The homogenization of the financial system and financial crises

Financial institutions, especially large banks, have reached beyond their traditional activities in recent years and have become more homogeneous as a result. Even though this brings about diversification gains, we show that their stability may fall as consequence since institutions' incentives for taking on risk and supplying liquidity deteriorate. Optimal regulation should hence not provide a relief for diversification. However, we also identify an important benefit of this development. When financial institutions become more homogeneous, there is less need for risk sharing among them. This in turn mitigates the impact of any imperfections such risk sharing may be subject to. (C) 2008 Elsevier Inc. All rights reserved.