Discrete Dynamics in Nature and Society
Volume 2016 (2016), Article ID 2967830, 5 pages
http://dx.doi.org/10.1155/2016/2967830

Research Article

Does Diversification Affect Banking Systemic Risk?

Shouwei Li

School of Economics and Management, Southeast University, Nanjing 211189, China

Received 14 July 2016; Accepted 6 November 2016

Academic Editor: Ricardo López-Ruiz

Copyright © 2016 Shouwei Li. This is an open access article distributed under the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.

Abstract.

This paper contributes to the understanding of the linear and nonlinear causal linkage from diversification to banking systemic risk. Employing data from China, within both linear and nonlinear causality frameworks, we find that diversification does not embody significant predictive power with respect to banking systemic risk.

1. Introduction

The 2007–2009 financial crisis has shed light on the significance of systemic risk and has made the concern about systemic risk increased by academics, regulatory bodies, and central banks. There is a growing literature on systemic risk. It mainly analyzes two aspects of systemic risk: the measure of systemic risk [1–3] and factors that may cause changes in the level of systemic risk, such as hedge funds [4], the opaque [5], financial system consolidation [6], and network structures [7–10].

It is well known that individual risk can be reduced through diversification [11]. However, the relationship between diversification and systemic risk is less commonly known [12]. And it is widely accepted that diversification at financial institutions benefits the stability of the financial system [13]. In fact, diversification has its costs. It enables institutions to become more similar to each other and hence systemic risk becomes more likely, which is the dark side of diversification [12, 13]. In the case of full diversification or full risk sharing, Shaffer [14] and Ibragimov et al. [15] find that diversification may benefit individual institutions but often increases systemic risk. Wagner (2010) shows that any degree of diversification increases systemic risk. Raffestin [16] also confirms the negative effect of diversification and goes more in depth by considering any level of diversification and any number of failures.

The above theoretical findings reveal the negative effect of diversification on systemic risk. Based on the linear and nonlinear causality tests, in this paper we aim to examine whether there is the causal relationship from diversification to banking systemic risk by using data from the Chinese banks. In fact, systemic risk is a complex phenomenon [17, 18]. In this paper, we focus on analyzing it from a technical-econometric point of view, which is useful to understand it from a different perspective. Similar to some studies [19–23], in this paper we measure banking systemic risk based on Contingent Claims Analysis. However, the purpose of this paper is different from theirs, and the novelties of this paper are as follows: the causal relationship from diversification to banking systemic risk is empirically tested; the causality tests are conducted within both linear and nonlinear frameworks; we conduct an empirical analysis for Chinese banking sector. After this introduction, Section 2 describes the methodology. Section 3 presents the data and empirical results, while Section 4 provides a conclusion.

2. Methodology

2.1. Diversification Measures

In this paper, the diversification indicator is calculated from the perspective of banks’ profitability. There are different calculation methods for diversification of banks (e.g., [24–26]). We adopt the method proposed by Elsas et al. (2010). Moreover, we use the unweighted average diversification of banks () and the weighted average diversification of banks () to measure banking diversification, where the weight is the individual market-capital weight. Elsas et al. (2010) classify bank’s non-interest-related activities into net commission revenue, net trading revenue, and all other net revenue and illustrate the diversification indicator of bank at time as follows:

where denotes gross interest revenue, net commission revenue, net trading revenue, and all other net revenue, respectively. indicates total operating revenue, which is equal to the sum of the absolute values of , and .

2.2. Systemic Risk Measures

In this paper, we measure banking systemic risk based on Contingent Claims Analysis (CCA). It is a framework that combines market-based and balance sheet information to obtain financial risk indicators, such as Distance-to-Default (DD), probabilities of default, risk-neutral credit risk premia, and expected losses on senior debt [20]. The CCA approach has been adopted to investigate banking systemic risk based on aggregated DD series [19–23]. Therefore, we also use the unweighted average DD series () and weighted average DD series () to measure banking systemic risk, where the weight is the individual market-capital weight.

Similar to Singh et al. (2014), , the distance-to-default of bank at time , is calculated from the following equations:

where is the value of bank assets, the time horizon of debt, the face value of the debt, the volatility of bank assets, the risk-free rate, the market value of bank equity capital, and the volatility of bank equity capital, respectively.

