The Pronounced Impact of Macroeconomic Stress on the Financial Sector: Implications for Real Sector Growth

The financial sector incurred big losses during the recent financial collapse and recession. The losses occurred despite regulatory requirements imposed upon the financial services industry meant to ensure confidence and stability. This study analyzes the profitability and stock returns of financial sector firms during periods of economic and financial market turbulence. It shows that economic downturns and financial stress have a pronounced impact on financial firms. We find that the increased sensitivity to financial market distress appears to increase with recent trends in the financial services industry such as deregulation, globalization, and financial innovation. Moreover, we determine that the source of the increased sensitivity is likely driven by non-depository institutions, such as finance and investment, but not insurance companies. These results raise the question of whether the current regulatory regime can succeed in ensuring that financial markets are sufficiently stable to service an increasingly complex global economy.