Bank Exposure to Interest Rate Risks During Financial Liberalization: Evidence from South Korea

This study documents the changing impact of long and short term interest rate risks on the equity prices of banks in South Korea during the process of financial liberalization. Consistent with the presence of regulatory constraints, Korean bank equity returns are found to be sensitive to both anticipated and unanticipated changes in interest rates in the first period (1976-81) when banks were largely under government control. However, during our last period (1989-99) of liberalization, Korean bank equity returns were found to have a positive association only with unanticipated short-term interest rates. Consistent with the ability to manage other interest rate risks successfully, in this last liberalization period, Korean bank equity returns had no association with long-term or with anticipated short-term interest rates. In view of the continued interest in banking and financial market liberalization among many Asian, African, and formerly socialist countries including China, these results should be of much banking and policy interest. JEL Classifications: G21, G28, E44, L89     

Modeling Asset Premiums and the Riskfree Rate in General Equilibrium CCAPM

We elaborate on the consumption capital asset pricing model (CCAPM) to reveal a set of underlying forces that determine asset returns. We use generalized preferences, allow for labor-leisure choice, a broad asset portfolio, and holding international claims. A calibration of the model with US data learns that excess stock and bond returns can be replicated. At the same time, however, the riskfree interest rate generally appears to be mispriced, consistent with Weil (1989). Additional results show that in general two optimal values of the intertemporal substitution parameter correspond with a specified coefficient of risk aversion. Tests that assess the dynamic properties of the model yield mixed results, but are most favorable when home bias is allowed.     

Determinants of bank interest margins: Impact of maturity transformation

This paper explores the extent to which interest risk exposure is priced into bank margins. Our contribution to the literature is twofold: First, we extend the Ho and Saunders (1981) model to capture interest rate risk and expected returns from maturity transformation. Banks price interest risk according to their individual exposure separately in loan and deposit intermediation fees, but reduce (increase) these charges for loans (deposits) when positive excess holding period returns from long-term exposures are expected. Second, we test the model-derived hypotheses not only for the commonly investigated net interest margin but also for interest income and expense margins separately in a sample encompassing the German universal banking sector between 2000 and 2009. Our results suggest that banks price their individual interest rate risk and corresponding expected excess holding period returns via the asset side into the net interest margin. For liabilities, we find that interest rate risk exposure is only priced in by smaller, local banks.     

The Behavior of Eurocurrency Returns Across Different Holding Periods and Monetary Regimes

Recent empirical studies of the risk premium across foreign exchange and other asset markets such as equity and longer term bonds have found conflicting evidence about the latent variable model restrictions of the consumption-based intertemporal capital asset pricing model. While studies using data for holding periods of one month or less generally reject the model, evidence using three-month holding periods indicates that the model cannot be rejected when including the returns on long relative to short deposit rates. This paper investigates the sources of differences in results using returns on foreign exchange and Eurocurrency deposits at three different maturities.     

Sources of Bank Interest Rate Risk

We investigate bank stocks'sensitivity to changes in interest rates and the factors affecting this sensitivity. We focus on whether the exposure of commercial banks to interest rate risk is conditioned on certain balance sheet and income statement ratios. We find a significantly negative relation between bank stock returns and changes in interest rates over the period 1991–1996. We also find that bank characteristics measured from basic financial statement information explain bank stocks'sensitivity to interest rate changes. These results suggest that bank managers, analysts, and regulators can use this information to assess the relative risk exposure of banks.     

Model uncertainty and systematic risk in US banking

This paper uses Bayesian Model Averaging to examine the driving factors of equity returns of US Bank Holding Companies. BMA has as an advantage over OLS that it accounts for the considerable uncertainty about the correct set (model) of bank risk factors. We find that out of a broad set of 12 risk factors only the market, real estate, and high-minus-low Fama–French factors are reliably related to US bank stock returns over the period 1986–2010. Other factors are either only relevant over specific subperiods or for subsets of bank holding companies. We discuss the implications of our findings for empirical banking research.     

INTEREST RATE SENSITIVITY OF BANK STOCK RETURNS: SPECIFICATION EFFECTS AND STRUCTURAL CHANGES

In this paper the interest rate sensitivity of bank stock returns under alternative econometric specifications and the changes in the sensitivity over time are studied. Results indicate that the sensitivity depends on the econometric specification and the period considered. Bank stock returns show a sensitivity to long-term government security returns and innovations, but not to short-term government security returns and innovations except under one specification. Since 1980, banks seem to have reduced their interest rate risk exposure. Finally, while long-term returns are positively associated with stock returns, short-term returns show a positive association only since 1980.     