2.3. Linear and Nonlinear Granger Causality Tests

Granger [27] defines causality between two variables in terms of predictability. The linear causal relationship between two variables can be tested within a VAR framework, where the null hypothesis of no causality is tested via the significant contribution that past values of one variable can offer in predicting current values of another [28]. Since the linear Granger causality test cannot capture nonlinear and higher order causal relationships [29], we further consider a nonlinear Granger causality test, which was developed by Baek and Brock [30] and modified by Hiemstra and Jones [31]. Under certain variance conditions, Diks and Panchenko [32] find that the Hiemstra-Jones (HJ) test could overreject the null hypothesis. To compensate this shortcoming, Diks and Panchenko (2006) propose a new test statistic (hereafter DP test). In this paper we adopt the DP test to check the nonlinear Granger causality.

Suppose and are both strictly stationary time series, and . In the null hypothesis that does not Granger cause , Diks and Panchenko (2006) find that there is the following equation:

where is the probability density function. Let indicate the local density estimators of a -variate random vector at by

where ; is an indicator function and is the presetting bandwidth depending on the sample length . Then, the new test statistic can be expressed as

Diks and Panchenko (2006) demonstrate that converges to the standard normal distribution under certain conditions.

3. Data and Empirical Results

3.1. Data and Preliminary Analysis

Considering the difference of the listed times, in this paper we analyze 14 listed banks in China, where their stock codes are 600000.SH, 600015.SH, 600016.SH, 600036.SH, 601009.SH, 601166.SH, 601169.SH, 601328.SH, 601398.SH, 601939.SH, 601988.SH, 601998.SH, 000001.SZ, and 002142.SZ, respectively. Data employed in this paper stem from the Wind Database and the quarterly reports of banks, where the Wind Database is a leading integrated service provider of financial data in China. The time interval is from October 2007 to June 2014. In this paper, is one year; is total liabilities of banks; is set as the one-year deposit interest rate during the trading period; is calculated as the standard deviation of daily equity logarithmic returns multiplied by the square root of the number of trading days in a month. In addition, similar to Gropp and Moerman [33], Blundell-Wignall and Roulet [34], and Saldías (2013), the data from the quarterly reports of banks are interpolated to yield monthly observations by using a cubic spline. Through the calculation, the results of banking diversification and systemic risk are obtained and shown in Figures 1 and 2, respectively.

Figure 1: Banking diversification based on and .

Figure 2: Banking systemic risk based on and .

3.2. Empirical Results

Before conducting the linear and nonlinear Granger causality tests, we apply Augmented Dickey-Fuller (ADF) test and Phillips-Perron (PP) test to analyze whether there are unit roots for all of the four variables, namely, , and . Table 1 illustrates the test results. In every case, we reject the null hypothesis of a unit root for the two tests. Obliviously, all of the variables are stationary and thus suitable for further statistical analysis with linear and nonlinear Granger causality tests.

Table 1: Descriptive statistics, ADF, and PP tests.

Mean
0.2033
0.2481
9.1082
12.1065

Max.
0.3387
0.3494
15.8531
21.7681

Min.
0.1712
0.1920
2.2956
2.7469

Std. Dev.
0.0261
0.0254
3.0371
4.4227

ADF-statistic
−3.9769 (0.0025)
−3.5122 (0.0105)
−4.9869 (0.0001)
−5.3665 (−0.0000)

PP-statistic
−5.7817 (0.0000)
−4.9423 (0.0001)
−5.1851 (0.0000)
−5.5970 (−0.0000)

Notes: the numbers in parentheses refer to the values.

We first investigate whether there is the linear causal relationship from diversification to banking systemic risk, by implementing the standard Granger causality test [27]. The results are reported in Table 2. They reveal that the null hypothesis of linear causality running from diversification to banking systemic risk is never rejected for both tests. Therefore, there is no linear causality running from diversification to banking systemic risk.

Table 2: Linear Granger causality tests.

Null hypothesis examined
VAR lag length
-statistic
value

does not Granger cause
3
0.7397
0.5319

does not Granger cause
5
0.4252
0.8295

Notes: the VAR lag lengths were selected based on the Schwartz Information Criterion (SIC).

Before testing for nonlinear Granger causality, we conduct the Brock-Dechert-Scheinkman (BDS) test to investigate whether the residual series are characterized by nonlinearities, where the residual series are from VAR models. We estimate the VAR model with the endogenous variables , and , respectively, where the lag of the VAR model is set based on Schwartz Information Criterion. We use these residual series so that any linear predictive power has been removed. Table 3 displays the results of the BDS tests. We can see from it that nonlinearities are in diversification and systemic risk. Such result signifies that nonlinear Granger causality test is appropriate in our study.

Table 3: BDS tests for nonlinearity.

