The Two Faces of Interbank Correlation

Abstract: We decompose the correlation of bank stock returns into a systemic risk component and a component arising from diversification activities. Estimation for U.S. Bank Holding Companies (BHCs) shows the diversification component to be large and positively related to BHC performance during the crisis of 2007-2009. This suggests that it is important to distinguish between the two sources of interbank correlations when quantifying systemic risk at banks. Our decomposition also permits us to estimate the marginal gains from diversification, which turn out to be rapidly declining with bank size. Since large banks are additionally found to display high levels of the systemic risk component, they are hence predominantly exposed to the undesirable source of interbank correlation.