The Hidden Risk of Systemic Frailty: The Underestimated Importance of Differentiation and Innovation in European Banking

This article explores the concept of systemic frailty as a structural condition, characterized by correlated vulnerabilities across financial institutions. Drawing on institutional theory, it examines how institutional isomorphism, regulatory incentives and legitimacy-seeking behavior may contribute to the emergence of such vulnerabilities within banking systems. European banks operate in an increasingly complex environment shaped by technological change, geopolitical tensions, evolving macroeconomic conditions and heightened societal expectations. While prudential regulation and supervision have materially strengthened capital adequacy, liquidity resilience, governance and risk-management practices, institutional and regulatory pressures may under certain conditions contribute to convergence in business models, risk perceptions and organizational behavior. Such convergence may increase the likelihood that common shocks affect multiple institutions simultaneously. Building on this insight, the article conceptualizes systemic frailty as a structural condition in which converging business models, risk perceptions, organizational practices and regulatory incentives generate correlated vulnerabilities across institutions. While correlation-driven vulnerabilities are well established in the systemic-risk literature, the contribution of the article lies in explaining how institutional isomorphism and regulatory incentives may contribute to their endogenous emergence. The article further distinguishes systemic frailty from related concepts such as contagion, common exposures, herding and systemic linkage. Using a conceptual and theory-building approach, the article develops a framework linking institutional isomorphism, innovation and systemic frailty. It concludes that supervisory frameworks may benefit from greater recognition of diversity, adaptability and correlated vulnerabilities alongside institution-level resilience. Finally, it proposes the Impact Factor as a conceptual supervisory overlay, designed to complement existing prudential frameworks by incorporating institutions’ contributions to system-wide diversity, adaptability and correlated vulnerability into supervisory assessments.