Cyclicality in catastrophic and operational risk measurements

Using equity returns for financial institutions we estimate both catastrophic and operational risk measures over the period 1973–2003. We find evidence of cyclical components in both the catastrophic and operational risk measures obtained from the generalized Pareto distribution and the skewed generalized error distribution. Our new, comprehensive approach to measuring operational risk shows that approximately 18% of financial institutions’ returns represent compensation for operational risk. However, depository institutions are exposed to operational risk levels that average 39% of the overall equity risk premium. Moreover, operational risk events are more likely to be the cause of large unexpected catastrophic losses, although when they occur, the losses are smaller than those resulting from a combination of market risk, credit risk or other risk events.     

The Cost of Deposit Insurance for Privately Held Banks: A Market Comparable Approach

Previous empirical studies that use an option pricing model to estimate deposit insurance costs have been limited to banks that issue publicly traded securities: a bank's security prices are used to infer its risk characteristics. However, if deposit insurance costs are needed for privately held banks, as would be the case under a system of risk-based insurance premiums, then an alternative method is required. This paper presents a “market comparable” approach for valuing private banks' deposit insurance. The approach first uses information on public depository institutions to identify the statistical relationships between a bank's supervisory accounting data and its risk characteristics derived from equity market data. Second, it uses these relationships to predict the risk characteristics of a private depository institution based on its supervisory accounting data. This approach is applied to over 7000 private banks and thrifts to estimate their risk characteristics and their implied risk-neutral and physical probabilities of insolvency. For the vast majority of institutions, these risk characteristics and insolvency probabilities are within a reasonable range.     

A look inside AMLF: What traded and who benefited

The Federal Reserve’s AMLF program was designed to provide liquidity to money market funds (MMFs). Between September 2008 and May 2009, the program made $217 billion in non-recourse loans to depository institutions and bank holding companies to purchase asset-backed commercial paper from MMFs. JP Morgan and State Street dominated the program, accounting for over 90% of all loans made. Our analysis suggests that JP Morgan exhibited more self-dealing behavior than State Street. We find that JP Morgan and State Street earned economically and statistically significant cumulative returns of 2.28% and 2.49% (respectively) over the first seven days of the program after controlling for market returns and heteroscedasticity.     

Market Reactions to Tangible and Intangible Information

The book‐to‐market effect is often interpreted as evidence of high expected returns on stocks of “distressed” firms with poor past performance. We dispute this interpretation. We find that while a stock's future return is unrelated to the firm's past accounting‐based performance, it is strongly negatively related to the “intangible” return, the component of its past return that is orthogonal to the firm's past performance. Indeed, the book‐to‐market ratio forecasts returns because it is a good proxy for the intangible return. Also, a composite equity issuance measure, which is related to intangible returns, independently forecasts returns.     

The Market's Assessment of the Financial Services Modernization Act of 1999

We examine the impact of the events leading up to and including the passage of the Financial Services Modernization Act (FSMA) of 1999 on the stock returns of banks, brokerage firms, and insurance companies. We find that the impact is positive for all institutions. Bank gains are positively related to size and capitalization. Brokerage firms gain regardless of size, but the gains are inversely related to capitalization and insurance companies gain regardless of size or capital position. The strong positive reaction suggests that the market expects the institutions to benefit from the new opportunities created by the FSMA's passage.     

Do some lenders have information advantages? Evidence from Japanese credit market data

Using detailed Japanese credit data, we test for the existence of a credit market hierarchy. Empirical tests indicate that firms with information problems are more likely to carry higher proportions of relationship loans from main banks than non-main banks, holding constant risk and control factors. We further examine credit specialization on the part of lenders by testing the relationship between client firms' information and risk characteristics and the concentration of loans obtained from depository institutions versus other financial institutions. However, no significant differences in information superiority between these two types of financial institutions are found. We conclude that our evidence supports the credit market hierarchy hypothesis for Japanese main banks in particular but not depository institutions in general.     

Market perception of efficiency in bank holding company mergers: the roles of the DEA and SFA models in capturing merger potential

Using the Stochastic Frontier Approach (SFA) and Data Envelope Analysis (DEA), this study examines the influence of bank efficiencies on the market assessment of bank holding company (BHC) mergers. The following two questions are addressed: (1) Is the target BHC's frontier efficiency reflected in the bidder BHC's abnormal returns? and (2) Does the difference in frontier efficiency between the bidder and/or target banks relative to their peer institutions influence the acquirer's abnormal returns? In support of the Inefficient Management Hypothesis, the findings indicate that bidder wealth effects do incorporate the target's X-efficiency as well as the difference in bidder/target efficiencies relative to their peer institutions.     

