International Propagation of the Credit Crisis: Lessons for Bank Regulation*

The authors use a large sample of non‐U.S. banks to examine the origins and spread of the 2007–2009 crisis. Using both stock market and structural variables, they test whether the effects of the crisis on individual banks are better explained by crisis models or by the VaR‐type analysis of the Basel system. The latter emphasizes risk weightings for individual assets while ignoring linkages that could leave banks exposed to systemic shocks. Consistent with crisis models, the authors find that a small set of pre‐crisis measures of a bank's international linkages, leverage, and the fragility of its liability structure does a good job of discriminating between banks that suffered a large impact and those that did not. (Indeed, these measures explain almost 50% of the differences among banks' stock returns during the crisis period, and almost 40% of the changes in the variability of those returns.) The authors also provide evidence of both a direct linkage among banks' stock returns and an indirect linkage that could reflect either linkages in the real economy or common demands by investors for liquidity. The authors run a “horse race” that demonstrates that simple measures of book leverage were better predictors of bank performance than the Basel capital ratios. They find that banks with lower Basel risk weightings prior to the crisis proved, on average, to be more exposed to the crisis. The authors' explanation is that banks with lower Basel risk measures tended to operate with higher leverage and more aggressive funding strategies, which in turn exposed them to greater crisis risk (even as they conformed to the letter of the Basel system in terms of asset risk measures). Finally, the authors find no evidence that substandard governance was a separate contributing factor to crisis exposure. Banks with substantial international business that were exposed to systemic shocks had high governance scores.     

How Banks' Value-at-Risk Disclosures Predict their Total and Priced Risk: Effects of Bank Technical Sophistication and Learning over Time

Using a sample of eight large commercial banks from 1994 to 2000, Jorion (2002) finds that banks' VaR disclosures for their trading portfolios predict trading income variability. We extend Jorion's findings using a larger sample of 17 banks from 1997 to 2002 reporting trading VaRs under FRR No. 48 (1997). We find that banks' trading VaRs have predictive power for trading income variability that increases with bank technical sophistication and over time. We find that banks' trading VaRs have predictive power for a bank-wide measure of total risk, return variability, and for two bank-wide measures of priced risk, beta and realized returns.     

Contagion during the Greek sovereign debt crisis

We examine the impact of news about Greece and news about a Greek bailout on bank stock prices in 2010 using data for 48 European banks. We identify the twenty days with extreme returns on Greek sovereign bonds and categorise the news events during those days into news about Greece and news about the prospects of a Greek bailout. We find that, except for Greek banks, news about Greece does not lead to abnormal returns while news about a bailout does, even for banks without any exposure to Greece or other highly indebted euro countries. This finding suggests that markets consider news about the bailout to be a signal of European governments' willingness in general to use public funds to combat the financial crisis. Sovereign bond prices of Portugal, Ireland, and Spain respond to both news about Greece and news about a Greek bailout.     

Extreme dependence in investor attention and stock returns – consequences for forecasting stock returns and measuring systemic risk

We characterize co-movements in investor attention by modeling multivariate internet search volume data. Using a variety of copula models that can capture both asymmetric and skewed dependence, we find empirical evidence of strong non-linear and asymmetric dependence in the attention investors give to companies. Modeling three years of daily stock returns and search volumes from Google Trends for 29 bank names, we find a striking similarity between the dependence structure inherent in stock returns and the dependence in the corresponding time series of search queries. We then document the existence of significant asymmetric and skewed tail dependence in the joint distribution of stock returns and investor attention. Finally, stock returns and internet search volumes appear to evolve concurrently in real time with neither one leading the other. Our findings have important implications, e.g. for the analysis of banks' interconnectedness based on equity data and the pricing of investor attention in the cross-section of stock returns.     

Ambiguity and risk factors in bank stocks

The determinants of banks' cost of equity are not well understood. We depart from prior work assuming rational expectations and instead explore the impact of Knightian uncertainty or ambiguity on bank stocks. We test a large set of asset pricing models and find that investors' lack of confidence in both the drift and correlation structure driving bank stock returns affects banks' cost of capital. We also investigate the economic relation among ambiguity, market liquidity, and banks' capital shortfall, which reveals the transmission channels through which ambiguity may increase the probability of a systemic crisis. Our findings have implications for macroprudential policy.     

Environmental engagement and stock price crash risk: Evidence from the European banking industry

This paper investigates the impact of banks' environmental engagement on their future stock price crash risk. Given the strong commitment of European institutions towards a low carbon economy, we focus on European banks, which are expected to be crucial actors in driving this challenge. Using a sample of 447 bank-year observations across 22 European countries from 2015 to 2021, we find a negative relationship between banks' environmental engagement and future stock price crash risk, in accordance with the signalling theory, suggesting that a high level of environmental engagement corresponds to high ethical standards of bank managers and high levels of financial transparency.     

How Sensitive Are Bank Managers to Shareholder Value?

