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Supervision should take the financial sector's heterogeneity into consideration

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Published: 31 May 2018

Zonreflectie gebouw

There are indications of increased homogeneity among banks. More attention should be given to promoting heterogeneity in the financial sector, as this helps to improve financial stability. This is the conclusion of a study into proportional and effective supervision, which DNB published today. A more diverse financial sector reduces the impact of an external shock on financial stability.

Over the past ten years, banking regulation and supervision have become both stricter and more comprehensive. Necessarily so, as post-crisis regulatory reforms were needed to increase the resilience of individual banks while restoring financial stability.

As a result, the risk-absorbing capital of financial institutions has increased significantly, because banks bolstered their capital in terms of both quantity and quality. While higher capital requirements make banks safer, this does not automatically imply that the banking sector as a whole has become less sensitive to risks.

Increasing homogeneity is an important point for concern. A useful pointer in this respect is the heightened correlation between returns on bank stocks. The above chart shows the trend of increasing homogeneity by looking at the correlations between the return on equity of 33 large European banks over three consecutive periods of regulation. The mean correlation between stock returns for these banks increased over time, from 6% in the 2000-2007 Basel I period to 26% in the 2008-2013 Basel II period and 48% in the 2014-2017 Basel III period. Similar changes and increased correlations cannot be seen in other sectors.

Regulation may be one of the factors explaining this. All banks are subject to the same statutory restrictions when optimising their balance sheets. The more numerous and detailed these restrictions are, the more banks' activities may be pushed in the same direction. However, other factors unrelated to regulation may also play a role. Indications of increasing homogeneity must therefore be studied in further detail and closely monitored.

In the Netherlands, homogeneity in the banking sector warrants attention with a view to financial stability. The sector has become substantially less diverse in recent decades. We highlighted this trend in our 2015 report "Perspective on the structure of the Dutch banking sector". Homogeneity among financial institutions is an uncertain factor for financial stability because these institutions are exposed to the same types of risks, and their response to shocks is similar.

The study therefore recommends that increased attention should be devoted to heterogeneity in regulation and supervision. More diversity at a sector level will contribute to reducing systemic risk. One way of achieving this is to promote proportionality in regulation and supervision to facilitate compliance by smaller, less complex or more specialised banks. The study published today lists recommended actions aimed at improving proportionality in regulation and supervision and reducing the regulatory burden. More generally, identification of anticipated and unanticipated responses to new rules should be an integral part of the regulatory design process.

Proportional and effective supervision

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