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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 cannot be dichotomized changing bank risk. because 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 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 . 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 greater risk in the post-1 979 environment .. .stock volatility compared to the period before. Because of Bank risk should have affected not only the importance of the October 1 979 change average bank equity percentage returns but in Federal Reserve operating procedures for also their monthly volatility'and sensitivity monetary policy, that month was used as the to economy-wide factors such 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 ... debtrisk expect their monthly stock prices to have The chart shows the average risk premia for become more volatile and perhaps more the 15 bank debt issues and for Moody's Baa sensitive to movements in the overall bonds, both relative to Aaa corporate bond stock market. 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. At least until 1982, the ity of a company's (bank's) equity to the capital market did not perceive the post­ "common risk factors" that affect all stocks. 1 979 environment as detrimental to large A beta of 1.0 implies that the bank's stock is banks. as sensitive to common risk factors as the average stock in the S&P 500. Since the post-1979 period is regarded generally as having been a turbulent one for Given the importance of such common risk economic activity and banking deregula­ factors in equity valuation, an examination tion, the evidence of stable capital risk for of bank capital risk should also address the banks of over $1 billion in assets and question of whether or not the betas of bank declining betas for the $1 0+ billion banks is stocks rose in the turbulent post-1979 envi­ encouraging. However, it may not be sur­ ronment -that is, whether banks were more prising since, unlike many thrifts and small or less insulated from the risk factors that banks, large banks are generally considered cause vagaries in the stock market. to be fairly well 'protected from and the adverse consequences of dereg­ Betas of the 91 bank stocks were estimated ulation. Perhaps investors perceived that using month-end stock price data for mid­ regulators and government had increased 1972 through mid-1 982, allowing for a their implicit protection of the capital change in beta between the pre- and post­ holders of large banks. A more likely cause, October 1979 periods. The results were though, is that the managements of these striking. The average pre-October 1 979 beta banks took discretionary action to reduce was .90. Since the average beta in the stock the risk of their capital by altering their market is 1.0, this meant that equities of portfolios, operations, and/or capital lever­ banks with over $1 billion in assets were less age positions. sensitive to common risk factors than was Jack Beebe the average stock in the S&P 500. Moreover, in the post-October 1979 period, the aver­ age bank beta declined to .76. For the 20 banks with over $10 billion in assets, the

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BANKINGDATA-TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) SelectedAssets and liabilities Amount Change Changefrom LargeCommercial Banks Outstanding from year ago 8/24/83 8/17/83 Dollar Percent loans'{gross,adjusted) and investments" 160,638 -1,068 145 0.1 loans (gross,adjusted) - total# 140,248 - 961 38 0.0 Commercial and industrial 43,009 - 412 - 978 - 2.2 Real estate 56,534 31 - 1,120 1.9 loans to individuals 24,216 89 841 3.6 5ecu'ritiesloans 2,511 - 362 173 7.4 U.S. Treasurysecurities" 7,461 30 1,114 17.6 Other securities" 12,928 - 136 - 1,007 - 7.2 Demand deposits - total# 38,983 -2,694 1,272 3.4 Demand deposits- adjusted 28,274 -1,094 1,415 5.3 Savingsdeposits - totalt 65,647 - 356 34,752 112.5 Time deposits- total# 67,102 132 - 32,998 - 33.0 Individuals, part. & corp. 61,232 157 - 29,157 - 32.3 (large negotiable CD's) 17,943 - 176 - 19,773 - 52.4 WeeklyAverages Weekended Weekended Comparable of Daily Figures 8/24/83 8/17/83 year-agoperiod MemberBank Reserve Position ExcessReserves (+ )/Deficiency (-) 88 121 67 Borrowings 11 39 87 Net free reserves'(+l/Net borrowed(-) 77 82 20 .. Excludestrading account securities. # lndudes items not shown separately. t Includes Mo.neyMarket Deposit Accounts; accounts,and NOW accounts. Editorialcomments may be addressed to theeditor (Gregory Tong) or to theauthor . ... Freecopies of this andother FederalReserve publications can beobtainedby callingor writing the Public mationSection, Federal Reserve Bank of SanFrancisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974·2246. .