Daniel T. Walz is an Associate Professor of Business Administration at Trinity University, San Antonio. Roger W. Spencer is Professor of Economics at Trinity University. San Antonio

Spencer, Roger W.

Walz, Daniel T.

English

Georgia Southern University: Digital Commons@Georgia Southern

Southern Business Review Volume 15 Issue 2 Article 8 September 1989 The Interest Sensitivity of Commercial Bank Equity Returns: New Evidence Daniel T. Walz Trinity University Roger W. Spencer Trinity University Follow this and additional works at: https://digitalcommons.georgiasouthern.edu/sbr  Part of the Business Commons, and the Education Commons Recommended Citation Walz, Daniel T. and Spencer, Roger W. (1989) "The Interest Sensitivity of Commercial Bank Equity Returns: New Evidence," Southern Business Review: Vol. 15: Iss. 2, Article 8. Available at: https://digitalcommons.georgiasouthern.edu/sbr/vol15/iss2/8 This article is brought to you for free and open access by the Journals at Digital Commons@Georgia Southern. It has been accepted for inclusion in Southern Business Review by an authorized administrator of Digital Commons@Georgia Southern. For more information, please contact digitalcommons@georgiasouthern.edu. THE INTEREST SENSITIVITY OF COMMERClAL BANK EQUITY RETURNS: NEW EVIDENCE Daniel T. Walz and Roger W. Spencer Introduction On what do bank equity returns depend'! Market model studies of mo,t firm, relate equity returns solely to a market index. However, commercial banks arc ,o closely identified with financial variables that it might be ex-pected that intcre,t rate changes would affect bank equity returns as well. A number of ,tudies in recent years have attempted to measure the effect of interest rate movements on bank stock returns. Flannery and Jame, ( 1984) employ a two index market model to demonstrate that the returns for a port-folio of commercial banb are inversely related to unexpected changes in a variety of interest rate mca~ure,. Sweeney and Warga ( 1986) found that the returns of both public utilities and commercial banks arc inversely related to unexpected rate changes. They also found that the sensitivity of a firm', returns to interest rate change, may be priced by the market. That is, they found evidence that equilibrium firm return~ are positively related to firm intcrc~t sensitivity. While the~c ,tudic, provide \aluable insights regarding the effects of in-terc,t rate .:hange, on .:ommcr.:ial bank returns, questions remain. Both of tile ,tudie~ cited above employ the two index market model; that is, both studies regress firm or portfolio returns against the returns of a market in-dex and unexpe.:ted changes in a single interest rate. The use of a single rate represent, an implicit assumption that either the slope of the term strtH:tun: of intere~t rates is .:on,tant over time or the equity return, are unrelated to unexpected changes in the term ,tru.:ture of interest rate,. The use of a sin-gle rate aho implies that unexpected changes in the ,tructure of risk premia among interest ratc, (the difference, in required yields among ,ecuritie, of differing ri sk) haVl' no effect on bank equity returns. However, Fogler, Kose, and Tipton ( I 981) and Roll and Ros, ( I 984) ha, e recently presented empirical evidence which demonstrates that, on average. l"irm returns generally ;ire related to both term stnKture and risk prcmia fac-tors. The unexamined issue is whether bani-. equity rcturn~ arc abo affected by changes in the term structure and change, in risl-. premia. This is an im-portant topic because the sensitivity of bani-. equity return~ to these factor, indicates the degree to whi.:h bank5 can insulatc or hedge thermel\es against changes in the structure of interest rates. This is the issue addressed in this paper. Specifically, the purpose of this paper is to determine whether the equity return~ for a portfolio of commercial banks arc signifi.:antly related to four factors: the market index, unexpected t.:hanges in the level of interest rates, unexpected changes in the slope of the term stru.:turc of interest rates, and 53 ( unexpected changes in market risk premia. The methodology and data are described in the following section of the paper, followed by an examination of the results, and a discussion of the implica1ions of these results. Mcthodolol!