Resolving the Puzzling Intertemporal Relation between the Market Risk Premium and Conditional Market Variance: A Two-Factor Approach

The existing empirical literature fails to agree on the nature of the intertemporal relation between risk and return. This paper attempts to resolve the issue by estimating a conditional two-factor model motivated by Merton's intertemporal capital asset pricing model. When long-term government bond returns are included as a second factor, the partial relation between the market risk premium and conditional market variance is found to be positive and significant. The paper also helps explain the convoluted empirical relation between the market risk premium, conditional market variance, and the nominal risk-free rate previously reported in the literature.     

A Market-based Risk Classification of Financial Institutions

In this article we derive, estimate, and analyze a multifactor model of the monthly holding period returns on the stocks of exchange-traded financial institutions. In addition to bond and equity returns, the factors include default, liquidity, and term structure risk premiums plus variables that measure changes in deposit demand. To ensure that our sample has a large number of firms, we use data from January 1981 through December 1988. The equity return explains a large share of time-series variation in financial institutions' returns. The additional factors implied by theory have little incremental explanatory power. The two-factor model regression coefficients have considerable cross-sectional variation. This permits us to group intermediaries into portfolios with similar risk exposures. These portfolios bear no relation to the SIC codes that group intermediaries by their charters and lines of business.     

Return generating process and the determinants of term premiums

This paper examines asset pricing theories for treasury bonds using longer maturities than previous studies and employing a simple multi-factor model. We allow bond factor loadings to vary over time according to term structure variables. The model examines not only the time variation in the expected returns of bonds but also their unexpected returns. This allows us to explicitly test some asset pricing restrictions which are difficult to study under existing frameworks. We confirm that the pure expectation theory of the term structure of interest rates is rejected by the data. Our empirical study of a two-factor model finds substantial evidence of time-varying term-premiums and factor loadings. The fact that factor loadings vary with long-term interest rates and yield spreads suggest that bond return volatilities are sensitive to interest rate levels.     

Common risk factors in bank stocks

This paper provides evidence on the risk factors that are priced in bank equities. Alternative empirical models with precedent in the nonfinancial asset pricing literature are tested, including the single-factor CAPM, three-factor Fama–French model, and ICAPM. Our empirical results indicate that an unconditional two-factor ICAPM model that includes the stock market excess return and shocks to the slope of the yield curve is useful in explaining the cross-section of bank stock returns. However, we find no evidence that firm specific factors such as size and book-to-market ratios are priced in bank stock returns. These results have a number of important implications for the estimation of the banks’ cost of capital as well as regulatory initiatives to utilize market discipline to evaluate bank risk under Basel II.     

The Investment Performance of Low-grade Bond Funds

This study extends the literature on the pricing of low-grade bonds by examining the performance of low-grade bond funds. The findings reveal that over the long run low-grade bond fund returns are approximately equal to the returns provided by an index of high-grade bonds. The relative risks of high and low-grade bonds are more difficult to assess. Because of their shorter durations, low-grade bonds are less sensitive to movements in interest rates than high-grade bonds. On the other hand, low-grade bonds are much more sensitive to changes in stock prices than high-grade bonds. When adjusted for risk using a simple two-factor model, the returns on low-grade bond funds are not statistically different from the returns on high-grade bonds.     

Bank loan-loss provisions and the income-smoothing hypothesis: An empirical analysis, 1976–1984

This article tests an income-smoothing hypothesis for a sample of 106 large bank holding companies for the period 1976 to 1984. Our focus is on the behavior of the provision for loan losses as a function of bank income and alternative measures of business conditions likely to affect loan portfolio risk-taking or quality. Using an econometric model with pooled time-series, cross-sectional data, we find evidence of income-smoothing behavior over our test period. Our dummy-variable models indicate that regional banking companies tend to engage in income smoothing more than money-center banks. Alternative motivations for income-smoothing behavior, which include bank regulatory policy, risk management, agency theory, and compensation policy, are explored and their policy implications considered.     

An International Asset Pricing Model with Time-Varying Hedging Risk

This paper employs a two-factor international equilibrium asset pricing model to examine the pricing relationships among the world's five largest equity markets. In addition to the traditional market factor premium, a hedging factor premium is included as the second factor to explain the relationship between risks and returns in the international stock markets. Moreover, a GARCH parameterization is adopted to characterize the general dynamics of the conditional second moments. The results suggest that the additional hedging risk premium is needed to explain rates of return on international equities. Furthermore, the restriction that the coefficient on the hedge-portfolio covariance is one smaller than the coefficient on the market-portfolio covariance can not be rejected. This suggests that the intertemporal asset pricing model proposed by Campbell (1993) can be used to explain the returns on the five largest stock market indices.     

