Meeting report
Does Business Model Instability Imperil Banks’ Stability? Evidence from Europe

Time: May 24, 2017 – 11:00 am to 12:00 pm
Place: HEC Montréal, Montréal

Presented by Valerio Pesic, Professor, Department of Management, Sapienza University, Rome

In the years prior to the Great Financial Crisis (GFC), banking business metamorphosed from being the economy’s most regulated and traditional sector into one of the most dynamic casino-like and increasingly better paid jobs. Bank profitability jumped from the usual 5% or so to beyond 10% or even 25% at some banks. With hindsight, the GFC of 2007-2009 was a sudden wake up call to the tough reality that those profitability levels were unsustainable as they held risks, which were largely unmanageable by the banks themselves. Indeed, too often banks achieved high profits by changing their business approach and taking excessive risks, largely not accounted in the regulatory metrics. One of the main lessons to be learned is that a bank’s performance cannot be based only on its profitability. One must consider how much risk is associated to that profitability. Analytically, the Z-score proposed in 1968 by Ed Altman is one of the most accepted approximations to measure risk-adjusted performance. Z-score is, in fact, also labeled “distance to default”. This paper investigates what happens to its Z-score when a bank switches its business model. Building on the research by Ayadi et al. (2016) that identifies business models of banks in Europe, our empirical analyses deliver clear indications that, controlling for various other determinants, banks business model stability increases the overall bank stability, or soundness, whilst banks switching their business model are 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 supervisor.