} and Data J\s with Fogler et al., (1981), Flannery and Jame, (1984), and Sweeney and Warga (1986), the basic equation to be estimated is the familiar market model adjuMed by the inclusion of intereM race variables. Specifically, the following equation is estimated u,ing OLS: (I) \\ here r;1 is the common ~lock return for bani.. i in month t, Rmt is 1he return for the marke1 index for month i. Lt is the unexpected change in the level of interest rate, for month i (proxied by the change in 1hc 90 day Treasury Bill race), S1 is the unexpected change in the slope of lhe term \truc1ure of interest rate~ during month i (proxied by 1hc change in the difference be-tween the 30 year U.S. Government Bond rate and the 90 day Treasury Bill rate), and At represent~ the unexpecled change in marJ..et risJ.. aversion dur-ing month i (proxied by 1he change in the difference between the average rate on AAA raced corporate bond, and 1he long 1erm government bond rate). These intere~t race \ariablcs \\ere chosen hecau,e I hey were the mca~ures used by Roll and Rms (1984) and thus allo\, the resull, ofthi\ ,tudy to be com-pared to their findings. Becaw,c market returns rnufd be significamly corrcfa1ed wi1h lhese interes1 rale measures (thus po,ing significant problems of mullicollinearity), the in-terest race measure, arc firs! regressed again\l the market return. The errors of these regressions 1hu, represent interesl race changes uncorrelated wilh the equity market (the interesl rate change\ orthogonal 10 market returns). These uncorrelated interesl changes are the inlerest rate changc5 U\Cd in equa-l ion (I). A common criticism of such models as equation {I) (see Brennan (1981)} is that ~uch multi-factor model\ may !>uffer from an omiued-\ariables problem leading to bia\ed coefficient eMimatcs. In order to determine whether the above equation i5 mis~pccified and whether signifh.:anl factor~ arc omit-ted, a variation of the regression specification error tc5t (RESET) proposed by Ramsey ( 1969) and developed by Thursby and Schmidt ( I 977) and Thursby ( 198 I) is employed. As5ume the model 10 be tC\led for ~pecification error is: y = XB + u (2) RESET test~ the 5ignificance of C in the augmented regression: Y = XB + ZC + u (3) 54 where Z is a matrix of te!>t variables such as powers of the independent vari-ables and: G = AY Au (4) where: A (5) , and: (6) If the model is correctly specified, E(C) = 0. Ram~ey ( 1969) has !>hown that the te~t statbtic for thi\ procedure has an F distribution with the numer-ator of the F-statistic having degrees of freedom equal to the number of ex-planatory power~ and denominator of the F-statistic having degrees of freedom equal to the number of observations minu, the number of explana-tory variable~. Using simulation. Thur~by (1977) found that the RESE1 procedure 1\a~ best able to dbcern misspecification 1\hen the second. third, and fourth pow-ers of each explanatory variable \\ere included in the augmented regression. Therefore. the augmented regression te~ted by the RESE1 procedure in this study include, four proposed market factor~ and their ,econd. third. and fourth pov.er~. The returns data con!>ist of the monthly returns of commercial bani..s from January 1974 through December 1985 (see Exhibit I). Thew banl,.5 represent all bani.., with complete returns data in the center for research in Securitie~ Pril:es (CRSP) monthly ma,ter file for the e,timation period. Our , proxy for the market returns v.a, the monthly return, for a value weighted index of all stock, listed on the New York Stoel, Exchange. Monthly U.S. 1 Trea~ury Bill rates. U.S. Government Bond Ralt:\, and corporate bond rate, were collected from Bu5ine,, Conditions Digest. -The rc~ulb of e,timating equation I for an equally weighted portfolio of 2.t commercial bani.., art· pre!>ented in Table I. An equally Y.cighted portfo-lio was used rather than a \alue ,~cightcd portfolio so 1ha1 the large money center hani..s would 1101 dominate the findings. (Sec Exhihil I for a complete listing of the \ample banks.) Several resuh~ emerge. The model explaim a significant proportion of rhe, ariance of portfolio rerurm over the January 1978 - December 1985 period. The model R2 is greater rhan .66. Three of the four factor coefficients are also significant. Specifically, the coefficients a5soeiatl·d with the mari..et index, the change in Treasury Bill rates. and the change in the difference between long- and short-term government interest rates are all significant. The coefficient associated with a change in mari..et ri5k aversion (the change in the difference between long-term government and corporate rates) is not found to be significant for the portfolio returns. ss Exhibit I -Sample Bankl> Bank of Virginia Bank America Corr. CBT Corp. Chase rvlanhattan Corr. Chemical Corp. Citicorp Continental lllinoi~ Crocker Equimark First Bank Sy~tem FiN City Bancorr. lnterfirst Fir~t National State Bancorp. Fir,t United Bancorr. First Virginia Bank, Fir,t Wisrnnsin Corp. General Banc,hare, Harris Bancorp Inc. Key Bank, NCNB Corp. Rerublic of Te\as Corp. Southea~t Banl..ing Corr. Texa, American Banc~hares Union Commerce Corp. The signs of the coefficients appear reasonable, given the result, of other ~tudies. The coefficient a~sociated with the market index, the bank portfo-lio's "beta," is .927. This indicate~ that the bani... portfolio has slightly less ,ystematic risl.. than the market. This beta value is some\\ hat larger than the beta \alues reported by either Fogler. Kase, and Tipton ( 1981) or Flannery and James (1984 ). For e:1.ample, the beta reported in the Flannery and Jame, study has a \aluc of .56. The difference in beta \alue, between this study and previous one i.