Derivatives, Portfolio Composition, and Bank Holding Company Interest Rate Risk Exposure

This article examines the role played by derivatives in determining the interest rate sensitivity of bank holding companies' (BHCs) common stock, controlling for the influence of on-balance sheet activities and other bank-specific characteristics. The major result of the analysis suggests that derivatives have played a significant role in shaping banks' interest rate risk exposures in recent years. For the typical bank holding company in the sample, increases in the use of interest rate derivatives corresponded to greater interest rate risk exposure during the 1991–1994 period. This relationship is particularly strong for bank holding companies that serve as derivatives dealers and for smaller, end-user BHCs. During earlier years, however, there is no significant relationship between the extent of derivatives activities and interest rate risk exposure. There are two plausible interpretations of the relationship between interest rate derivative activity and interest rate risk exposure in the latter part of the sample period: one interpretation suggests that derivatives tend to enhance interest rate risk exposure for the typical BHC in the sample, while the other suggests that derivatives may be used to partially offset high interest rate risk exposures arising from other activities. The analysis provides support for the first of these two interpretations.     

What explains the lack of monetary policy influence on bank holding companies?

In this paper, we investigate how monetary policy innovations affect the equity returns of bank holding companies (BHCs). We also examine bank characteristics to determine what explains the cross-sectional and time-series variation in the returns' sensitivity. Similar to non-financial firms, we find that only unanticipated components affect bank equity returns; however, this effect is absent in the second half of our sample period. Smaller, less liquid banks have higher sensitivity; a higher ratio of time deposits to total deposits reduces this sensitivity. A higher ratio of non-interest income to total income also reduces this sensitivity, while capital-constrained banks have a higher sensitivity to monetary policy innovations. We argue that a higher dependence on non-interest income and the use of interest rate derivatives together may explain the disappearing influence of monetary policy on these BHCs.     

Asset pricing,time-varying risk premia and interest rate risk

This paper investigates the role of interest rate risk in explaining security price changes. We develop and test a two-factor linear beta pricing model of security returns in which the factors are the excess returns on the long-term, riskless bond and the equal-weighted equity market index. We find that time-variation in the interest rate and market risk premia influence expected security returns. Furthermore, conditional interest rate volatility affects security returns, particularly during periods of substantial interest rate movements.     

Re-examination of interest rate sensitivity of commercial bank stock returns using a random coefficient model

This article develops and tests a random coefficient two-index model for commercial bank stock returns which controls for the time-varying interest rate sensitivity caused by a bank's changing maturity profile. Using a sample of 51 actively traded commercial banks, the seemingly unrelated regression results provide evidence that commercial bank stock returns are significantly interest rate sensitive. The effect of interest rate changes on bank stock returns is found to be positively related to the maturity mismatch between the bank's assets and liabilities, when the proxy for interest rate changes and the proxy for maturity mismatch are compatible to each other.This article was written while I was a doctoral student at the University of North Carolina at Chapel Hill. It was presented at the 1989 FMA Annual Meeting in Boston.     

An Investigation of the Impact of Interest Rates and Interest Rate Volatility on Australian Financial Sector Stock Return Distributions

Abstract:   This paper extends the existing literature by analysing the dual impact of changes in the interest rate and interest rate volatility on the distribution of Australian financial sector stock returns. In addition, a multivariate GARCH‐M model is used to analyse the impact of deregulation on the financial institutions sector. It was found that there is a consistent inter‐temporal trade off between risk and return over the different regulatory periods. Moreover, finance corporations were found to be highly sensitive to new shocks across the financial sector and deregulation increased the risk faced by finance corporations and small banks – effectively increasing the required rate of return and explaining the continued rationalisation of these sectors. Furthermore, deregulation has changed the fundamental relationship between interest rates and large bank stock excess returns from positive in the pre‐deregulation period to negative in the post‐deregulation period. This reflects the changing institutional environment from one of controlled credit rationing to a more competitive environment.     

Bank Holding Company Acquisition Activity: Evidence From Pre- and Post-Deregulation Periods

Both acquisition activity and deregulation have had an impact upon share price and performance of commercial bank holding companies. The purpose of this study is twofold: First, to discern the effects of acquisition activity from the effects of the passage of the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) and Garn-St Germain Depository Institutions Act of 1982 (GSG) on balance sheet composition of bank holding companies; and second, to examine the effects of deregulation on returns to shareholders of acquiring bank holding companies. This study finds that commercial bank holding companies involved in acquisitions experience significant changes in their balance sheet composition, not as a result of acquisition activity, but as a result of deregulation. Additionally, bank holding companies that announced acquisitions prior to the effective date of deregulation earned abnormal returns that were significantly negative, whereas holding companies announcing acquisitions after enactment of deregulation earned returns that were not significantly different from zero. Also, the abnormal returns found in previous studies of bank acquisitions may be biased upward because of increases in systematic risk associated with the passage of DIDMCA and GSG.