Interest Rate Sensitivity of Bank Stock Returns:
Re-examination since Basel Accords
Adam J. Fagan
University of AlaskaAnchorage
E-mail:
Suresh C. Srivastava
University of AlaskaAnchorage
3211 Providence Drive, Anchorage, AK 99508
E-mail:
Edward Forrest
University of AlaskaAnchorage
E-mail:
EXPANDED ABSTRACT
Corresponding author: Suresh Srivastava
Interest Rate Sensitivity of Bank Stock Returns:
Re-examination since Basel Accords
Abstract
The Basel I and Basel II accords have been known as a source of speculation regarding their overall impact on the banking industry. As the Basel I accord has been, and currently is, still in effect to help try and regulate credit risk many believe that this policy has had an effect on the interest rate that can be felt through changing returns on bank stocks. With talks of a newly reformed Basel II accord currently underway and slated to be in place by 2008 it is speculated that it will also have as much, if not more, of an impact on the industry as Basel I. Specifically, this paper examines the returns on bank stocks to determine whether the implementation of the Basel I accord or the announcement on the Basel II accord have had any discernable impacts
I. Introduction
The Basel I and subsequently the Basel II accords are a series of regulations passed by the Basel Committee (BCBS) to try and better regulate the banking industry. The Basel I accord, established in 1988, was the first of it’s kind and was initially established as a way to reach an agreement among the G-10 central banks to recognize common minimum capital standards. The standards set forth dealt primarily with the issue of credit risk and the need for a universal structure to determine said risk. “Assets of banks were classified and grouped in five categories according to credit risk, carrying risk weights of zero (for example home country sovereign, ten, twenty, fifty, and up to one hundred percent. Banks with international presence are required to hold capital equal to 8 % of the risk-weighted assets.” The Basel accord was then deemed to be enforceable by law and required to be adopted by the G-10 countries by 1992. The Basel II accord is essentially a much expanded upon and updated version of the aforementioned Basel I. The Basel II was brought about to try and make some much needed amendments to the Basel I which many felt was now outdated. Furthermore regulators felt that the Basel I was too risk insensitive and could be easily circumvented if given the right conditions. As a result deliberations began on the Basel II in January of 2001 in an attempt to mitigate the earlier Basel I’s shortcomings. To do so it was determined that the Basel II would have to encapsulate the three following ideals, ensuring that capital allocation is more risk sensitive, separating operational risk from credit risk, and attempting to align economic and regulatory capital more closely to reduce the scope of regulatory arbitrage. These changes are projected to have wide sweeping effects on the banking industry when the Basel II accord is finally put into action. It should be noted that although the Basel II accord is not currently in action it is, and has since it’s initial announcement, already had an effect on the banking industry as these institutions begin to make strides in an effort to be ready for this change over.
II. Interest Rate Risk
Interest rate sensitivity of commercial bank stock returns has been the subject of considerable research. Stone (1974) proposed a two-factor model incorporating both the market return and interest rate variables as return generating factors. While some studies have found the interest rate factor to be an important determinant of common stock returns of banks [Fama and Schwert (1977), Lynge and Zumwalt (1980), Christie (1981), Flannery and James (1984), Booth and Officer (1985)], others have found the returns to be insensitive [Chance and Lane,(1980)] or only marginally explained by the interest rate factor [Lloyd and Shick (1977)]. A review of the early literature can be found in Unal and Kane (1988). Sweeney and Warga (1986) used the APT framework and concluded that the interest rate riskpremium exists but varies over time. Flannery, Hameed and Harjes (1997) tested a two-factor model for a broad class of security returns and found the effect of interest rate risk on security returns to be rather weak. Bae (1990) examined the interest rate sensitivity of depository and nondepository firms using three different maturity interest rate indices. His results indicate that depository institutions’ stocks are sensitive to actual and unexpected interest rate changes, and the sensitivity increases for longer-maturity interest rate variables. Song (1994) examined the two-factor model using time-varying betas. His results show that both market beta and interest rate beta varied over the period 1977-87. Yourougou (1990) found the interest rate risk to be high during a period of great interest rate volatility (post-October 1979) but low during a period of stable interest rates (pre-October 1979). Choi, Elyasiani and Kopecky (1992) tested a three-factor model of bank stock returns using market, interest and exchange rate variables. Their findings about interest rate risk are consistent with the observations of Yourougou (1990).
