Bank activity and funding strategies : the impact on risk and returns

This paper examines the implications of bank activity and short-term funding strategies for bank risk and returns using an international sample of 1,334 banks in 101 countries leading up to the 2007 financial crisis. Expansion into non-interest income generating activities such as trading increases the rate of return on assets, and it may offer some risk diversification benefits at very low levels. Non-deposit, wholesale funding, by contrast, lowers the rate of return on assets, although it can offer some risk reduction at commonly observed low levels of non-deposit funding. A sizeable proportion of banks, however, attract most of their short-term funding in the form of non-deposits at a cost of enhanced bank fragility. Overall, banking strategies that rely prominently on generating non-interest income or attracting non-deposit funding are very risky, which is consistent with the demise of the U.S. investment banking sector.