September 2020 issue contents
Systemic risk and the Fallacy of Composition: Empirical Evidence from Japanese Regional Bank

Naohisa Hirakata,a Yosuke Kido,b and Jie Liang Thumc


We examine a sample of Japanese regional banks and explore whether exposure to market risk factors affects systemic risk through banks' portfolio composition or revenue source, using Adrian and Brunnermeier's (2016) CoVaR to proxy for systemic risk. We find that the securities investment and fee- and commission-related activities of Japanese regional banks exert positive and significant effects on systemic risk by generating higher co-movement among banks, even though they reduce standalone bank risk through portfolio diversification. Further, the marginal effect of an increase in common risk factors on systemic risk is larger when other banks are already highly exposed to common risk factors. We interpret the results as suggestive of "fallacy of composition," since the behavior of individual banks could be individually optimal but collectively has an unwelcome systemic effect. Our results have important implications from the macroprudential perspective.

JEL Code: D21, G28, G32, G38, G62.

Full article (PDF, 33 pages, 760 kb)

a Bank of Japan
b International Monetary Fund
c Monetary Authority of Singapore