Banking Stability: The Impact of Financial Sector Heterogeneity on Systemic Risk in Financial Crises and Economic Recessions

Financial institutions heterogeneity, a high degree of dissimilarity across multiple dimensions, including business focuses, correlated asset holdings, capital structures, and funding sources, reduces systemic risk. We empirically test this hypothesis using a bank holding company (BHC) level heterogeneity index based on granular balance-sheet, income statements, cash flow statements, and off-balance-sheet information for the U.S. bank holding companies over a sample period spanning the second quarter of 2000 to the fourth quarter of 2021. We find that the BHC-level heterogeneity negatively correlates with BHC-level systemic risk, SRISK, measured both at the global and local level. We also construct a sector-heterogeneity index and demonstrate that a reduction of heterogeneity occurred in the U.S. financial sector prior to both the Great Recession (2007-2009) and the COVID-19 Recession, especially for the largest bank holding companies (BHCs). As such, a declining level of financial sector heterogeneity can be an early warning signal of economic recessions.