Capital Risk of Large Banks

IF1@\JY\\,Jk)\1 September 9, 1983 CapitalRisk of large Banks Late 1 979 marked a threshold for the bank negative net worth and fail. But holders of ing industry. Around that time, a number of bank common equity are also concerned major economic and regulatory develop about the level and variability of profits, ments created a new, uncertain environ even if failure is not imminent. In reality, the ment for banks that had the potential of two kinds of risk cannot be dichotomized changing bank risk. because risk of ruin is simply an extreme consequence of profit risk: If profits vary On the economic front, rapid escalations in enough on the downside, default and bank the rate of inflation and in the level of inter ruptcy become more probable. est rates took place while the economy was operating at capacity, making a combina Regulators-particularly the FDIC, which tion that has often been followed by reces bears some of the financial risk in the event sions. In response to rising inflationary of failure-assess the risk of a bank by pressures, the Federal Reservechanged its observing directly its management of assets, monetary operating procedures in October liabilities, operations, and capital. (In fact, 1 979 to place greater emphasis on control a numerical "CAM E L" rating is assigned on ling the quantity of money in the short run the basis of appraised Capital, Assets, Man while allowing the federal funds rate to agement, Earnings and Liquidity.) An-insti fluctuate over a wider range. Coinciding tution judged to have a non-negligible risk with the new operating procedure was a of ruin is subjectto mandates and close scru substantial increase in the level and volatil tiny by the regulators. Investors in the stock ity of all market interest rates. and bond markets and lenders of uninsured liabilities also perform their own surveil In the regu latory sphere, momentum was lance of bank risks. The purchasers of bank building for landmark legislation to deregu debt issues and uninsured liabilities are late banks. By March 1 980, Congress had concerned with risk of ruin (default risk) passed the Depository Institutions Deregu while the purchasers of equity are con lation and Monetary Control Act, which, cerned with both the risk of ru in and among other things, called for the removal profit risk. of deposit rate ceilings by 1 986 and A bank's risk can be assessedby taking an extended deposit insurance from $40,000 to inside look, as the regu lators do. But one can $1 00,000 per account At the request of the also assessthe market's perception of bank Administration, the Federal Reserve also risk by observing the risk premia on bank imposed the Credit Control Program from debt and uninsured liabilities and the March through July of 1 980, which caused behavior of bank equity prices. From these large swings in bank lending, money observations one can infer whether inves growth, market interest rates, and perhaps tors view a bank as having become more or economic activity. less risky. (However, one cannot infer from these indicators alone whether a change in Bankrisk the market's perception of bank risk is dueto Did banks become more risky in the post regulatory efforts, government "protec 1 979 environment?To answerthis question, tion," or discretionary policies on the part we must first ask what we mean by bank risk. of the bank's management.) Holders of bank capital and uninsured lia bilities, as well as bank regulators, are Observations,. concerned ultimately with the "risk of ruin" We can test whether bank debt and equ ity -the possibi lity that the bank wi II approach capital became more risky after 1 979 by 1 IED@Jh1lk©tt IP If@\IT\l(cli Opinions expressed in this newsletter do not necessarily reflect the vievvs 01 the rnanagement of the Federa! Reserve Bank o( San Francisco, or of the Board of Governors of the Federal Reserve Svstem. observing the actual price behavior of bank shows very little increase in the average risk capital before and after. Unfortunately, debt premium for these 15 bank debt issues, with and equity issuesof smaller banks and thrifts the exception of the Credit Control period are rarely actively traded, and even when (March-July, 1 980) and possibly a small traded, prices often are not reported on increase in 1 982. * Consequently, these national exchanges. In fact, debt capital bank debt issues have not been perceived as issues are scarce even for large banks. For significantly more risky in the turbulent this reason, this study of bank capital risk is post-1 979 environment. confined to debt and equity of bank holding companies ("banks") with total assetsof .. .stock prices over $1 billion at year-end 1 981 . Forthe On average over the period from 1 972 to most part, these large institutions were not October 