DP7170 Bank Activity and Funding Strategies: The Impact on Risk and Return

Author(s): Asli Demirguc-Kunt , Harry Huizinga

Publication Date: February 2009

Keyword(s): bank fragility , financial crisis , non-interest income share , universal banking , wholesale funding

JEL(s): G1 , G21 , G28

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP7170.asp.asp

This paper examines the implications of bank activity and short-term funding strategies for bank risk and return using an international sample of 1334 banks in 101 countries leading up to the 2007 financial crisis. Expansion into non-interest income generating activities such as trading increases the rate of return on assets, and it may offer some risk diversification benefits at very low levels. Non-deposit, wholesale funding in contrast lowers the rate of return on assets, while it can offer some risk reduction at commonly observed low levels of non-deposit funding. A sizeable proportion of banks, however, attract most of their short-term funding in the form of non-deposits at a cost of enhanced bank fragility. Overall, banking strategies that rely prominently on generating non-interest income or attracting non-deposit funding are very risky, consistent with the demise of the U.S. investment banking sector.