Systemic Risk and Portfolio Diversification: Evidence from the Futures Market

Studies link the systemic risk of banks to their use of derivatives. A greater use of derivatives has been part of a shift in banks' business models away from traditional lending toward the use of trading to generate income. This new business model has created new interlinkages and stronger comovements among banks. Derivatives trading creates a common exposure channel because it makes banks more vulnerable to simultaneous losses. This paper explores how the Canadian futures market contributed to systemic risk by causing simultaneous trading losses across Canadian banks during the 2008 financial crisis.

The paper accomplishes four main goals.

1. It breaks down observed portfolio comovements into two drivers—portfolio similarity and cross-price correlations—and explores the magnitude of each.
2. It compares the effect of portfolio similarity on portfolio returns for core versus non-core banks.
3. It breaks down portfolio similarity into two drivers—portfolio concentration and portfolio diversification.
4. It explores how these two variables evolved around the 2008 crisis.

The findings show that core banks as a whole traded against the periphery, increasing their risk of simultaneous losses. For core banks, futures returns moved together because of similar portfolios; however, for non-core banks, comovements were due mostly to cross-price correlations. Overall, core banks were more diversified than non-core banks, but those among them with more concentrated positions had higher systemic risk. Core banks were also overall more similar in their diversification. By contrast, non-core banks were more concentrated than core banks, but also had a smaller portfolio overlap. This nuances how we understand concentration versus diversification as systemic risk sources in derivatives markets, showing that both may play a role, but for different types of banks.