1 979, percentage returns of the 91 saddled with huge portiol ios of fixed-rate large-bank stocks (as measured by monthly mortgages as were savings and loan associ percentage changes in stock prices) per ations, mutual savings banks, and some formed about as well as the S&P 500 index. small commercial banks. Accordingly, the In contrast, the bank stocks on average post-1 979 risk observed for these large performed somewhat betterthan the S&P banks should not be appl ied to thrifts or even 500 from October 1 979 through the middle to small banks. Their situations are very·· of 1 982 (the end of the test periodl. Although different. Large banks generally are better such ave,age returns make no allowance for protected against rate risk and better pos returns that may be required as compen tured for deregulation than are smaller sation for risk, the evidence of average stock institutions. They also may be better able to price returns suggests at least that investors diversify into new financial services. did not perceive the post-1 979 environment as being detrimental to the values of banks To obtain data for large bank capital issues, with over $1 billion in assets. However, the the author selected month-end price data stock returns of banks in the $1-5 billion (from the early 1 970s through mid-1 982) for asset range performed modestly better than capital debt of 15 banks and common equ ity those of banks with over $5 billion in assets, of91 banks in the$1 -1 22 billion asset range. and 1 982 proved to be a year of mixed stock He then tested whether or not the debt and performance for banks. equity prices of these banks indicated .. .stock volatility greater risk in the post-1 979 environment Bank risk should have affected not only compared to the period before. Because of average bank equity percentage returns but the importance of the October 1 979 change also their monthly volatility'and sensitivity in Federal Reserve operating procedures for to economy-wide factors such monetary policy, that month was used as the as inflation, turning point in breaking the data into pre real economic activity, and interest rates. If and post-1 979 periods. banks have been perceived as more risky in the post-1 979 environment, one should expect their monthly stock prices to have ... debtrisk become more volatile and perhaps more The chart shows the average risk premia for sensitive to movements in the overall the 15 bank debt issues and for Moody's Baa stock market. bonds, both relative to Aaa corporate bond issues. Throughout the 1 974-79 period, the *The increased monthly variation in the bank debt issues were considered by the bank bond risk premium after October market to be about as risky as Baa bonds. 1 979 is related to infrequent tradingof However, during the post-1 979 period, the bank debt during a period of volatile bank bonds were considered to be less risky interest rates, not to increased risk of than Baa's. In fact, the post-1 979 period bank debt. 2 Debt Risk Premia (relative to Aoa corporate Issues) .30 .25 .20 .15 .10 .05 .ool--------- J .....-..:. ..... - .05 1974 1976 1978 lkt. 1980 1982 The volatility of equity prices of large banks decline in beta was dramatic-from an aver did not increase in the post-1979 period. age beta of 1.1 6 to an average of .63. Average stock-price volatility, as measured by the standard deviation of monthly returns The latter estimates indicate that the average for the 91 banks compared to that of the S&P risk sensitivity of the very large banks went 500, changed little in the post-1979 period; from above average to well below average that of banks with $1 -10 billion in assets between the pre- and post-October 1 979 posted only a slight increase while the aver periods! We must conclude that the equity age stock-price volatility of banks with over of the largest banks on average has been $10 billion in assets decreased slightly. perceived by market participants as being better insulated from common risk factors Finance theory singles out the "beta" of a since October 1979 than in the earlier 1970s. stock as the single most important measure of the stock's riskiness. Beta indicates the Conclusion sensitivity (elasticity) of the stock's price to What does one make of all this evidence? movements in the price of the overall stock For large banks with over $1 billion in assets, market. Because all equities are sensitive to post-1 979 perceived capital risk for both macroeconomic factors, such as inflation, debt and equity has been no greater on real economic growth and earnings, and average, and has been lower for the largest interest rates, that affect the overall stock banks on average, than it was in the prior market, beta gives a measure of the sensitiv seven-year period.

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