Does the stock market value bank diversification

1

• Does the stock market value bank diversification?
• Lieven Baele (Tilburg University)
• Olivier De Jonghe (Ghent University)
• Rudi Vander Vennet (Ghent University)
• SUERF/NIESR Seminar
• "De-Regulation and Integration in European
  Banking"

2
Diversification an evolution in the making

• Europe Second Banking Directive (1989)
• Geographical diversification single banking
  license, home country control
• Functional deregulation no restrictions on
  financial conglomeration
• United States
• Legal restrictions Glass-Steagall Act, McFadden
  Act
• Geographical diversification 1994, Riegle-Neal
  Act
• Functional diversification 1999,
  Gramm-Leach-Bliley act
• ? Broader scope for diversification in Europe
• ? Earlier deregulation

3
Financial Conglomerates in Europe

• Broad spectrum
• commercial banking
• securities-related activities
• insurance

4
Evolution of functional diversification

5
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

6
Structure of the talk

• Theoretical foundations
• Measurement of long-run performance and risk
• Data and Methodology
• Results
• Conclusion

7
Diversification and profitability theory

• Advantages
• Revenue synergies
• Cost economies of scale and scope
• Information economies
• Corporate governance through takeover market
• Costs
• Agency costs
• Regulatory costs
• ? Existing empirics offers mixed evidence

8
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

9
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)

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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
• Based on stochastic frontier analysis
• ? Adjusted Tobins Q

11
Bank performance results
12
Bank risk multifactor CAPM
13
Bank risk results
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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

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Results Franchise value

• Diversified banks
• Higher return potential
• Closer to the frontier
• Nonlinear relation
• Jointly significant
• Exponentially increasing
• Capital (), Efficiency (), Size (-)
• Diversification BENEFIT
• in Financial Conglomerates in Europe

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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

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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

18
Results total risk

• Similar to idiosyncratic risk
• Nonlinear, U-shaped
• Lower minimum 22
• gt Mixture of effects of underlying components

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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

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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