Jonathan A. Neuberger

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 94-12, March 25, 1994
Industry Effects in the Stock Returns
of Banks and Nonfinancial Firms
The volatility of an individual company's stock
price is indicative ofthe risk of holding that stock.
This volatility depends on a number of factors.
Some of the factors that influence stock risk are
quite general, like the extent to which the firm's
stock price varies with changes in the overall
market. This kind of risk is often referred to as
market or systematic risk.
Other sources of risk are less general. Some may
be specific to the firm, such as its degree of lev-
erage or the willingness of its management to
pursue risky projects. Another may be specific
to an industry. That is, firms engaged in similar
businesses or activities may share a common ele-
mentof risk. This so-called "industry effect" may
be quite strong in the banking industry, since
banks are subject to an extensive system of regu-
lations that restricts what they can do and, often,
howthey can do it. Moreover, many banks interact
regularly with one another, maintaining signif-
icant correspondent relationships in deposit-
taking or lending activities. These relationships
make it more likely that bank stocks are subject
to significant industry risk effects. Close inter-
actions between banking companies also raise
concerns about possible contagion effects in the
banking industry. Contagion occurs when sol-
vency problems at one bank can spill over to
affect the financial condition of other institutions,
even though those other banks might not be di-
rectly involved in the original problem. Concerns
about contagion might be heightened ifevidence
of a strong industry effect exists in bank stocks.
In this Weekly Letter, I investigate the role of
industry effects in stock return behavior for banks
as well as for companies in nine nonfinancial
sectors. I then consider whether the stock risk
associated with different-sized companies exerts
any identifiable influence on the risks of other-
sized firms in the same industry. The analysis
shows that significant industry effects exist in
most of the ten sectors. However, the industry
effects among the banking firms in the sample
appear stronger and more consistent than those
of the nonfinancial companies. One interpreta-
tion of these industry effects is that "the market"
views certain companies as being particularly
informative about the risks of doing business in
that industry. In assessing the future prospects for
firms in the industry, investors and other market
participants may look especially to these influen-
tial firms. Shocks to the stock returns of these
important companies may presage more wide-
spread shocks to the industry as a whole.
Measuring risk
Volatility of stock prices is a widely used measure
of risk. This is because the stock market pro-
cesses information about companies in a way
that is considered to be independent and effi-
cient. In this analysis, I look at monthly stock
returns for companies in 10 different industries
over the 10-year period from 1982 to 1991. The
sectors include banking, oil and gas exploration,
food, chemicals, fabricated metals, machinery,
electrical equipment, transportation, instruments,
and utilities.
The companies in each industry are divided into
three portfolios (sets of firms) based on size: the
large portfolios contain the stock returns ofthe
largest one-third of the companies in the sample
in each industry, the medium portfolios contain
the next largest one-third, and the small portfo-
lios contain the rest. The nonfinancial companies
range in size from multinational conglomerates
with several hundred billion dollars in assets to
relatively small companies with a market value
of only a few million dollars. The banking firms
in the sample are all fairly large; the smallest
bank had over $3 billion in assets as ofthe end
of 1991.
The portfolios are divided by size in part because
companies of different sizes often display differ-
ent stock price behavior. For example, in many
empirical estimates, large nonfinancial com-
panies often exhibit lower market-related risk
than smaller companies. Notably, the opposite is
true in estimates of banking firms; larger banksFRBSF
tend to have higher market risk than smaller
publicly traded banks. Another reason for using
size-based portfolios is that they may capture the
market's use of information to assess industry
risk. The idea is that market participants use in-
formation on certain firms in order to evaluate
industry risk effects. In general, more information
should be available about the largest firms in
each industry. Moreover, market analysts may
concentrate their information-gathering efforts on
these larger firms in the belief that they are most
representative of industry-specific risks. Ifthis
is the case, then the risks ofthese larger firms
would be expected to exert a positive impact on
the risks of smaller firms in the same industry.
The analysis requires estimating an asset-pricing
model that explains the stock return on each
portfolio as a function of its own "risk;' a feature
that is common to many models of asset-pricing.
In this particular instance, the risk measure is the
conditional variance ofthe portfolio's stock re-
turn. The intuition behind this measure of risk is
that investors must assess the expected return
and risk of an asset before they decide to hold it.
They make this assessment conditional on some
set of relevant information. When the information
changes, investors will alter their perceptions of
the asset's risk. In this model,changes in condi-
tional risk affect future values of each portfolio's
stock return, which in turn, may influence future
conditional risk. This framework is based on a
class of models called GARCH, which stands for
Generalized Auto-Regressive Conditional Het-
eroskedasticity. The fiamevvoik diffeis fiom most
empirical applications of traditional asset pricing
models which use unconditional measures of risk
that are not permitted to change over time.
Industry effects
To get evidence on possible industry effects,
I look at how the risk of the three portfolios in
each industry are related. Evidence of significant
cross-portfolio risk effects are indicative of so-
called "causality in variance" (Engle, Ng, and
Rothschild 1990) whereby the conditional risk
of one portfolio affects the risk and return of an-
other. Accordingly, I look at all possible pairwise
combinations between the different-sized port-
folios in order to determine the pattern of such
