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Does the stock market value bank diversification? Lieven Baele (Tilburg University) Olivier De Jonghe (Ghent University

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Does the stock market value bank diversification? Lieven Baele (Tilburg University) Olivier De Jonghe (Ghent University) Rudi Vander Vennet (Ghent University). Evolution of functional diversification. Do financial conglomerates possess a comparative advantage in terms of return/risk profile?.

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slide1
Does the stock market value bank diversification?
  • Lieven Baele (Tilburg University)
  • Olivier De Jonghe (Ghent University)
  • Rudi Vander Vennet (Ghent University)

Olivier De Jonghe ([email protected])

do financial conglomerates possess a comparative advantage in terms of return risk profile
Do financial conglomerates possess a comparative advantage in terms of return/risk profile?
  • Long-term performance and riskiness
      • Capital market data
  • Focus on Europe
      • broader scope for functional diversification
      • early deregulation: initiated by Second Banking Directive in 1989
  • Anticipation of results:
      • functional diversification can improve future bank profits
      • diversification can decrease idiosyncratic risk
      • more diversified banks have higher systematic risk

Olivier De Jonghe ([email protected])

diversification and profitability theory
Diversification and profitability: theory
  • Advantages
  • Revenue synergies
  • Cost economies of scale and scope
  • Information economies
  • Costs
  • Agency costs
  • Regulatory costs

Olivier De Jonghe ([email protected])

diversification and bank risk
Diversification and bank risk
  • Portfolio theory
  • non-correlated revenue sources
  • Correlation between interest and non-interest income
  • (1980-1996)
  • Cyclicality of revenue sources
  • Non-interest income may vary less/more with overall business cycle conditions
  • e.g.: mortgages vs life insurance vs investment banking

Olivier De Jonghe ([email protected])

slide6
Data
  • Listed European banks
  • 17 European countries
  • 1989 – 2004
  • Data sources
    • Bankscope: balance sheet and income statement
    • Datastream: market capitalization and daily returns
  • Daily returns Liquidity criterion (143 out of 255 banks)

Olivier De Jonghe ([email protected])

bank performance measurement
Bank performance: measurement
  • Franchise value
  • the present value of the future stream of profits that a firm is expected to earn as a going concern
  • usually proxied by Tobin’s Q
  • This paper:
  • Correct for noise and ineffciency
  • Market value inefficiency: apply stochastic frontier analysis
  • Adjusted Tobin’s Q :

Olivier De Jonghe ([email protected])

bank risk enhanced market model
risk sensitivities

idiosyncratic shock

bank stock returns

EU-wide risk factors

EU stock market

Interest rate

Default risk

FF HML

Local risk factors

Local stock market

Exchange rate

Bank risk: enhanced market model

Olivier De Jonghe ([email protected])

method
Method
  • Panel data set-up:
  • With: yi,t is a return or risk metric
  • X1 : functional diversification
  • Non-interest income to total income
  • Loans-to-assets
  • Revenue diversity measure
  • X2 : control variables
  • Capital ratio
  • Asset risk (LLP)
  • Inefficiency (Cost-income)
  • Size

Olivier De Jonghe ([email protected])

results franchise value
Results: Franchise value
  • Diversified banks
    • Higher return potential
    • Closer to the frontier
  • Capital (+), Efficiency (+), Size (-)
  • Diversification BENEFIT
  • in Financial Conglomerates in Europe

Olivier De Jonghe ([email protected])

results systematic risk
Results: systematic risk
  • Diversification increases systematic risk
    • Nonlinear, exponentially
    • Example: D(non-interest income share) = 0.10

market beta increases with 0.11

  • Larger banks have higher betas
  • Capital: non-linear, U-shaped
  • More diversified banks have larger exposure to:
          • changes in market sentiment
          • economy-wide shocks

Olivier De Jonghe ([email protected])

results idiosyncratic risk
Results: idiosyncratic risk
  • Nonlinear relationship, U-shape
  • Minimal risk at 36%
  • Non-interest income is twice as
  • volatile as interest income
  • Low correlation between sources of income
  • Capital (+), Efficiency (-), LLP(+)
  • Size (-)
  • Diversification offers a
  • large potential for bank risk reduction in Europe

Olivier De Jonghe ([email protected])

robustness
Robustness
  • Different diversification measures
  • Economically inspired
    • Subsample of most profitable banks
    • Subsample of well-capitalized banks
    • Subsamples of largest banks
    • Control for important mergers
  • Data– or statistically inspired
    • Winsorized sample
    • Contemporaneous
    • Traditional Q
  • Risk-return trade-off: system of equations

Olivier De Jonghe ([email protected])

conclusion
Conclusion
  • Does the stock market value bank diversification?
  •  focus on Europe
  • Diversification offers potential to improve future bank profits
  • Diversified banks co-vary more with the market
  • Idiosyncratic risk can be reduced!
  • Investors face classic return/risk trade-off
  • Bank-dependent parties mainly care about idiosyncratic risk
  • Regulators: bank-specific and systematic risk!

Careful monitoring of financial conglomerates

Olivier De Jonghe ([email protected])

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