~ probably the difference in the time period examined. Previous studies loo!... at bank returns during the 1970's while this study in-vestigates bank returns predominantly during the 1980\ - a period of great regulatory reform for financial institutiom. The negative coefficients associated with the proxies for unexpected changes in the level and term structure corroborate and extend the findings of Flan-nery and James ( I 984) and Sweeney and Warga ( 1986). The~e results sug-gest that, on average (since the portfolio coefficients repre,ent the average of the coefficients of the individual banks), commercial banks have longer maturity assets than liabilitie5. Therefore, an increase in the level or the slope of the term structure of interest rares should diminish the market value of banks' assets to a greater degree than banks' liabilities. 56 ----Table I - Results of Estimating Equation I for an Equally Weighted Portfolio of 24 Commerdal Banks (.January 1978 • December 1985) R2 = .66 Intercept = - .002 RESET F-statistic = .354 Independent Variable Market Index Unexpected Change in the Level of Interest Rate, Unexpected Change in the Term Structure of I ntercst Rates Unexpected Change in Risk Prcmia • = significant at the .0001 level Coc·fficicnt .927* - .039· - .049* -.020 The magnitude, of these coeffich:nts indicate that the sensitivity of equity returns to change, in the level or slope of the term structure is very ,trong. Literally, the,e coefficient~ imply that an unexpected increase in the Treasu-ry Bill rate of I% will re~ult in a 3. 960/o decrea,c in bank equity value, and that a 10/o increa~e in the diffaence between the long-term and ,hort-term government bond rate will de..:rcase equity ,·alue by 4.9%. Ah hough the coefficient a,sociatcd with the proxy for changes in market ri,k aver,ion i, negative, as a priori rea,oning would wggest, the fact that this coefficient is not significant is ,omcwhat ,urprising. Given that a sig-nificant proportion of the liabilitic, of mo,t commercial bank~ are guaran-teed by the Federal Depo~it Insurance Corp., one might prewme that an unexpected increase in the rbk premia demanded by the market ~hould decrease the market value of bank asset~ more than the market value of bank liabilitic,, and thus diminish the ,alue of the bank·~ equity. Therefore, it might be expected that increases in the value of the ri~k proxy would nega-tively affect bank equity returns to a significant degree. Table I also indicates that the F-statistic associated with the Thursby test for model ~pecifo:ation is not significant. The Thursby procedure therefore implies that no significant factors have been omitted from equation I. While this finding may require further research, it is quite important in that it im-plies that bank equity returns, on average, may only be significantly related to these factors: the market index , the level of interest rates. and the slope of the term structure of interest rates. The results of estimating equation I for each of the 24 commercial banks individually are presented in Table 2. Generally, the individual results tend 57 to reinforce the portfolio finding~. The equity return~ for all of the sample banks are ~ignificantly and positively related to the market factor (all hough the variation in "beca" is large, ranging from roughly .56 10 1.36). The eq-uity returns of all but six banb arc ~ignificantly and negatively related to the term 5tructure lc\el and term ,tructurc slope variable~. Table· 2 - The Rl'sult!> of E!>timatinJ.! Equation I for Each lndi,idual Comml'rcial Bank in thl' 2--1 Bank Sampk <Januar~ 1978 - Dcccmhl'r 1985) Variable al bli b2i h3i b4i Ml'an .337 -.001 .882* • -.041** - .Ost•• - .039* • ,ignificant at the .0 I le\ d •• ~ignificant at the .0001 level Standard Dc•vi;1tio11 .099 .001 .218 .021 .033 -.067 Minimum Maximum Value Valm' .136 .491 -.021 .008 .580 1.420 -.075 .019 -.118 .()35 - .300 .()35 There arc also significant differences between the indi\ idual and portfo-lio results. The major diffrrence is that\\ hile the coeffh:ient a,sociated \1ith risl,. a\ersion is not significant for the portfolio e~timation of equation (I), this coefficient is ,ignificant for a majority of thl· indi\ idual hank regres-sions. In other words, although bank equity returns, on average, might not he significantly related to changes in market ri,k aversion, the equity returns of many indi\idual hank, arc related lo thi~ factor. Thi, finding implies that the market perceive5 that commercial bank, differ ~ome,\ hat widely in rbL Another difference between the portfolio and indhidual finding, is that the model explain~ less of the variance