We test for the existence of market discipline by shareholders of banks with a wide range of ownership structures. Discipline by shareholders manifests itself through monitoring banks’ level of risk as well as through influencing banks’ management actions. We find that shareholders utilize the relation between stock returns and different types of risk measures to monitor risky banks. Shareholders partially influence bank management by responding to decreasing stock returns with a demand to improve loan quality. Moreover, the influence on management in small banks is more pronounced compared to large banks.     

Do local analysts have an informational advantage in forecasting stock returns? Evidence from the German DAX30

Utilizing data from the German DAX30 stock index, we investigate whether local analysts have an informational advantage in forecasting stock returns. We analyze whether banks’ buy and sell recommendations improve on the out-of-sample predictability of daily stock returns and the market-timing ability of investors who base their decisions on such recommendations. We find that, indeed, in a few cases German banks do have better stock-forecasting ability for daily stock returns than do foreign banks. However, the value added of bank recommendations is generally small and sensitive to the model-selection criterion used by an investor in setting up a forecasting model for stock returns.     

Corporate governance and recent consolidation in the banking industry

Using the universe of publicly traded banks at year-end 1993, we find that target banks' outside directors, but not inside directors, tend to own more stock than their counterparts in other banks. Having an outside blockholder is also associated with banks becoming targets. In contrast to existing research on industrial firms, board structure does not help determine which sample banks sell. Neither the fraction of outsiders on a bank's board nor having an outside-dominated board differentiate the target banks in our sample. Instead, outside directors/shareholders and blockholders appear to be primarily responsible for encouraging bank managers to accept an attractive merger offer     

Economic conditions,lending competition,and evaluation effect of credit line announcements on borrowers

This paper examines the determinants of the signaling effect of acquiring lines of credit (LCs) on borrower stock returns by testing the economic conditions and lending competition hypotheses. The economic conditions hypothesis is tested by examining the loan cyclicality and handpicking effects. The former predicts a negative relationship between economic conditions and borrower returns because of banks' loose (strict) screening practices in a booming (recessionary) economy, whereas the latter expects a positive relation around the time of the LC announcements. The lending competition hypothesis proposes that the more competitive the lending market is, the looser the banks' screening practices will be. Thus, a negative competition-borrower relation will result. Using LC data from 2001 to 2010 concerning 501 stock-listed firms in Taiwan, we find that evidence supports the lending competition hypothesis and the handpicking effect of the economic conditions hypothesis.     

Youth,adolescence, and maturity of banks: Credit availability to small business in an era of banking consolidation

This paper addresses the relationship between the aging process at new and relatively young banks and the tendency of banks to make loans to small businesses. Defining small business loans as C&I loans that are under $1 million in size, we analyze a sample of banks that had assets of less than $500 million in assets for the years 1993–1996 and that were 25 years of age or younger. We find, as have earlier studies, that banks' proclivities for small business lending are negatively related to their age and to their size. We proceed much farther, however, by introducing a number of additional explanatory variables, including the start-up year of the bank. We find that small business lending is negatively related to its being part of a MBHC. Also, small business lending is positively related to higher concentration rates in urban areas but is negatively related to higher concentration in rural areas. Despite the inclusion of these additional variables and a number of alternative specifications, the negative effects of a bank's age on its small business lending persist.     

The Coordination Role of Stress Tests in Bank Risk‐Taking

We examine whether stress tests distort banks' risk‐taking decisions. We study a model in which a regulator may choose to rescue banks in the event of concurrent bank failures. Our analysis reveals a novel coordination role of stress tests. Disclosure of stress‐test results informs banks of the failure likelihood of other banks, which can reduce welfare by facilitating banks' coordination in risk‐taking. However, conducting stress tests also enables the regulator to more effectively intervene banks, coordinating them preemptively into taking lower risks. We find that, if the regulator has a strong incentive to bail out, stress tests improve welfare, whereas if the regulator's incentive to bail out is weak, stress tests impair welfare.     

Liquidity creation,regulatory capital,and bank profitability

We examine the interrelationships among liquidity creation, regulatory capital, and bank profitability of US banks. We find that regulatory capital and liquidity creation affect each other positively after controlling for bank profitability. However, this relationship is largely driven by small banks and primarily during non-crisis periods. It is also sensitive to the level of banks' regulatory capital and how it is measured. Furthermore, we find that banks which create more liquidity and exhibit higher illiquidity risk have lower profitability. Finally, the relationship between regulatory capital and bank performance is not linear and depends on the level of capitalization. Regulatory capital is negatively related to bank profitability for higher capitalized banks but positively related to profitability for lower capitalized banks. Therefore, a change in regulatory capital has differential impacts on bank performance. Our findings have various implications for policymakers and bank regulators.     

Sovereign Credit Risk,Banks' Government Support,and Bank Stock Returns around the World

We explore the joint effect of expected government support to banks and changes in sovereign credit ratings on bank stock returns using data for banks in 37 countries between 1995 and 2011. We find that sovereign credit rating downgrades have a large negative effect on bank stock returns for those banks that are expected to receive stronger support from their governments. This result is stronger for banks in advanced economies where governments are better positioned to provide that support. Our results suggest that stock market investors perceive sovereigns and domestic banks as markedly interconnected, partly through government guarantees.     

