexity as one of the main criteria for the designation of a bank as systemically important, we have very little evidence as to how complexity affects risk management in financial institutions. This issue is further complicated by the lack of a clear definition of complexity. In this paper, the authors follow the guidelines provided by the Bank for International Settlements (BIS), which describe complexity as the activities of banks outside of the traditional business of banking and strictly separate it from other measures such as interconnectedness and size. Based on these guidelines, the authors use the gradual deregulation of banks' nonbank activities in the United States between 1996 and 1999 as a natural experiment that has led to increased complexity in the banking system.
Key Findings
- The frequency and magnitude of operational risk events in U.S. bank holding companies (BHCs) increased significantly following the deregulation.
- This trend is particularly strong for banks that had already engaged in regulated activities but were bound by regulations, making them more likely to take advantage of the deregulation by increasing their diversification into such previously regulated activities. This result holds in comparison both with banks that did not engage in regulated activities before the deregulation and with nonbank financial institutions that were never subject to these regulations in the first place.
Exhibits
Implications
The results suggest that the increased complexity due to expansion into nonbank business lines leads to a deterioration of banks' risk management and to higher operational risk. These results reveal the darker side of post-deregulation diversification, which in earlier studies has been shown to lead to improved stock and earnings performance. These findings have important implications for the regulation of financial institutions deemed systemically important, a designation tied closely to their complexity by the Bank for International Settlements and by the Federal Reserve.
Abstract
How does business complexity affect risk management in financial institutions? The commonly used risk measures rely on either balance-sheet or market-based information, both of which may suffer from identification problems when it comes to answering this question. Balance-sheet measures, such as return on assets, capture the risk when it is realized, while empirical identification requires knowledge of the risk when it is actually taken. Market-based measures, such as bond yields, not only ignore the problem that investors are not fully aware of all the risks taken by management due to asymmetric information, but are also contaminated by other confounding factors such as implicit government guarantees associated with the systemic importance of complex financial institutions. To circumvent these problems, we use operational risk events as a risk management measure because (i) the timing of the origin of each event is well identified, and (ii) the risk events can serve as a direct measure of materialized failures in risk management without being influenced by the confounding factors that drive asset prices.
Using the gradual deregulation of banks' nonbank activities during 1996–1999 as a natural experiment, we show that the frequency and magnitude of operational risk events in U .S. bank holding companies have increased significantly with their business complexity. This trend is particularly strong for banks that were bound by regulations beforehand, especially for those with an existing Section 20 subsidiary, and weaker for other banks that were not bound and for nonbank financial institutions that were not subject to the same regulations to begin with. These results reveal the darker side of post-deregulation diversification, which in earlier studies has been shown to lead to improved stock and earnings performance. Our findings have important implications for the regulation of financial institutions deemed systemically important, a designation tied closely to their complexity by the Bank for International Settlements and the Federal Reserve.