UNLISTED TRADING PRIVILEGES,LIQUIDITY, AND STOCK RETURNS

In this study we examine the effect of dual trading through unlisted trading privileges (UTPs) on liquidity and stock returns. Stocks with UTPs trade in a different market structure than stocks listed and traded only on the AMEX and NYSE. Differences in market structure may affect stock returns through liquidity services provided by the competing markets. The sample comprises 852 AMEX and NYSE firms that began unlisted trading on the Philadelphia, Pacific, Midwest, or Cincinnati exchanges between 1984 and 1988. The results show significantly positive abnormal returns around the SEC's announcement of a regional exchange's filing for UTPs. The results also suggest that increased competition improves trading liquidity. Only stocks with low liquidity before UTPs announcements experience significantly improved liquidity and positive stock returns.     

The valuation effects of the 1977 Community Reinvestment Act and its enforcement

We examine the wealth effects of the passage of the Community Reinvestment Act (CRA) of 1977 for commercial banks and savings and loan associations. we find significantly negative average excess returns for small NYSE/AMEX banks and S&Ls to certain events concerned with the passage of the CRA; in contrast, there is no evidence that large NYSE/AMEX institutions or NASDAQ institutions experience wealth losses. We also study the effects of individual CRA protests against institutions and find they produce significantly negative excess returns which are not reversed when the protests are resolved. Our results have implications for proposed changes to CRA and for the future consolidation of the financial services industry. The results also demonstrate the difficulties associated with studying returns from the early years of the NASDAQ market.     

The Impact of the Financial Institutions Reform, Recovery and Enforcement Act On The Risk of Savings Institutions

The Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989 was intended to enhance the safety of savings institutions. We develop and test a model showing how institution‐specific characteristics modify the overall effect of FIRREA on the risk of savings institutions. Our model incorporates market risk, interest rate risk, and exposure to real estate conditions. We find that risk shifts vary across savings institutions. Larger institutions exhibit no obvious shift in risk, while smaller institutions show reduced risk since FIRREA. Moreover, the effects are more favorable for institutions that maintained higher capital levels in response to FIRREA's provisions.     

VOLUME AND R2: A FIRST LOOK

Roll (1988) reports that when days on which public announcements occur are excluded from a regression of stock returns on market returns, the R²s are largely unaffected. To explain his findings, Roll suggests that much of the firm-specific movements in common stocks may be a result of private information or occasional trading frenzy. As a test of Roll's conjecture, volume is used in this study as a proxy to capture the impact of firm-specific information and irrational trading. If Roll's conjecture is correct, the R² should rise when high-volume days are excluded from a regression of stock returns on market returns. The results presented here are consistent with that prediction, but they are not strong.     

Tail dependence and indicators of systemic risk for large US depositories

In this study, we investigate the extreme loss tail dependence between stock returns of large US depository institutions. We find that stock returns exhibit strong loss dependence even in their limiting joint extremes. Motivated by this result, we derive extremal dependence-based systemic risk indicators. The proposed systemic risk indicators reflect downturns in the US financial industry very well. We also develop a set of firm-level average extremal dependence measures. We show that these firm-level measures could have been used to identify the firms that were more vulnerable to the 2007–2008 financial crisis. Additionally, we explore the performance of selected systemic risk indicators in predicting the crisis performance of large US depository institutions and find that the average stock return correlations are also good predictors of crisis period returns. Finally, we identify factors predictive of extremal dependence for the US depository institutions in a panel regression setting. Strength of extremal dependence increases with asset size and similarity of financial fundamentals. On the other hand, strength of extremal dependence decreases with capitalization, liquidity, funding stability and asset quality. We believe the proposed indicators have the potential to inform the prudential supervision of systemic risk.     

A NOTE ON INTEREST RATES AND THE RISK OF BANK AND SAVINGS AND LOAN STOCK

This study examines the relationship between interest rates and the risk of bank and savings and loan stocks. Implied standard deviations from call option prices are used as risk estimates of the financial institutions’ stocks. Results indicate that there is a positive relationship between the risk of depository institution equities and the general level of interest rates. In addition, an upward shift in their risk occurred in late 1982, coinciding with several events that were important to the financial industry (the Penn-Square Bank failure, the Mexican debt crisis, and the passage of the Garn-St. Germain Depository Institutions Act).     

Stealing Deposits: Deposit Insurance,Risk‐Taking,and the Removal of Market Discipline in Early 20th‐Century Banks

Deposit insurance reduces liquidity risk but can increase insolvency risk by encouraging reckless behavior. Several U.S. states installed deposit insurance laws before the creation of the Federal Deposit Insurance Corporation, and those laws applied only to some depository institutions within those states. These experiments present a unique testing ground for investigating the effect of deposit insurance. We show that deposit insurance removed market discipline constraining uninsured banks. Taking advantage of World War I's rise in world agricultural prices, insured banks increased their insolvency risk and competed aggressively for deposits. When prices fell after the war, the insurance systems collapsed and suffered high losses.     

