Three Decades of Financial Sector Risk
61 Pages Posted: 16 Mar 2006
Date Written: April 2006
This paper examines the evolution of risk in the U.S. financial sector using firm-level equity market data from 1975 to 2005. We find that over the past three decades, financial sector volatility has steadily increased, particularly from 1998 to 2002. Increased volatility, driven by common shocks and rising cross-industry correlations within the financial sector, suggests that the financial services industry has indeed become riskier. At a fundamental level, this likely reflects the deregulation and financial innovation that have enabled financial institutions to evolve towards a greater mix of riskier assets with common exposures as they exploit their diversification gains. This upward trend in volatility was exacerbated by a series of large shocks from 1998 to 2002. The period since 2002, however, has been relatively quiescent and suggests the extraordinary volatility from 1998 to 2002 had an important transitory component.
We also examine how the evolution of the financial sector compares to the rest of the market. In addition to growing in relative importance, we show that the volatility of the financial sector has increased in both absolute and relative terms. The correlation between the financial sector and non-financial sector, however, has been declining. This suggests that financial shocks have not been transmitted to the rest of the economy, which is consistent with the classical view that finance is primarily a "veil" that has little effect on the real economy. This suggests that shocks to the financial sector, while not unimportant, may not have the severe negative consequences that some fear.
Despite the recent decline in volatility, our results offer some cause for concern. Even as firms become more diversified, the U.S. financial sector appears riskier than in the past as larger firms are increasingly exposed to common shocks. This raises the possibility of systemic risk if all firms respond similarly to market events and makes the collapse of a major financial institution more likely to lead to a more significant financial crisis, i.e., the tail event described by Rajan (2005). While such a scenario is not likely in any given year, the economy may be more vulnerable to this type of widespread financial crisis.
Keywords: Financial Services and Risk
JEL Classification: G20, G10
Suggested Citation: Suggested Citation