Interest Rate Sensitivity (3)

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Interest Rate Sensitivity of Bank Stock Returns:

Re-examination since Basel Accords

Adam J. Fagan

University of Alaska Anchorage

E-mail: [email protected]

Suresh C. Srivastava

University of Alaska Anchorage

3211 Providence Drive, Anchorage, AK 99508


Edward ForrestUniversity of Alaska Anchorage


EXPANDED ABSTRACT

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mailto:[email protected]








Corresponding author: Suresh Srivastava

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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

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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.

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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 risk premium 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

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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.

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III. Two-Factor Asset Pricing Model

A. The Model

Stone (1974) proposed the following two-factor bank stock return generating model:

R jt = αj + β1jR mt + β2jR It + εjt (1)

where R jt is the bank common stock return, R mt is the market return, and R It 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

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 on market returns is used as the orthogonal interest rate factor.

2The 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)].

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choice of the bond market index for the two-factor model determines what unexpected change is

captured by the coefficient β2j.

References

Bae, S.C., 1990. “Interest Rate Changes and Common Stock Returns of Financial Institutions:

Revised” Journal of Financial Research 13, 71-79.

Booth, J.R., and D.T. Officer, 1985. "Expectations, Interest Rates, and Commercial Bank

Stocks." Journal of Financial Research 8, 51-58.

Box, G.E.P., and G.M. Jenkins, 1976. Time Series Analysis, Forecasting and Control ,Holden-Day.

Chance, D.M., and W.R. Lane, 1980. "A Re-examination of Interest Rate Sensitivity in the

Common Stock of Financial Institutions." Journal of Financial Research 3, 49-55.

Chen, N. R. Roll, and S. Ross, 1986. “Economic Forces and the Stock Market” Journal of

Business, 59, 383-404.

Choi, J.J., Elyas Elyasiani, and K. Kopecky, 1992. “The Sensitivity of Bank Stock Returns to

Market, Interest, and Exchange Rate Risks” Journal of Banking and Finance 16, 983-1004.

Christie, A.A., 1981. "The Stochastic Behavior of Common Stocks Variances: Value, Leverage

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Cox, J.C., J.E. Ingersoll, and S.A. Ross, 1985. “An Intertemporal General Equilibrium Model of

Asset Prices.” Econometrica 53, 363-84.

Elyasiani, Elyas, and Mansur Iqbal, 1998. “Sensitivity of the bank stock returns distribution to

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Fama, E.F., and M.R. Gibbons, 1982. "Inflation, real returns and capital investment" Journal of

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Fama, E.F., and W.G. Schwert, 1977. "Asset returns and Inflation." Journal of Financial Economics 4, 115-146.

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Stock Returns of Financial Institutions." Journal of Finance 39, 1141-1153.

Flannery, M.J., A.S. Hameed, and R.H. Harjes, 1997. “Asset Pricing Time-varying Risk Premia

and Interest Rate Risk” Journal of Banking and Finance 21, 315-335.

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French, K.R., R.C. Ruback, and G.W. Schwert, 1983. "Effects of Nominal Contracting

Hypothesis on Stock Returns." Journal of Political Economy 91, 70- 96.

Llyod, W.P., and R. Shick, 1977. "A Test of Stone's Two Index Models of Returns." Journal of

Financial and Quantitative Analysis 12, 363-376.

Lynge, M., and J. Zumwalt, 1980. "An Empirical Study of Interest Rate Sensitivity of

Commercial Bank Returns: A Multi Index Approach." Journal of Financial and Quantitative

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Merton, R.C., 1973. "An Intertemporal Capital Asset Pricing Model." Econometrica 41,

867-887.

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Song, F., 1994. “A Two Factor ARCH Model for Deposit-institution Stock Returns” Journal of Money Credit and Banking 26, 323-340.

Srivastava, S. C., S. Hamid and A. H. Choudhury, 1999. "Stock and Bond Market Linkage in the

Empirical Study of Interest Rate Sensitivity of Bank Returns." Journal of Applied Business

Research 15, 47-58.

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Financial and Quantitative Analysis 9, 709-721.

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Stock Market." Journal of Finance 41, 393-410.

Unal, H., and E.J. Kane, 1987. "Two Approaches to Assessing the Interest-Rate Sensitivity of

Deposit-Institutions' Equity Returns." In Research in Finance, 7, Jai Press Inc., GreenwichConn., 113-132.

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Interest Rate Sensitivity (3)