The Homogenization of the Financial System and Financial Crises
CentER Discussion Paper Series No. 2006-72
36 Pages Posted: 11 Nov 2005 Last revised: 30 Oct 2010
Date Written: January 10, 2008
Financial institutions have reached beyond their traditional activities in recent years and have become more homogenous as a result. We show that, although the resulting diversification gains make institutions appear individually less risky, financial stability does not necessarily improve since the total risks in the financial system may remain unchanged. Stability may even fall because institutions' incentives for holding liquidity and limiting their riskiness deteriorate following diversification. Optimal regulation may hence not provide a relief for diversification. However, there are also important benefits of this development. When financial institutions become more homogenous, the need for inter-institutional risk sharing decreases. The impact of any imperfections such risk sharing may be subject to is hence mitigated. Moreover, institutions then need to rely less on such risk sharing, which reduces externalities among them and lessens the need for regulating them.
Keywords: conglomeration, consolidation, homogenization, financial crises, regulation, welfare
JEL Classification: G21, G28
Suggested Citation: Suggested Citation