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Does Business Model Instability Imperil Banks’ Soundness? Evidence from Europe

Rym Ayadi, Giovanni Ferri, Valerio Pesic
July / August 2018 - n. 7-8
Jel codes: G2, G21, G28

In the years prior to the Great Financial Crisis, banking business metamorphosed from being the economy’s most regulated and traditional sector into one of the most dynamic casino-like. Bank profitability jumped from the usual 5% or so to beyond 10% or even 25% at some banks. Those profitability levels were unsustainable as they hid risks. Indeed, too often banks achieved high profits by changing their business approach and taking excessive risks, largely not accounted in the regulatory metrics. This paper investigates what happens to its risk-adjusted performance, measured by its Z-score, that identifies business models of banks in Europe, our empirical analyses deliver clear indications that, banks business model stability increases the overall bank soundness, whilst banks switching their business model get seemingly closer to default. The policy implication is that business model switching may lead banks to undertake new risks they are unprepared for. As such, regulators and supervisors should generally avoid promoting business model change and pay special attention when a bank switches its business model.

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