Dimension

2
−3.8423 (0.0001)
−0.6427 (0.5204)
−9.1869 (0.0000)
1.5600 (0.1187)

3
−0.4873 (0.6260)
−13.3144 (0.0000)
7.8086 (0.0000)
−15.3745 (0.0000)

4
9.3044 (0.0000)
−7.8907 (0.0000)
9.5483 (0.0000)
−9.0653 (0.0000)

5
13.2436 (0.0000)
−5.1281 (0.0000)
3.0661 (0.0022)
−5.9859 (0.0000)

6
9.5288 (0.0000)
−4.9559 (0.0007)
−1.4166 (0.0860)
−4.1693 (0.0000)

Notes: each column represents the test results of the VAR residuals for the corresponding variable as the dependent variable. The numbers represent the -statistics and those in parentheses are the values.

Now we conduct the nonlinear causality test. Based on the standardized residuals of VAR models, we set the bandwidth as 1.5 and the embedding dimensions as 1 to 8, where the empirical results from the DP test are presented in Table 4. It can be seen from Table 4 that the null hypothesis of no nonlinear Granger causality from diversification to banking systemic risk is not rejected. Therefore, there is no nonlinear causality running from diversification to banking systemic risk.

Table 4: Nonlinear Granger causality tests.

Embedding dimension
: does not cause
: does not cause

DP statistic ( value)
DP statistic ( value)

1
−1.2210 (0.8889)
−1.5430 (0.9386)

2
−0.9050 (0.8172)
−0.9670 (0.8332)

3
−1.0380 (0.8503)
−0.0640 (0.5254)

4
−1.2460 (0.8936)
−0.3470 (0.6357)

5
0.0450 (0.4820)
−0.3320 (0.6300)

6
−0.3640 (0.6422)
−0.2410 (0.5952)

7
−0.5360 (0.7041)
0.3320 (0.3700)

8
−0.0580 (0.5271)
1.0420 (0.1486)

Notes: the DP statistic is generated based on Diks and Panchenko (2006) methodology.

4. Conclusion

Recently, the negative effect of diversification on systemic risk is analyzed in the some literature. This paper adopts both linear and nonlinear Granger causality tests to examine whether there is the causal relationship from diversification to banking systemic risk. Based on the banking data from China, our empirical findings reveal that there is no linear or nonlinear causal relationship from diversification to banking systemic risk. A possible reason is that banking systemic risk is largely derived from the cyclical fluctuations of the macroeconomy, while diversification mainly affects banking nonsystemic risk. Overall, our results show that diversification does not affect banking systemic risk in China.

Competing Interests

The author declares that there is no conflict of interests regarding the publication of this paper.

Acknowledgments

This research is supported by NSFC (no. 71201023, no. 71371051, no. 71301078, and no. 71671037), Humanities and Social Science Planning Foundation of the Ministry of Education of China (no. 16YJA630026), Teaching and Research Program for Excellent Young Teachers of Southeast University (no. 2242015R30021), the Fundamental Research Funds for the Central Universities (no. 2242016K40118), and Social Science Fund Project of Jiangsu Province (no. 15GLC003).

References

A. Hattori, K. Kikuchi, F. Niwa, and Y. Uchida, “A survey of systemic risk measures: methodology and application to the Japanese market,” Tech. Rep. 14-E-03, Institute for Monetary and Economic Studies, Bank of Japan, 2014.

J. C. Reboredo and A. Ugolini, “Systemic risk in European sovereign debt markets: a CoVaR-copula approach,” Journal of International Money and Finance, vol. 51, pp. 214–244, 2015.

L. Black, R. Correa, X. Huang, and H. Zhou, “The systemic risk of European banks during the financial and sovereign debt crises,” Journal of Banking and Finance, vol. 63, pp. 107–125, 2016.

R. J. Bianchi and M. E. Drew, “Hedge fund regulation and systemic risk,” Griffith Law Review, vol. 19, no. 1, pp. 6–29, 2010.

J. S. Jones, W. Y. Lee, and T. J. Yeager, “Opaque banks, price discovery, and financial instability,” Journal of Financial Intermediation, vol. 21, no. 3, pp. 383–408, 2012.

G. N. F. Weiß, S. Neumann, and D. Bostandzic, “Systemic risk and bank consolidation: international evidence,” Journal of Banking and Finance, vol. 40, no. 1, pp. 165–181, 2014.

E. Nier, J. Yang, T. Yorulmazer, and A. Alentorn, “Network models and financial stability,” Journal of Economic Dynamics and Control, vol. 31, no. 6, pp. 2033–2060, 2007.

S. Lenzu and G. Tedeschi, “Systemic risk on different interbank network topologies,” Physica A: Statistical Mechanics and Its Applications, vol. 391, no. 18, pp. 4331–4341, 2012.

