Bob DeYoung’s Discussion FDIC Fall Conference, 2006

1. Bob DeYoung’s DiscussionFDIC Fall Conference, 2006 “Does the Stock Market Value Bank Diversification?” Baele, De Jonghe, and Vander Vennet. “Product Diversification in the European Banking Industry: Risk and Loan Pricing Implications,” Lepetit, Nyes, Rous, and Tarazi.

2. 1. Baele, De Jonghe, and Vander Vennet • Test whether market assessments of risk and bank value are related to “diversification.” • Data from 17 European countries, 1989-2004. • “Functional diversification” measures: • NII share of revenue; Loan share of assets. • Diversity of Revenues (NII vs. other) and Assets (Loans vs. other); measures range from 0 to 1. • Risk measures: • Market model parameters. • Bank value (franchise value) measure: • Noise-adjusted Tobin’s Q (adapted from Hughes, Lang, Mester, and Moon, 1999).

3. Main results (1) • Franchise value increases with both NII Share and Revenue Diversity. • “Level” result and “Diversity” result are really the same result, because mean NII is well less than .50. • Positive Q-NII relationship may be spurious. Many fee-based activities are off-balance sheet; if so, they show up in Q numerator but not in Q denominator. • “Stock market thinks NII levels and Revenue Diversity are signals of future growth in earnings.” Okay. But why? How? • A result that is not emphasized: • Q increases with Beta. • This establishes a positive Risk-Return tradeoff.

4. Main results (2) • Systematic Risk increases with NII. But Idiosyncratic Risk decreases with NII. • Positive NII-Beta relationship is now a stylized fact. On average, NII increases banks’ exposure to the business cycle and macro-economy. WHY?? • Negative NII-Idiosyncratic Risk finding less robust in this literature. WHY?? (No explanation in paper.) • Another under-emphasized result: • Beta increases with Loans-to-Assets. • WHY? (No discussion in the paper) • Authors remind us that implications of results vary for investors, managers, and regulators.

5. Franchise Value Measure (1) Objective: Create a more accurate measure of Q by removing “noise” from market prices. • Q = Mkt Val / Bk Val • Estimate market value frontier: ln(Mkt Val) = a + b*ln(Bk Val) + c*ln(Bk Val)2 + random error + ineff. • Set random error=0, and solve for Frontier Mkt Val. • QNA = Frontier Mkt Val / Bk Val*exp(ineff) • When ineff=0: exp(ineff) = 1 so franchise value Q is maximized. • When ineff>0: exp(ineff) > 1 so franchise value Q falls short of maximum.

6. Franchise Value Measure (2) • This may yield an improved measure of franchise value. But it is very unorthodox. Need more intuition in text to help finance reader. • Is QNA an ad hoc construct? Or can this measure be formally derived? • QNA versus Q: • Authors argue QNA is theoretically superior to Q. • Authors show correlation(QNA, Q) is high. • Can authors demonstrate superiority of QNA?

7. 2. Lepetit, Nys, Rous, and Tarazi • Test whether bank risk and loan pricing are related to “diversification.” • Data from 11 European countries, 1996-2001. • “Diversification” measures: • NII, Commissions, and Trading shares of revenue. • Risk measures: • Accounting ratios; Market measures; Pr(insolvency). • Loan pricing measures: • Interest rate margins; Risk spreads. • A story to interpret results: A strategic link between increased NII and lending practices.

8. Main results • Most measures of risk are positively associated with NII and Commission Income. • Uncontrolled tests, not regressions. • QUESTION: What’s included in “Commission Income?” • Loan interest margins are negatively associated with NII (multivariate regressions). • Proposed Story: These two results consistent with each other if banks are pursuing the following strategy: • Banks use loans as a “loss leader” to attract sales of fee-based financial services.

9. Loss Leader interpretation • I am unconvinced. More proof is required: • Is there a link between loan customers and fee-based customers? • Are returns from marginal fee-based activities large enough to offset reductions in infra-marginal spreads? • Is there anecdotal or case-study evidence from bankers to corroborate the story? • DeYoung, Hunter, Udell (2003) story: • New technology and deregulation led to new strategy. • Credit scoring and asset securitization  high NII. • Loans become commodities  low loan spreads. • Geographic freedom  provides necessary scale.

10. Common to both papers (1) • High level of NII used as a proxy for “diversification,” but this is a poor proxy. • NII can increase without a change in product mix (e.g., loan securitization, back-up credit lines). • DeYoung and Rice (2004): Correlation between ROE and Net Interest Income grew stronger in U.S. during 1990s, even as NII was increasing. • Both papers produce clean statistical results, but discussion is “sterile.” • Little interpretation of economics driving the results. • These are not standard, multi-industry finance tests. These are industry-specific tests. • Extant literature contains some plausible stories.

11. Common to both papers (2) • DeYoung and Roland (1999) offer a story (and some evidence) consistent with the positive NII-Beta results. • Traditional banking: • Bank-Borrower Relationships create switching costs that stabilize income across business cycle. • Fee-based (transactions) banking: • Fewer relationship-based switching costs. • Fee-based activities can be quite pro-cyclical (e.g., securities brokerage, mortgage banking). • Fee-based activities can require higher operating leverage, which amplifies revenue volatility.

12. A conflicting result across the papers • Lepetit, et al: Positive NII-idiosyncratic result. • Short 1996-2001 time frame. • Uncontrolled tests. • Baele, et al: Negative NII-idiosyncratic result. • Longer 1989-2004 time frame. • Controlled regression tests. • What would we expect? • NII from market-sensitive or non-relationship-based actitivies  Risk mainly systematic  NEGATIVE. • NNI from relationship-based activities  Risk will be less systematic  POSITIVE.

13. Bob DeYoung’s DiscussionFDIC Fall Conference, 2006 “Does the Stock Market Value Bank Diversification?” Baele, De Jonghe, and Vander Vennet. “Product Diversification in the European Banking Industry: Risk and Loan Pricing Implications,” Lepetit, Nyes, Rous, and Tarazi.