Jack Beebe

English

Research Papers in Economics

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September 9, 1983
Capital Risk of large Banks
Late 1979 marked athreshold for the bank-
ing industry. Around that time, a number of
majoreconomic and regulatory develop-
ments created a new, uncertain environ-
ment for banks that had the potential of
changing bank risk.
On the economic front, rapid escalations in
the rate ofinflation and in the level ofinter-
est rates took place while the economy was
operating at capacity, making acombina-
tion that has often been followed by reces-
sions. In response to rising inflationary
pressures, the Federal Reserve changed its
monetary operating procedures in October
1979 to place greater emphasis on control-
lingthe quantityofmoney in the short run
while allowing the federal funds rate to
fluctuate over a wider range. Coinciding
with the newoperating procedure was a
substantial increase in the level and volatil-
ity ofall market interest rates.
In the regu latory sphere, momentum was
building for landmark legislation to deregu-
late banks. By March 1980, Congress had
passed theDepository Institutions Deregu-
lation and Monetary Control Act, which,
among other things, called forthe removal
ofdeposit rate ceilings by 1986 and
extended deposit insurancefrom $40,000to
$100,000 per account At the request ofthe
Administration, the Federal Reserve also
imposed the Credit Control Program from
March through July of 1980, which caused
large swings in bank lending, money
growth, market interest rates, and perhaps
economic activity.
Bank risk
Did banks become more risky in the post-
1979environment?Toanswerthisquestion,
we mustfirst ask whatwe mean bybank risk.
Holders ofbank capital and uninsured lia-
bilities, as well as bank regulators, are
concerned ultimately with the "risk ofruin"
-thepossibilitythat the bank wiII approach
1
negative net worth and fail. But holders of
bank common equity are also concerned
about the level and variability ofprofits,
even iffailure is not imminent. In reality, the
two kinds ofrisk cannot be dichotomized
because risk ofruin is simply an extreme
consequence ofprofit risk: Ifprofits vary
enough on the downside, default and bank-
ruptcy become more probable.
Regulators-particularly the FDIC, which
bears some ofthe financial risk in the event
offailure-assess the risk ofa bank by
observingdirectly its management ofassets,
liabilities, operations, and capital. (In fact,
a numerical "CAMEL" rating is assigned on
the basis ofappraised Capital, Assets, Man-
agement, Earnings and Liquidity.) An-insti-
tution judged to have a non-negligible risk
ofruin is subjectto mandates and close scru-
tiny by the regulators. Investors in the stock
and bond markets and lenders ofuninsured
liabilities also perform their own surveil-
lance ofbank risks. The purchasers ofbank
debt issues and uninsured liabilities are
concerned with risk ofruin (default risk)
while the purchasers ofequity are con-
cerned with both the risk ofruin and
profit risk.
A bank's risk can be assessed by taking an
inside look, as the regu latorsdo. Butonecan
also assess the market's perception ofbank
risk by observingthe risk premia on bank
debt and uninsured liabilities and the
behavior ofbank equityprices. From these
observations one can infer whether inves-
tors view a bank as having become more or
less risky. (However, one cannot infer from
these indicators alone whether a change in
the market'sperceptionofbank risk is dueto
regulatory efforts, government "protec-
tion," or discretionary policies on the part
ofthe bank's management.)
Observations,..
We can test whether bank debtand equity
capital became more risky after 1979 byIP(~cdl~lfi5.\ll n«~~~lfW~
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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 behaviorofbank
capital before and after. Unfortunately, debt
and equity issues ofsmallerbanks and thrifts
are rarely actively traded, and even when
traded, prices often are not reported on
national exchanges. In fact, debtcapital
issues are scarce even for large banks. For
this reason, this study ofbank capital risk is
confined to debt and equityofbank holding
companies ("banks") with total assets of
over $1 billion at year-end 1981. Forthe
most part, these large institutions were not
saddled with huge portiolios offixed-rate
mortgages as were savings and loan associ-
ations, mutual savings banks, and some
small commercial banks. Accordingly, the
post-1979 risk observed forthese large
banks should notbe applied tothriftsoreven
to small banks. Their situations are very··
different. Large banks generally are better
protected against rate risk and better pos-
tured for deregulation than are smaller
institutions. They also may be better able to
diversify into new financial services.
To obtain data for large bank capital issues,
the author selected month-end pricedata
(from the early 1970sthrough mid-1982)for
capitaldebtof15 banks and common equity
of91 banks inthe$1-122 billion asset range.
Hethen tested whether or not the debt and
equityprices ofthese banks indicated
greater risk in the post-1979 environment
compared to the period before. Because of
the importanceofthe October 1979 change
in Federal Reserve operating procedures for
monetary policy, thatmonth was used as the
turning point in breaking the data into pre-
and post-1979 periods.
...debt risk
The chart shows the average risk premia for
the 15 bankdebtissues and forMoody'sBaa
bonds, both relative to Aaa corporate bond
issues. Throughout the 1974-79 period, the
bank debt issues were considered by the
marketto be about as risky as Baa bonds.
However, duringthe post-1979 period, the
bank bonds were considered to be less risky
than Baa's. In fact, the post-1979 period
2
shows very little increase in the average risk
premium for these 15 bank debt issues, with
the exception ofthe Credit Control period
(March-July, 1980) and possibly a small
increase in 1982.* Consequently, these
bankdebt issues havenotbeen perceived as
significantly more risky in the turbulent
post-1979 environment.
...stock prices
On average overthe period from 1972 to
October 1979, percentage returns ofthe 91
large-bank stocks (as measured by monthly
percentage changes in stock prices) per-
formed about as well as the S&P 500 index.
In contrast, the bank stocks on average