N. Hautsch, J. Schaumburg, and M. Schienle, “Financial network systemic risk contributions,” Review of Finance, vol. 19, no. 2, pp. 685–738, 2015.

A. Capponi and P.-C. Chen, “Systemic risk mitigation in financial networks,” Journal of Economic Dynamics and Control, vol. 58, pp. 152–166, 2015.

H. Markowitz, “Portfolio selection,” The Journal of Finance, vol. 7, no. 1, pp. 77–91, 1952.

M. R. C. Van Oordt, “Securitization and the dark side of diversification,” Journal of Financial Intermediation, vol. 23, no. 2, pp. 214–231, 2014.

W. Wagner, “Diversification at financial institutions and systemic crises,” Journal of Financial Intermediation, vol. 19, no. 3, pp. 373–386, 2010.

S. Shaffer, “Pooling intensifies joint failure risk,” Research in Financial Services, vol. 6, pp. 249–280, 1994.

R. Ibragimov, D. Jaffee, and J. Walden, “Diversification disasters,” Journal of Financial Economics, vol. 99, no. 2, pp. 333–348, 2011.

L. Raffestin, “Diversification and systemic risk,” Journal of Banking and Finance, vol. 46, no. 1, pp. 85–106, 2014.

C. Koehler, The Relationship between the Complexity of Financial Derivatives and Systemic Risk, 2011.

R. Herring and J. Carmassi, “Complexity and systemic risk: what’s changed since the crisis?” in The Oxford Handbook of Banking, A. N. Berger, P. Molyneux, and J. O. S. Wilson, Eds., Oxford University Press, Oxford, UK, 2nd edition, 2014.

International Monetary Fund, Global Financial Stability Report: Grapping with Crisis Legacies, International Monetary Fund, Washington, DC, USA, 2011.

M. Saldías, “Systemic risk analysis using forward-looking distance-to-default series,” Journal of Financial Stability, vol. 9, no. 4, pp. 498–517, 2013.

K. Harada, T. Ito, and S. Takahashi, “Is the Distance to Default a good measure in predicting bank failures? A case study of Japanese major banks,” Japan and the World Economy, vol. 27, pp. 70–82, 2013.

M. K. Singh, M. Gómez-Puig, and S. Sosvilla Rivero, Forward Looking Banking Stress in EMU Countries, 2014.

S. Li, Q. Pan, and J. He, “Impact of systemic risk in the real estate sector on banking return,” SpringerPlus, vol. 5, no. 1, pp. 1–9, 2016.

K. J. Stiroh and A. Rumble, “The dark side of diversification: the case of US financial holding companies,” Journal of Banking & Finance, vol. 30, no. 8, pp. 2131–2161, 2006.

L. Laeven and R. Levine, “Is there a diversification discount in financial conglomerates?” Journal of Financial Economics, vol. 85, no. 2, pp. 331–367, 2007.

R. Elsas, A. Hackethal, and M. Holzhäuser, “The anatomy of bank diversification,” Journal of Banking and Finance, vol. 34, no. 6, pp. 1274–1287, 2010.

C. W. J. Granger, “Investigating causal relations by econometric models and cross-spectral methods,” Econometrica, vol. 37, no. 3, pp. 424–438, 1969.

T. Dergiades, G. Martinopoulos, and L. Tsoulfidis, “Energy consumption and economic growth: parametric and non-parametric causality testing for the case of Greece,” Energy Economics, vol. 36, pp. 686–697, 2013.

H. Chen, J. D. Cummins, K. S. Viswanathan, and M. A. Weiss, “Systemic risk and the interconnectedness between banks and insurers: an econometric analysis,” Journal of Risk and Insurance, vol. 81, no. 3, pp. 623–652, 2014.

E. Baek and W. Brock, “A general test for nonlinear Granger causality: Bivariate Model,” Madison Working Paper, Iowa State University and University of Wisconsin, 1992.

C. Hiemstra and J. D. Jones, “Testing for linear and nonlinear Granger causality in the stock price-volume relation,” The Journal of Finance, vol. 49, no. 5, pp. 1639–1664, 1994.

C. Diks and V. Panchenko, “A new statistic and practical guidelines for nonparametric Granger causality testing,” Journal of Economic Dynamics and Control, vol. 30, no. 9-10, pp. 1647–1669, 2006.

R. Gropp and G. Moerman, “Measurement of contagion in banks' equity prices,” Journal of International Money and Finance, vol. 23, no. 3, pp. 405–459, 2004.

A. Blundell-Wignall and C. Roulet, “Business models of banks, leverage and the distanceto-default,” Financial Market Trends, vol. 2, pp. 1–29, 2012.