causality (for more extensive discussion, see
Neuberger 1994).
The estimates of these cross-portfolio effects
produce a number of significant coefficients,
some positive and some negative. Positive cross-
portfolio estimates are consistent with an indus-
try effect between companies of different sizes.
The interpretation of negative estimates is some-
what more problematic, but they are not indic-
ative of the kind of industry effects considered
here. If industry risk effects exist, it seems plaus-
ible that such effects would be constrained to be
positive. The negative estimates suggest that a
more complicated interaction may be occurring
between the different portfolios but I do not in-
terpret this as evidence of an industry effect.
Six of the ten industries included in the study
show positive significant estimates between port-
folios of different sizes. The sectors in which
these significant industry effects appear are
banking, oil and gas exploration, machinery,
electrical equipment, instruments, and utilities.
In all but one instance, the significant coeffi-
cients occur when the conditional risk of a
portfolio of larger firms is included in the esti-
mates of a portfolio of smaller ones. The one ex-
ception occurs in the utilities sector, where the
conditional risk of the small firms has a positive
effect on the stock risk of the medium firms.
Thus, there is substantial evidence that industry
effects exist in a broad array of industries and
that these effects generally run from larger to
smaller companies. This suggests that stock
market participants may look to larger firms as
being a more cost-effective source of information
about the risks facing firms operating in these
industries.
In most instances, the positive industry effects
occur in only one or two cases. That is, the larg-
est companies affect the risk of the medium-
sized companies but not the small ones, or both
large and medium-sized companies affect the
risk of the small companies but the large firms
have no effect on the medium ones. Of the in-
dustries that show significant industry effects,
however, the most consistent results occur in the
banking industry. The conditional risk of a port-
folio of larger banks is always significant with a
positive sign when included in the estimates of
a portfolio of smalier banks. Thus, the large-bank
portfolio significantly affects the estimates of
both the medium and small-bank portfolios, and
the medium-bank conditional variance is signi-
ficant in the small-bank equation. The positive
estimated coefficients mean that increases in
the conditional risk of the largest banks raise the
conditional risk of the smaller banks and, work-
ing through the return equations, raise the return
from holding these portfolios of assets. This find-ing confirms the importance of the largest banks
in the industry in influencing the market's view
of bank stock risk and return.
Concluding comments
The results presented here provide evidence that,
in a broad array of industries, the stock risk of
larger firms has a positive influence on the stock
risk of smaller firms. The strongest and most con-
sistent evidence of these industry effects occurs
among banking firms. It probably comes as no
surprise that the largest banks play an important
role in this industry. A failure of one of these
large institutions could have serious reper-
cussions for public confidence in the banking
system as well as for other financial intermedi-
aries that have significant business dealings with
the large bank. This concern has led to careful
scrutiny by regulators of the activities of the
largest banks, and may have given rise to such
notions as "too big to fail." The work described
here suggests that it is especially important to
understand what drives the risk of the largest
banks and to recognize that these companies
may have significant and wide-ranging effects
on the rest of the banking industry.
Jonathan A. Neuberger
Economist
References
Engle, Robert, Victor Ng, and Michael Rothschild.
1990. "Asset Pricing with a Factor-ARCH Covari-
ance Structure: Empirical Estimates for Treasury
Bills:' Journal of Econometrics 45, pp. 213-237.
Neuberger, Jonathan A. 1994. "Conditional Risk
and Return in Bank Holding Company Stocks:
A Factor-GARCH Approach:' Unpublished
manuscript.
MONETARY POLICY OBJECTIVES FOR 1994
On February 22 Federal Reserve Board Chairman Alan Greenspan presented a report to the Congress on the
Federal Reserve's monetary policy objectives for 1994. The report includes a summary ofthe Federal Reserve's
monetary policy plans along with a review of economic and financial developments in 1993 and the economic
outlook in 1994. Single or multiple copies ofthe report can be obtained upon request from the Publiclnformation
Department, Federal Reserve Bank of San Francisco, P.D. Box 7702, San Francisco, CA 94120; phone (415)
974-2246 or fax (415) 974-3341.
Opinionsexpressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or ofthe Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to theeditor orto the author.... Free copies of Federal Reserve publications can be
obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco 94120.
Phone(415) 974-2246, Fax (415) 974-3341.~ 1%\ ·S>lU! ueaqAos 41!M
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California's Neighbors
Inflation, Interest Rates and Seasonality
Difficult Times for Japanese Agencies and Branches
Regional Comparative Advantage
Real Interest Rates
A Pacific Economic Bloc: Is There Such an Animal?
NAFTA and the Western Economy
Are World Incomes Converging?
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Market Risk and Bank Capital: Part 1
Market Risk and Bank Capital: Part 2
The Real Effects of Exchange Rates
Banking Market Structure in the West
Is There a Cost to Having an Independent Central Bank?
Stock Prices and Bank Lending Behavior in Japan
Taiwan at the Crossroads
1994 District Agricultural Outlook
Monetary Policy in the 1990s
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The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.

Asset Pricing with a Factor-ARCH Covariance Structure: Empirical Estimates for Treasury Bills:'

Conditional Risk and Return in Bank Holding Company Stocks: A Factor-GARCH Approach:'

Industry effects in the stock returns of banks and nonfinancial firms

http://www.frbsf.org/publications/economics/letter/1994/el94-12.pdf

Industry effects in the stock returns of banks and nonfinancial firms

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Research Papers in Economics