performed somewhatbetterthan the S&P
500 from October 1979through the middle
of1982 (theendofthetest periodl.Although
such ave,age returns make noallowancefor
returns that may be required as compen-
sation for risk, theevidenceofaverage stock
price returns suggests at least that investors
didnotperceivethepost-1979environment
as being detrimental to the values ofbanks
with over $1 billion in assets. However, the
stock returns ofbanks in the $1-5 billion
asset range performed modestly better than
those ofbanks with over $5 billion in assets,
and 1982 proved to be ayearofmixedstock
performance for banks.
...stock volatility
Bank risk should have affected not only
average bank equity percentage returns but
also their monthlyvolatility'and sensitivity
to economy-wide factors such as inflation,
real economic activity, and interest rates. If
banks have been perceived as more risky in
the post-1979 environment, one should
expecttheirmonthly stock prices to have
become more volatile and perhaps more
sensitive to movements in the overall
stock market.
*The increased monthlyvariation in the
bank bond risk premium after October
1979 is related to infrequent tradingof
bankdebtduringa period ofvolatile
interest rates, notto increased risk of
bankdebt.Debt Risk Premia
(relative to Aoa corporate Issues)
Jack Beebe
The latterestimates indicatethatthe average
risk sensitivity ofthe very large banks went
from above average to well below average
between the pre- and post-October 1979
periods! We must concludethatthe equity
ofthe largest banks on average has been
perceived by market participants as being
better insulated from common risk factors
sinceOctober1979than in theearlier 1970s.
Conclusion
What does one make ofall this evidence?
For largebanks with over$1 billion inassets,
post-1979 perceived capital risk for both
debtand equity has been no greater on
average, and has been lower for the largest
banks on average, than it was in the prior
seven-year period. At leastuntil 1982, the
capital market did not perceive the post-
1979environment as detrimental to large
banks.
Since the post-1979 period is regarded
generally as having been a turbulentone for
economic activity and bankingderegula-
tion, the evidenceofstable capital risk for
banks ofover $1 billion in assets and
decliningbetas forthe $10+ billionbanks is
encouraging. However, itmay notbe sur-
prising since, unlike many thrifts and small
banks, large banks are generally considered
to be fairly well 'protected from interest rate
risk and theadverse consequences ofdereg-
ulation. Perhaps investors perceived that
regulators and government had increased
their implicit protection ofthe capital
holders of large banks. A more likelycause,
though, is that the managements ofthese
banks took discretionary action to reduce
the risk oftheir capital by altering their
portfolios, operations, and/or capital lever-
age positions.
declinein beta was dramatic-froman aver-
age beta of 1.16to an average of.63.
3
1982 1978 lkt. 1980 1976 .05 1974
Given the importanceofsuch common risk
factors in equity valuation, an examination
ofbank capital risk should also address the
question ofwhether or not the betas ofbank
stocks rose in the turbulent post-1979 envi-
ronment-thatis, whetherbanks weremore
or less insulated from the risk factors that
cause vagaries in the stock market.
Betas of the 91 bank stocks were estimated
using month-end stock price data for mid-
1972 through mid-1982, allowing for a
change in beta between the pre- and post-
October 1979 periods. The results were
striking. The average pre-October 1979 beta
was .90. Since the average beta in the stock
market is 1.0, this meantthat equities of
banks with over $1 billion in assets were less
sensitive to common risk factors than was
the averagestock 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
Finance theory singles out the "beta" ofa
stock as the single most important measure
ofthe stock's riskiness. Beta indicates the
sensitivity (elasticity) ofthe stock's price to
movements in the priceofthe overall stock
market. Because all equities are sensitive to
macroeconomic factors, such as inflation,
real economic growth and earnings, and
interest rates, that affect the overall stock
market, beta gives a measure ofthe sensitiv-
ityofacompany's (bank's) equity to the
"common risk factors" that affect all stocks.
A beta of 1.0 implies that the bank's stock is
as sensitive to common risk factors as the
average stock in the S&P 500.
.30
.25
.20
.15
.10
.05
.ool---------J.....-..:......-
The volatility ofequity prices of large banks
did not increase in the post-1979 period.
Average stock-price volatility, as measured
bythe standard deviationofmonthlyreturns
forthe 91 banks compared tothatofthe S&P
500, changed little in the post-1979 period;
that ofbanks with $1-10billion in assets
posted only a slight increase while the aver-
age stock-price volatilityofbanks with over
$10 billion in assets decreased slightly.UOl5u!4SEM. 4Eln • uo5i:lJO • epel\i:lN • OljePI
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millions)
Selected Assets and liabilities
Large Commercial Banks
Amount
Outstanding
8/24/83
Change
from
8/17/83
Change from
year ago
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'rities loans 2,511 - 362 173 7.4
U.S. Treasury securities" 7,461 30 1,114 17.6
Othersecurities" 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
Timedeposits - 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
Weekly Averages
of Daily Figures
Member Bank Reserve Position
Excess Reserves (+)/Deficiency(-)
Borrowings
Net free reserves'(+l/Net borrowed(-)
Weekended
8/24/83
88
11
77
Weekended
8/17/83
121
39
82
Comparable
year-ago period
67
87
20
.. Excludes tradingaccountsecurities.
# lndudes items not shown separately.
t IncludesMo.ney Market DepositAccounts; Super~NOWaccounts, and NOWaccounts.
Editorial comments maybeaddressedtotheeditor(GregoryTong) orto theauthor ....Freecopies of
this and other Federal Reserve publications can be obtained by calling or writing the Public Infor~
mation Section, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120. Phone
(415) 974·2246. .

Capital risk of large banks

http://www.frbsf.org/publications/economics/letter/1983/el83-36.pdf

Capital risk of large banks

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Research Papers in Economics