The Interaction between Risk, Return-Risk Trade-Off and Complexity: Evidence and Policy Implications for US Bank Holding Companies

Abstract

This paper examines two aspects of bank risk with a particular emphasis on examining the interaction between them. Moreover, throughout the analysis we differentiate between non-complex and complex banks, the latter of which could be seen as holding a further level of risk. We wish to establish how these risk behaviours interact with bank specific, market structure and economic factors. Key results indicate that earnings volatility (business risk) increases with market power but decrease with size and output. While risk-taking (managerial risk) decreases with market power and increases with size and output. Furthermore, in examining return per unit of risk, results demonstrate that increase return and risk-taking is associated with bank specific factors and the economic environment, whereas decreased risk taking is associated with market structure. This suggests a management of risk, which increases around factors under bank control or improving external environment but decreases with the interaction of competitors. Overall, the results suggest that policy should focus on liquidity and equity buffers that should operate counter-cyclicality but size and market structure per se are not determining factors for higher risk. In terms of the recent financial crisis, it is likely that the great moderation that proceeded it lead to higher risk-taking due to higher economic growth but without the necessary buffers being built up.

Keywords: Banks, Risk, Earnings, Volatility, Risk-Return, Complex, Prospect Theory, Market Structure, Sharpe Ratio

JEL Classification: C23, G21