THE 1982 DEPOSITORY INSTITUTIONS ACT AND SECURITY RETURNS IN THE SAVINGS AND LOAN INDUSTRY

This paper provides empirical evidence on the market response to the 1982 Garn-St. Germain Depository Institutions Act (DIA), as measured by changes in the prices of savings and loan associations' common stock. The analyses indicate positive, significant abnormal returns in the weeks immediately preceding both the passage of the DIA and the subsequent announcement of the specific terms of money market deposit accounts (MMDAs). No reaction to the surprise announcement of Super NOWs is found. Also, no significant changes in risk for savings and loans is detected surrounding the DIA and MMDA events. Consistent with the primary intent of DIA, this evidence suggests that investors perceived savings and loans to benefit from this legislation.     

Federal Home Loan Bank Lending to Community Banks: Are Targeted Subsidies Desirable?

The Gramm-Leach-Bliley Act of 1999 amended the lending authority of the Federal Home Loan Banks to include advances secured by small enterprise loans of community financial institutions. Three reasons for the extension of this selective credit subsidy to community banks and thrifts are examined, including the possible need to: subsidize community depository institutions, stabilize the Federal Home Loan Banks, and address a market failure in rural markets for small enterprise loans. We empirically investigate whether funding constraints impact the small-business lending decision by rural community banks. We estimate static and dynamic models of small-business lending by community banks. The data reject the hypothesis that access to increased funds will increase the amount of small-business loans made by community banks.     

A comparison among various dimensions of illiquidity effect: A case study of Finland

We study different dimensions of the illiquidity effect on asset returns in the Finnish market. The market illiquidity is measured as unexpected rises and falls in average monthly zero returns across all stocks. We find that for the returns on the specific class of assets, a flight to the liquidity effect is the most important systematic risk among all dimensions of the illiquidity effect. In other words, higher returns for illiquid assets in good times compensate for a pronounced drop in those returns in bad times and vice versa. Furthermore, only one illiquidity-related factor has a similar pricing capacity as Fama and French's (1993) three-factor model and Carhart's (1997) four-factor model in the context of this study.     

Stock Repurchases and Excess Returns: An Empirical Examination

The excess returns associated with repurchase announcements are viewed largely as a reaction to management's statement that the firm's shares are underpriced; management's signal provides new information that enhances the firm's market value. Although earlier studies have found the excess return to be closely related to the premium set by managment, other factors play a part in determining both the market reaction and the premium level set by management. Among these factors ar relative market capitalization, holdings by institutions, immediate alternative uses for cash, level of insider control, recent stock price performance, relative size of the tender offer, and the resultant change in the firm's capital structure.     

Wealth and risk implications of the Dodd-Frank Act on the U.S. financial intermediaries

We contribute to the current regulatory debate by examining the wealth and risk effects of the Dodd-Frank Act on U.S. financial institutions. We measure the effects of key legislative events of the Act by means of a multivariate regression model using the seemingly unrelated regression (SUR) framework. Our results indicate a mixed reaction by financial institutions during the various stages of the Act’s legislative process. Further tests reveal that any positive reactions are driven by small and/or low risk institutions, while negative ones are consistent across subsets; except for investment banks. We also find market risk increases for most financial institutions that are dominated by small and/or low risk firms. The cross-section results reveal that large institutions fare better than their smaller counterparts and that large investment banks gain value at the expense of others. Overall, the Dodd-Frank Act may have redistributed value among financial institutions, while not necessarily reducing the industry’s riskiness.     

PRICE AND VOLUME EFFECTS ASSOCIATED WITH THE CREATION OF STANDARD & POOR'S MIDCAP INDEX

In this paper we explore price and volume effects associated with the 1991 creation of Standard & Poor's MidCap 400 index. Prior work on changes in the composition of existing indices finds a significant price response to the announcement. Various authors link the effect to price pressure, information, an outwardly shifting demand curve for securities, and the increased attention that comes with inclusion in an index. Using event study methodology, we find significant price and volume effects during the two weeks leading up to the Standard & Poor's announcement, but no significant effect in the two-day interval around the event. Apparently, information leakage and/or anticipation preceded the creation of the index. The price run-up is permanent since the positive abnormal returns leading up through the announcement are not associated with significantly negative abnormal returns after the announcement. In addition, MidCap stocks significantly outperform the market during the fifty-two weeks following the announcement. Using cross-sectional regressions, we show that these prior-period abnormal returns are positively related to abnormal volume and institutional holdings. We also find that firms trading over-the-counter had larger price run-ups than NYSE or AMEX firms.