Preferential Regulatory Treatment and Banks' Demand for Government Bonds

The purpose of this paper is to analyze the impact of preferential regulatory treatment on banks' demand for government bonds. Using unique transaction‐level data, our analysis suggests that preferential treatment in microprudential liquidity and capital regulation significantly increases banks' demand for government bonds. Liquidity and capital regulation also seem to incentivize banks to substitute other bonds with government bonds. We also find evidence that this “regulatory effect” leads banks to reduce lending to the real economy.     

Examining bank SEOs: Are offers made by undercapitalized banks different?

Despite extensive monitoring, banking operations are often considered opaque, and despite explicit capital adequacy regulation, banks may have substantial discretion in their financing. Both monitoring and capital regulation have changed substantially over time, with the adoption of FDICIA being one important breakpoint. This article empirically studies seasoned equity offerings (SEOs) by banks to understand how opacity and capital regulation interact to determine the timing of bank SEOs and their market valuation. SEOs both by banks that are undercapitalized relative to regulatory standards and also well-capitalized banks are fully discretionary when it comes to SEOs, even before FDICIA. Both undercapitalized and well-capitalized banks experience similar and significantly negative stock price reactions to SEO announcements, and also have similar prior patterns of insider trading and similar economic drivers of the issuance decision. Moreover, post-SEO abnormal stock returns are similar to benchmark returns for both types of issuers in the long run, suggesting that, contrary to the well-documented evidence for industrial SEOs, investors understand the value implications of bank SEOs upon announcement. The evidence implies that undercapitalized banks' SEOs are more discretionary and that all bank SEOs are less opaque than implied by earlier studies.     

Risk taking behavior of privatized banks

We examine the risk taking behavior of privatized banks prior to and after privatization and find that privatized banks experience a significant decrease in risk after privatization; however they continue to exhibit higher risk than their rivals. This finding is consistent with the assertion that following privatization and the removal of government guarantees and subsidies, privatized banks become more prudent. Since rival banks do not experience a significant change in risk taking, we attribute the reduction in risk experienced by the privatized banks to changes in the banks' ownership structure rather than to industry factors. Interestingly, we also find that a higher fraction of the privatized banks' shares sold beyond a certain intermediate level induces higher risk taking, as the privatized bank becomes more accountable to shareholders. The finding that the fraction of shares sold is positively related to risk taking, coupled with the result that the privatized banks had higher risk in the pre-privatization period than in the post-privatization period suggests a nonlinear relationship between government/private ownership of banks and risk taking. Results of further analysis are consistent with a somewhat U-shaped relationship between private ownership and risk taking. The risk taking behavior of newly privatized banks is also influenced by the country's level of development and degree of political risk. Our results are robust to different measures of risk.     

Bank stock returns and economic growth

Previous research has established (i) that a country’s financial sector influence future economic growth and (ii) that stock market index returns affect future economic growth. We extend and tie together these two strands of the growth literature by analyzing the relationship between banking industry stock returns and future economic growth. Using dynamic panel techniques to analyze panel data from 18 developed and 18 emerging markets, we find a positive and significant relationship between bank stock returns and future GDP growth that is independent of the previously documented relationship between market index returns and economic growth. We also find that much of the informational content of bank stock returns is captured by country-specific and institutional characteristics, such as bank-accounting-disclosure standards, banking crises, enforcement of insider trading law and government ownership of banks.     

Bank Capital: Lessons from the Financial Crisis

Using a multicountry panel of banks, we study whether better capitalized banks experienced higher stock returns during the financial crisis. We differentiate among various types of capital ratios: the Basel risk‐adjusted ratio, the leverage ratio, the Tier 1 and Tier 2 ratios, and the tangible equity ratio. We find several results: (i) before the crisis, differences in capital did not have much impact on stock returns; (ii) during the crisis, a stronger capital position was associated with better stock market performance, most markedly for larger banks; (iii) the relationship between stock returns and capital is stronger when capital is measured by the leverage ratio rather than the risk‐adjusted capital ratio; (iv) higher quality forms of capital, such as Tier 1 capital and tangible common equity, were more relevant.     

Revisiting the merger and acquisition performance of European banks

The study examines the value creation of Merger and Acquisition (M&A) deals in European banking from 1990 to 2004. This is performed, first, by examining the stock price reaction of banks to the announcement of M&A deals and, second, by analysing the determinants of this reaction. The findings provide evidence of value creation in European banks as the shareholders of the targets have benefited from positive and (statistically) significant abnormal returns while those of the acquirers earn small negative but non-significant abnormal returns. In the case of the shareholders of the acquirers, domestic M&As and especially those between banks with shares listed on the stock market, seem to be more beneficial compared to cross-border ones or those when the target is unlisted. Shareholders of the targets earn in all cases positive abnormal returns. Finally, although the link between abnormal returns and fundamental characteristics of the banks is rather weak, it appears that the acquisition of smaller, less efficient banks generating more diversified income is more value creating, while acquisition of less efficient, liquid and characterised by higher credit risk banks is not a value creating option.