A new method to estimate the risk of financial intermediaries

In this paper we reconsider the formal estimation of the risk of financial intermediaries. Risk is modeled as the variability of the profit function of a representative intermediary, here a bank, as formally considered in finance theory. In turn, banking theory suggests that risk is determined simultaneously with profits and other bank- and industry-level characteristics that cannot be considered predetermined when profit-maximizing decisions of financial institutions are to be made. Thus, risk is endogenous. We estimate the new model on a panel of US banks, spanning the period 1985q1-2010q2. The findings suggest that risk was fairly stable up to 2001 and accelerated quickly thereafter and up to 2007. Indices of bank risk commonly used in the literature do not capture this trend and/ or the scale of the increase.