The issue of interest rate sensitivity remains empirically unresolved. Most of the studies use a variety of short-term and long-term bond returns as the interest rate factor without providing any rationale for their use. The choice of bond market index seems to affect the pricing of the interest rate risk. Yet, there is no consensus on the choice of the interest rate factor that should be used in testing the two-factor model. In this paper, we provide a plausible explanation of why pricing of interest rate risk differs with the choice of interest rate variable. We also suggest a hybrid return-generating model for bank stock returns in which the CAPM is augmented by three APT-type factors to account for unexpected changes in the inflation premium, the maturity-risk premium and the default-risk premium.The use of three additional factors provides a better understanding of the interest rate sensitivity and offers a plausible explanation for the time varying interest rate risk observed by other investigators. Our empirical investigation covers three distinction economic and bank regulatory environments: 1974-78, a period of increasing but only moderately volatile interest rates in a highly regulated banking environment; (2) 1979-84, a period characterized by high level of interest rates with high volatility, in which there was gradual deregulation of the banking industry and; and (3) 1985-90, a low interest rate and low-volatility period during which many regulatory changes were made in response to enormous bank loan losses and bankruptcies. The results of the multi-factor asset-pricing model are compared with those from the two-factor model in order to explain the time varying interest rate risk.
The rest of this paper is divided into five sections. In Section II, we describe the two-factor model of the bank stock return and the pricing of the interest rate risk. The multi risk-premia model and the specification of the factors are discussed in Section III. The data for this analysis is described in Section IV. Section V presents empirical results and Section VI concludes the paper.
III. Two-Factor Asset Pricing Model
A. The Model
Stone (1974) proposed the following two-factor bank stock return generating model:
Rjt = αj + β1jRmt + β2jRIt + εjt(1)
where Rjt is the bank common stock return, Rmt is the market return, and RIt is the innovation in the interest rate variable.[1] Coefficients αj and β1j are analogous to the alpha and beta coefficients of the market model, and β2j represents interest rate risk. Since then, numerous researchers have studied the pricing of interest rate risk with varying results. While Stone (1974) and others did not place an a priori restriction on the sign of β2j, the nominal contracting hypothesis implies that it should be positive. This is because the maturity of bank assets is typically longer than that of liabilities.[2] Support for this hypothesis was found by Flannery and James (1984) but not by French, Ruback and Schwert (1983).
B. Pricing of Interest Rate Risk
In addition to changes in the level of expected or unexpected inflation, changes in other economic conditions produce effects on interest rate risk. For example, according to the intertemporal model of the capital market [Merton (1973), Cox, Ingersoll, and Ross (1985)], a change in interest rates alters the future investment opportunity set;as a result, investors require additional compensation for bearing the risk of such changes. Similarly, changes in the investor's degree of risk aversion, default risk or maturity risk of bank financial assets causes additional shifts in the future investment opportunities for the bank stockholders. The specific choice of the bond market index for the two-factor model determines what unexpected change is captured by the coefficient β2j.
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1
[1]Srivastava, Hamid and Choudhury (1999) present alternate ways of specifying the innovations in the interest rate variable and its influence on the pricing of the interest rate risk. In our investigation, the error term from the regression of interest rates onmarket returns is used as the orthogonal interest rate factor.
[2]The sign of β2j is negative when changes in bond yields and not the bond market return are used as the interest rate factor [see Sweeney and Warga (1986)].