Bank Capital and Stock Performance of European Banks During the Financial Crisis

Bank Capital and Stock Performance of European Banks during the Financial Crisis Deyan Tsvetkov S2339943 Student MSc Finance University of Groningen Thesis supervisor: Prof. dr. Kasper Roszbach Abstract This paper investigates the relationship between bank capital levels prior to the crisis and subsequent stock price performance during the financial crisis that started in 2007. My paper follows a similar analysis as Demirguc-Kunt et al (2010) and Akhigbe et al (2012). Both papers analyze the relationship between bank capital and subsequent stock returns while also controlling for other bank specific characteristics such as size and liquidity. However, unlike these papers, my sample consists only of banks from the European Union countries. My sample of 118 banks is further divided in three different groups depending on total assets size. Another grouping of banks is based on whether or not they are members in the Eurozone. My null-hypothesis (H0) is that capital levels are not related to subsequent stock price performance. The alternative hypothesis (H1) is that capital is negatively related to subsequent stock price performance i.e. banks had poor quality assets. To test my hypothesis, first I run an OLS regression including only bank capital (defined as prior crisis Tier 1 ratio). The results on the full sample and the three different groups of banks based on size are insignificant. Only for the banks from non-Eurozone countries Tier 1 has a marginally significant effect. Furthermore, to deepen my analysis, I also include six other control variables such as size, reliance on non-interest income, and net-interest margin. I find that bank size is negatively related to subsequent stock returns at 1% significance level. Other variables that are found to be significant in explaining the stock performance during the crisis include assets growth in the year prior to the crisis, the ratio of liquid assets to total deposits and borrowings, and net-interest margin. Keywords: bank capital, stock price performance, financial crisis, European Union JEL classification: G21, O16 1 Introduction The financial crisis which started in 2007 injected a large degree of uncertainty into financial markets all over the world. Financial institutions suffered large losses related to subprime mortgages, mortgage-backed securities (MBS), collateralized debt obligations (CDO) and other assets that were wrongly assumed to be safe and of excellent quality. The stock prices of many banks plummeted and are yet to recover. Other banks were acquired at distressed prices and some were even forced to declare bankruptcy. Some financial institutions suffered large losses and ended up being acquired at a very low price by more stable banks. The financial crisis caused a recession in many developed economies around the world and had damaging longer- term effects on worldwide economic growth. Much has been published in recent years about the causes of the financial crisis, about banks’ business models, and many other topics. My paper aims to explore the relationship between the bank capital of European banks prior to the crisis and the subsequent stock price declines for the same banks during the financial crisis. Spence (1974) is one of the first authors who explore signaling theory and its use in the presence of asymmetric information. Since then this theory has been the foundation for many theoretical models and served as the basis for testing a wide range of hypotheses. Akhigbe et al (2012) mention that one of the main assumptions in the capital signaling theory is that there is information asymmetry between bank managers and investors regarding the quality of the assets held by the bank. The information available to the public about a bank’s assets is limited, which in turn leads to investors not being able to fully evaluate the real quality of those assets. Because of the existing requirements about risk-based capital, a certain bank’s capital levels may be perceived as a signal about the quality of its assets. Therefore, many investors may rely largely on the capital ratios as a signaling device of the bank’s risk exposure. However, the recent financial crisis indicated that the existing capital regulations were inadequate to keep the banking sector safe. The increasing number of financially distressed banks forced many governments to step in with bailout packages and various other kinds of liquidity and credit support programs. Basel II regulations failed to recognize the appropriate risk 2 for different financial instruments and also underestimated interconnectedness and the related systemic risk. Choudhry (2012) implies that an unplanned result of the original Basel accord was that securitization became very popular. Basel II was supposed to improve the Basel I rules and introduce an even safer framework, however, it failed to properly address securitization and structured products, which were two of the main reasons for the crisis. This study tests a capital signaling hypothesis where capital is indicative of asset quality. My analysis assumes that there are two main reasons why banks held large amounts of capital. On the one hand, some banks engage in more risk averse practices, thus holding more capital would hedge against some risk. These banks would have performed better during the financial crisis. On the other hand, banks may hold higher capital but the quality of their assets might turn out to be poor. The higher capital would imply a worse performance in the financial crisis because in a situation like this asset prices decline severely and capital turns out to be insufficient. This would lead to worse stock price performance for banks which were originally holding larger amounts of capital. My paper follows a similar analysis done by Akhibe et al (2012) and Demirguc-Kunt et al (2010). Nevertheless, there is some disagreement in the literature that explores the effects of bank capital over the stock performance. On the one hand, Akhibe et al (2012) find that better capitalized banks were the ones that experienced sharper declines in their stock prices. On the other hand, Demirguc-Kunt et al (2010) find some evidence that banks with higher capital (measured as total regulatory capital scaled by total un-weighted assets) prior to the crisis also had better performance during the crisis. The coefficient for their result, however, is small and only marginally significant. A main reason for the different results that these authors acquire is that they use different samples of banks for their empirical analysis. Akhibe et al (2012) use only U.S. banks, while Demirguc-Kunt et al (2010) use banks from all over the world. Therefore, these findings suggests that if some evidence works for the U.S., this does not mean that it will work for samples that consist of banks from other countries or regions. However, I was not able to find any paper that focuses on European banks. That is why, my analysis which uses sample of 118 European Union banks, will try to shed some light over this question – whether or not prior bank capital levels of European Union banks are related to subsequent stock returns during the financial crisis. I expect that my results will not be totally consistent with other authors’ findings because 3 of the specific nature of the financial crisis in Europe. The European Union crisis is different than the one in the U.S. – it lasts longer and the existence of the euro addresses a different set of challenges than sovereign currencies (i.e. there is a much stronger separation between fiscal and monetary policy in Europe than in most other countries). Speed of response to shore up capital and assist banks is also slower in Europe than in the US because the mechanism through which they decide is more cumbersome. By breaking the sample into Eurozone and non-Eurozone banks I also want to check if the regulatory framework in the Eurozone worked differently than outside of it. This topic of what might affect stock price performance during crisis periods is particularly important both for regulatory authorities and for investors. For regulation purposes, it is essential to see what the relationship, if any, is between various bank characteristic and bank performance during the crisis because that way the regulator might intervene with emergency liquidity injections, special assistance and even funds to recapitalize. Also, such an analysis might prove to be helpful in identifying which banks are more likely to be affected – that is why I also break up my full sample in three different groups of banks depending on their total assets size. For these reasons, an empirical research on this topic could prove to be useful for regulators – determining the factors that lead to better or worse performance during the crisis can be used to improve current regulation frameworks From an investment perspective, such analysis is relevant because it can give insights into which characteristics of a bank can be predictors of better performance in the event of a crisis. There are different types of investors depending on their risk appetite. Therefore, risk-averse investors for example, will be able to make a better choice between different bank investments when looking at their specific characteristics. The remainder of the paper is organized as follows. Section II presents an overview of the relevant literature. Section III and Section IV contain the methodology and the data description, respectively. Section V shows the results of the empirical model. Section VI concludes. 4 Section II. Literature Review Akhibe et al (2012) investigate the relationship between the bank capital level prior to the 2007–2009 financial crisis and the exposure of bank stock prices and stock volatility during the crisis. They use weighted least squares to perform a multivariate analysis applied to the pre-crisis and crisis period for 288 U.S.

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