Decomposing Large Banks’ Systemic Trading Losses

Abstract: Large banks’ tendency to suffer simultaneous trading losses, which strengthen systemic risk, is often attributed to portfolio overlap. By contrast, I show that common macro-shocks that cause non-overlapping assets to move together in crises are at least as important as portfolio overlap, but are inadequately treated by Basel III capital requirements. This highlights an unintended consequence of portfolio differentiation, whereby reducing portfolio overlap can increase trading loss comovements from common shocks. I propose three policy options for improving the Basel III standard and advocate for higher regulatory scrutiny on banks’ internal risk models.