eThesis - School of Business electronic theses

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PURPOSE AND MOTIVATION: The purpose of this study is to examine the effect functional diversification on the credit risk of financial institutions. The focus is on whether financial institutions should be allowed to combine commercial banking and investment banking functions under one financial conglomerate. Under current regulators financial institutions are allowed to combine the functions, however regulators are considering driving regulation towards separating commercial and investment banking. This study sheds light on whether the contemplated separation of investment and commercial banking increases or decreases the credit risk of financial institutions.

DATA AND METHODS: The data sample of his study consists of 51 financial institutions from Europe and the US, with a time span ranging from 2007 to 2014. Functional diversification is measured using income and asset based measures, collected from the annual financial statements of the financial institutions. Credit risk is measured with the financial institution level credit default swap (CDS) spreads and the CDS spread difference with banking sector CDS index spreads. The impact of functional diversification on credit risk is examined with multiple panel data regressions, where the credit risk of financial institutions is explained with the functional diversification measures and a set of control variables. Furthermore, multiple robustness checks are developed.

FINDINGS: Based on the results, functional diversification decreases the credit risk of financial institutions at the financial institution credit risk level and compared with the average credit risk in the banking sector. The results are confirmed with multiple robustness checks. Based on the results the contemplated separation of commercial and investment banking with new regulation can have grave consequences. Separating the two functions would decrease functional diversification increasing the credit risk of financial institutions and the probability of financial institution failures.