of individual bani,. returns, on aver-age, than it doe~ the variance of portfolio return,. Till' average R2 for the estimation of equation I for indi\idual bani.., \\a~ roughly .J4. Thi~ result i~ not ~urprising in that it might be expected that the me of average or port-folio return, would filter out much of the noise in the return, data. Table 2 aho indicate, that there is a ~omewhat wide variance in the sen,i-tivity of bank equity return, to changes in the level and slope of the term structure of rates. The respective ~tandard deviation~ arc .021 and .033. This finding implies that the market believe~ that hank~ differ significantly in the duration or maturity of the assets and liabilities they hold. Thus it appears that the market discerns wide variations in "gaps" (rate sensitive assets -rates sensitive liabilities) among commercial banks. 58 Summar) Several recent studies have found that bank equity returns are significant-ly related to unexpected changes in the le\ el of interest rates as well as the market index. The purpo5e of this study was to determine whether the equi-ty returns of a sample of commercial banks are 5ignificantly related to unex-pected changc5 in the slope of the term 5tructure of interest rate5 and unexpected change5 in market risk aversion as well as these other two fac-tors. This study find'> a significant negative relationship, on average, between changes in the slope of interest rates and bani,. equity returns. This reprewnts evidence that the market believes, on average. the duration or maturity of bank assets is significantly greater than the duration of bank Jiabilitic5. The study also find, that the mean equity return'> for a portfolio of com-mercial bank, are not significantly related to change~ in market risk a,er-sion. However. the study finds that the equity returns for a majority of the indi\ i<lual sample banks arc significantly and negatively related 10 changes in market rislo. aversion. The,e results thus indicate that the market may be-lieve that commercial bank'> differ significantly in the riskines, of their a,\et or liability portfolios. Additionally, this study uses the regression specification error test (RESET) developed by Ramsey ( 1969), Thur,by and Schmidt (1977). and Thursby (1981) in order to tlctcrmine whether any faclOrs relevant to the pricing of commercial bank equitie5 were omitted from the model tested . This proce-dure Jailed to reject the null hypothesis of correct model specification. Thus, the hypothesi5 that bank equity return~ are significantly related to the fol-lowing three factors is not rejected: the market index, the le\'cl of the term structure of illlere!)t rate~. and the ,lope or the term ,trucwre or intere~t rate, . Finally. the study find, that commercial bunks differ significantly in their sensitivity to change, in the ,truuurc of interest rate!>. Bibliograph) Brennan, r-1. "Dbcu!>!>ion: Trea!)ury Bill Factor, and Common Stock Returns." .Journal or Fin:rncc, 36 (\lay 1981 ). pp. 353-354. Flannery. M. and C. James. ''The Effect of lntcrc!>t Ratc Change~ on the Common Stock Return, of Financial Institutions," .Journal or Fimrnt·(•, 39(September 1984), pp. 1141 -1153. Fogler, H ., J. Kose, and J. Tipton. "Three Factor~. lntere,t Rate Differen-tial\ and Stock Groups," Journal of Finance, 36 (May 1981 ), pp. 323-335. Ram5cy, J . "Test!> for Specification Errors in Classkal Linear Least Squares Regression Analysis," Journal or th<' Royal Statistical Socict}, Serb B. 31 (1969, No. 2), pp. 350-371. 59 -Roll, R. and S. Ross. "The Arbitrage Pricing Theory Approach to Strategic Portfolio Planning." Financial Analysts Journal, 18 (May 1984), pp. 14-26. Sweeney, R. and A. Warga. "The Pricing of Interest Rate Risk: Evidence From the Stock Market." .Journal of Financ<' (June 1986), pp. 393-410. Thursby, J. and P. Schmidt. "Some Properties of Tests for Specification Error in a Linear Regre,~ion Model." Journal of th<' Am<'rican Statistical Association, 72 (September 1977), pp. 635-641. Thursby, J. "A Test Strategy for Discriminating Between Autocorrelation and Mis~pecification in Regression Analysis," ThC' Rl•vi<'W of Economics and Statistics (February 1981), pp. 117-123. Daniel T. Wal1 is an A,,ociatc Profe,,or of 13u,ine~\ Administration at Trini-ty Uni\'ersity, San Antonio. Roger \\'. Spencer b Profes~or of Economics at Trinity University. San Antonio. 60 SOU n!ER BUSI F. Landrum Box 81 53 Geor~ia Southern Collc~c State,boro, GA 30460 IU VII-\\ Zach Henderson Library-Acquisit ions Georgia Southern College LB 6074 Statesboro, GA 30460 Non-Profit 0rJ!.3ni,ation U.S. Po,taJ!.c Paid ~tatc,boro. Ga. 30460 Permit No. 286 

The Interest Sensitivity of Commercial Bank Equity Returns: New Evidence

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The Interest Sensitivity of Commercial Bank Equity Returns: New Evidence

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