Diversification in the Financial Services Industry: The Effect of the Financial Modernization Act

Abstract

The intent of the Financial Services Modernization Act of 1999 (FSM) was to strengthen the overall financial services sector by allowing financial firms to diversify across industries within the financial sector. Similar to other studies of the reaction to this Act, we observe that investors consider the FSM to be good news. More interestingly, we also observe that systematic risk increased for some types of firms, but decreased for others as barriers were lowered. This finding is consistent with the idea that the reduction of regulation may increase systematic risk, but that the effects of deregulation on risk may be mitigated by anticipated effects of diversification. Specifically, bank holding companies that chose to diversify into other financial industries experienced increases in systematic risk while those that did not diversify realized decreases in systematic risk. Overall, we find that the systematic risk of financial firms converged and increased in the past few years as firms expanded into non-traditional businesses. In addition, we find that the Act reduced systematic risk for some firms, specifically those that diversified their product lines with insurance products.