The origin of financial instability and systemic risk: Do bank business models matter?

Using a large sample of European listed banks, we investigate the relationship between a bank’s business model and systemic risk between 2005 and 2020, a period which includes various episodes of instability. Our findings indicate that, during tranquil periods, banks with different business models exhibit similar sensitivity to systemic risk. However, during periods of instability, the type of business model becomes critical: investment banks contribute more to and are more exposed to systemic risk. Distinguishing between endogenous and exogenous crises, our results reveal that market-oriented banks contribute more to systemic risk when instability is endogenous to the financial sector. Conversely, focused retail banks consistently show lower contributions and exposures to systemic risk. Additionally, our findings highlight the importance of business model migrations in reducing systemic risk. Banks transitioning from diversified to more retail-oriented models reduce their systemic risk, whereas migrations in the opposite direction do not exhibit the same benefit. These findings underscore the importance of maintaining diverse business models in the banking sector to enhance financial stability. • The study investigates the relationship between a bank’s business model and systemic risk. • During tranquil periods, banks with different business models exhibit similar sensitivity to systemic risk. • During periods of instability, investment banks contribute more to and are more exposed to systemic risk. • Market-oriented banks contribute more to systemic risk when instability is endogenous to the financial sector. • Focused retail banks show lower contributions to and exposures to systemic risk across different crisis periods.