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Risk Exposure, Liquidity and Bank Governance: Are They Different Before, During and After the Recent Financial Crisis?

Prof. Miroslav MateevPetko Bachvarov

2016 World Finance Conference, New YorkJuly 29-31, 2016

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AGENDAAGENDA

1. Results2. Theoretical background3. Research hypotheses4. Data set and methodology5. Empirical results6. Conclusions

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1. MOTIVATION1. MOTIVATION• This research is an extension of Beltratti and Stulz

(2012) work on bank performance during the period of July 2007 and December 2008.We limit our study to hundred and two financial

institutions. All of them listed on the stock market We investigate the bank performance during the crisis of

2007 and 2008 using different measures of bank performance.

We also take into account prior and post crisis period as a robustness check of our main hypothesis.

Our results provide further support of the arguments that the excessive risk taking during the crisis cause financial instability of the banking sector.

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1. RESULTS1. RESULTS•Using different samples of 102 financial institutions

we find that: Financial institutions with lower capital position but

higher non-interest income and better liquidity performed much better during the crisis.

Banks with higher exposure to risk and larger non-interest activities fared better during the crisis.

Governance is negatively related to the bank risk taking during the crisis but similarly to Beltratti and Stulz (2012), there is no positive and significant relation between ownership and the stock performance of banks during the crisis.

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2. THEORETICAL BACKGROUND2. THEORETICAL BACKGROUND• Considerable amount of literature on 2007 crisis:

Many scholars have argued that lax regulation, insufficient capital, excessive reliance on short-term financing, and poor governance, all contributed to making the crisis as serious as it was.

Levine (2010) and Dam (2010) argue that regulators failed to regulate most of the risky activities of banks that later on brought many negative consequences to the banking system.

According to Demirgüc-Kunt et al. (2010) capital was not the major cause of the crisis, but it became important, specifically for the largest banks, during the crisis.

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THEORETICAL BACKGROUND (1)THEORETICAL BACKGROUND (1) Beltratti and Stulz (2012) find the differences in banking

regulations across countries to be generally uncorrelated with the performance of banks during the crisis.

Beltratti and Stulz (2012) find strong evidence that banks that relied more on deposits for their financing in 2006 fared better during the crisis.

Similarly, Demirgüc-Kunt and Huizinga (2010) illustrate the fact that banks, whose short-term finance was based on sources different from client deposits, performed poor during the crisis.

John et al. (2008) claim that risk taking by corporations is primarily influenced by the ownership structure.

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THEORETICAL BACKGROUND (2)• Laeven and Levine (2009) find that banks with more

powerful owners tend to take greater risks..• Bebchuk and Spamann (2010) pinpoint that the weak

features of the corporate governance played an utmost role in the banks’ performance during the crisis.

• Beltratti and Stulz (2012), and Dooley et al. (2009) show that ineffective regulation was one of the factors to influence the banks' performance during the crisis.

• Further, Levine (2010) strongly accused the regulatory system for being “blind” during the recent financial crisis.

• Demirgüc-Kunt et al. (2013) find the banks that performed poorly during the crisis and were saved to have the lowest capital requirements.

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THEORETICAL BACKGROUND (3)• No convincing evidences exist that:

(1) Capital position was a major reason of the poor bank performance during the crisis. Therefore, our work seeks to extend previous research on the impact of capital adequacy (Demirgüc-Kunt et al., 2013, Laeven and Levine, 2009, and Beltratti and Stulz, 2012).

(2) Tighter regulation was associated in general with better bank performance during the crisis or with less risky banks before the crisis.

Therefore, we seek to provide further evidences that some of these factors have come with positive effects, whereas others have destructive outcomes.

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3. RESEARCH HYPOTHESES Hypothesis 1: Financial institutions with a significant

fraction of their financing acquired through short-term funding in the capital markets are expected to perform worse during the crisis.

Hypothesis 2: Poor corporate governance should have a negative effect on bank performance during the crisis.

Hypothesis 3: Banks from countries with stricter regulations are expected to perform better during the crisis.

Hypothesis 4: Banks with adequate capital should not experience a decrease in their equity return during the crisis compared to banks whose capital was insufficient.

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4. DATA SET AND METODOLOGY• Our sample consists of 102 banks that can be viewed as

“Large Financial Institutions” from 33 countries. We have three sections: Europe, The Rest of Europe and World (see Table 1).

• The data set includes both traditional and non-traditional (i.e., investment) banks.

• Our bank performance measure is the arithmetic mean of the bank stocks, computed based on data available from Bloomberg.

• Our sample comprises the so called ‘crisis period’ that is, from the beginning of 2007 to the end of 2008. We also consider the prior and post crisis period as a robustness check.

• We estimate variables related to different bank characteristics using different sources (i.e., Annual Reports, Datastream, Bankscope, and OSIRIS databases.)

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DATA SET AND METODOLOGY (1)• Our empirical analysis is based on panel data. • We use Hausman (1978) test in order to estimate the

specification of our model (i.e., random or fixed effect specification).

• We construct three different sub-samples: 1) one that includes all banks in our sample, and 2) a second one in which we omit all banks outside Europe 3) a third one in which we have only large banks (i.e. asset position > $50bn)

• In some of the regressions, we control for country fixed effects. We cannot control for country fixed effects in all regressions because of possible multicollinearity when using our regulatory and macroeconomic variables.

