Author(s):
Priyank Gandhi and Amiyatosh Purnanandam
Date:
June 2022
Abstract:
We show that the U.S. commercial banks have become increasingly similar in their risk exposure after the global financial crisis. Pairwise correlation in bank equity returns increased threefold after the enactment of annual stress tests under the Dodd-Frank Act (DFA). Non-financials and non-bank financial firms do not exhibit such a pattern, and within banks, the pattern is stronger for the stress-tested banks. We develop a theoretical model to derive conditions under which stress tests can increase commonality across banks. Consistent with the model, the sensitivity of banks’ equity returns to macroeconomic factors and their asset holdings have become similar after the DFA. Moreover, after a bank fails the stress test, its portfolio becomes similar to other banks, providing a causal interpretation of our results. Finally, the stress tests’ results across banks have become similar over time. Our findings raise concerns about correlated risk in the system and the cost of future bank failures through correlated fire-sale.
Link: United They Fall: Bank Risk after the Financial Crisis