The Broadening of Activities in the Financial System: Implications for Financial Stability and Regulation

Conglomeration and consolidation in the financial system broaden the activities financial institutions are undertaking and cause them to become more homogenous.Although resulting diversification gains make each institution appear less risky, we argue that financial stability may not improve as total risk in the financial system remains the same.Stability may even fall as institution' incentives for providing liquidity and limiting their risk taking worsen.Optimal regulation may thus not provide a relief for diversification.However, we also identify important benefits of a broadening of activities.By reducing the differences among institutions, it lowers the need for inter-institutional risk sharing.This mitigates the impact of any imperfections such risk sharing may be subject to.The reduced importance of such risk sharing, moreover, lowers externalities across institutions.As a result, institutions' incentives are improved and there is less need for regulating them.