Source: Author’s calculations, Beltratti and Stulz (2012).12

Table 1 Country characteristics

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5. EMPIRICAL RESULTS1. Bank Equity Returns (see Table 2)• The average return for the crisis period is extremely

poor -26.18.These returns contrast sharply with the positive average return of 25.30% for the so-called “prior crisis” period.

• The range of funding fragility ratio during the meltdown period is significantly wide with a minimum level of 0.13% and a maximum of 72.39%.

• Interestingly, it is visible that Equity Volatility shows also a considerable wide with a minimum of 1.92% and a maximum of 48.08% during the crisis. In other words, some of the financial institutions in our sample experienced less volatile equity position.

• Income diversity has a mean value of around 43.79% and a standard deviation of 22.13% for both years.

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Table 2: Bank Statistics

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Table 2: Bank Statistics

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EMPIRICAL RESULTS (1)2. Characteristics of Poor- and Better-Performing

Financial Institutions (see Table )• There is a significant difference in the average return

performance between these two groups, especially in 2007.

• Banks that performed poorly during the crisis had significantly high return in 2006 as their average return was 15.14%. Same for the better-performing banks with a return of 30.03% in 2006.

• The funding fragility measure also shows large difference between the two groups of banks (44.52% and 43.26% in 2007 and 2008, respectively, against 25.87% and 18.37%, for the second group).

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EMPIRICAL RESULTS (2)2. Characteristics of Poor- and Better-Performing

Financial Institutions (cont.)• The better-performing banks had a significantly higher

stock return compared to the poor-performing banks: --73.95% (2007) versus 27.56% (2008)

• It can be seen that the ROA ratio in lower-quartile banks was significantly lower, compared to one in 2008 (i.e., 0.30% for the bottom quartile banks and 1.34% for the top quartile banks). In other words, banks experienced a very poor asset return at the beginning of the crisis.

• The better-performing financial institutions had less ex-ante risk using the distance to default measures, such as Equity Volatility and Altman Z-score.

Table 3

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EMPIRICAL RESULTS (3)3. Multiple Regressions (see Tables 4 and 5)• The analysis in the previous section shows that the

financial institutions that performed worst during the crisis had, on average, significantly lower returns, less deposits and loans, higher ex ante risk, lower loan loss provision, and lower capital position.

• Surprisingly, however, they had lower funding fragility, and they all came from countries with less strict regulations.

• We first run our model (see Table 4) without regulatory and macroeconomic variables, but with country fixed effects, whereas in the second regression (see Table 5), we use regulatory and macroeconomic variables, but without country fixed effects.

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EMPIRICAL RESULTS (4)• Corporate Governance Effects (Table 4)• In contrast with Beltratti and Stulz (2012), we do not

find that deposit ratio is economically significant, whereas Altman Z-score, stock returns in 2006 and noninterest ratio, all have positive and significant coefficients.

• Similarly to Beltratti and Stulz (2012), we find that ownership variable is statistically insignificant in all model specifications, which implies no relation with poor bank performance during the crisis period.

• The results show that banks with better capital position performed less poorly during the recent financial crisis. We find, however, the coefficient on funding fragility to be negative and highly insignificant in all models.

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EMPIRICAL RESULTS (5)• The noninterest ratio is found positive and significant in

all models. Thus, we may conclude that financial institutions that relied heavily on noninterest activities performed better during the crisis.

• Regulation and Macroeconomic Effects (Table 5)• We reject the hypothesis that there is a strong positive

relation between poor bank performance and lax regulations as we find the coefficient on restrictions of bank activities negative and strongly significant.

• In line with Demirgüc-Kunt et al. (2013), we find that capital position did play an important role in bank performance during the crisis (both measures - capital ratio and Tier 1 - have negative and highly significant coefficients).

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EMPIRICAL RESULTS (6)• Our composite variable (institution) is found statistically

insignificant. Does so funding fragility variable.• While the log of GDP per capita shows a negative and

statistically significant effect, the current account is found highly insignificant.

• When add Z-score instead of beta, the results show that our measure of distance to default has a strong and positive effect on bank return during the crisis.

• Ex Ante Risk and Bank Characteristics (Table 6) Deposits are found to have a positive and marginally

significant effect on bank risk. Therefore, we can argue that banks with a large proportion of deposits accumulated a higher risk during the crisis.

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EMPIRICAL RESULTS (7)• A strong negative relation exists between ownership and

earnings volatility. We find a similar relation between our risk measure and income diversity.

• In contrast with Beltratti and Stulz (2012), we do not find supportive evidences that banks in countries with a formal deposit insurance regime and with more active private monitoring of banks have higher volatility.

• Based on our results, we argue that there is no strong relation between bank regulations and excessive risk taking during the crisis.

• Therefore, banks from more restricted and regulated countries had a better performance due to a possible luck.

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7. CONCLUSIONS• Our findings are in line with the previous empirical analyses

that emphasize on the fragility of banks financed with short-term funds and the capital adequacy as one of the causes of poor bank performance during the crisis.

• We find that financial institutions with lower capital position but higher non-interest income and better liquidity performed much better during the crisis.

• Our results show that governance is negatively related to the bank risk taking during the recent crisis. But, we do not find a positive and significant relation between ownership by the controlling shareholder and the stock performance of banks.

• Similarly, no systematic evidence exists that stronger regulation led to better performance of banks during the recent financial crisis.

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Table 4 Return regressions with corporate governance and country-fixed effects (2007-2008)

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Table 5 Return regressions with regulatory and macroeconomic effects (2007-2008)

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Table 10 Return regressions with different measures of ex ante risk (2007-2008)