Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Does the stock market value bank diversification? Lieven Baele (Tilburg University) Olivier De Jonghe (Ghent University) Rudi Vander Vennet (Ghent University)

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Evolution of functional diversification

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe  Long-term performance and riskiness  Capital market data  Focus on Europe  broader scope for functional diversification  early deregulation: initiated by Second Banking Directive in 1989  Anticipation of results:  functional diversification can improve future bank profits  diversification can decrease idiosyncratic risk  more diversified banks have higher systematic risk Do financial conglomerates possess a comparative advantage in terms of return/risk profile?

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Diversification and profitability: theory Advantages 1)Revenue synergies 2)Cost economies of scale and scope 3)Information economies Costs 1)Agency costs 2)Regulatory costs

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Diversification and bank risk Portfolio theory  non-correlated revenue sources Correlation between interest and non-interest income ( ) Cyclicality of revenue sources  Non-interest income may vary less/more with overall business cycle conditions e.g.: mortgages vs life insurance vs investment banking EU average-0.09 Euro area average-0.25 US 0.80 Japan-0.20

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Data Listed European banks 17 European countries 1989 – 2004 Data sources ‣ Bankscope: balance sheet and income statement ‣ Datastream: market capitalization and daily returns Daily returns  Liquidity criterion (143 out of 255 banks)

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Bank performance: measurement Franchise value the present value of the future stream of profits that a firm is expected to earn as a going concern  usually proxied by Tobin’s Q This paper:  Correct for noise and ineffciency  Market value inefficiency: apply stochastic frontier analysis  Adjusted Tobin’s Q :

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Bank performance: results

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Bank risk: enhanced market model bank stock returns EU-wide risk factors EU stock market Interest rate Default risk FF HML Local risk factors Local stock market Exchange rate risk sensitivities idiosyncratic shock

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Method Panel data set-up: With:y i,t is a return or risk metric X 1 : functional diversification Non-interest income to total income Loans-to-assets Revenue diversity measure X 2 : control variables Capital ratio Asset risk (LLP) Inefficiency (Cost-income) Size

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Results: Franchise value Diversified banks ‣ Higher return potential ‣ Closer to the frontier Capital (+), Efficiency (+), Size (-) Diversification BENEFIT in Financial Conglomerates in Europe

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Results: systematic risk Diversification increases systematic risk ‣ Nonlinear, exponentially ‣ Example:  (non-interest income share) = 0.10  market beta increases with 0.11 Larger banks have higher betas Capital: non-linear, U-shaped More diversified banks have larger exposure to: -changes in market sentiment -economy-wide shocks

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Results: idiosyncratic risk Nonlinear relationship, U-shape Minimal risk at 36% Non-interest income is twice as volatile as interest income Low correlation between sources of income Capital (+), Efficiency (-), LLP(+) Size (-) Diversification offers a large potential for bank risk reduction in Europe

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Robustness Different diversification measures Economically inspired ‣ Subsample of most profitable banks ‣ Subsample of well-capitalized banks ‣ Subsamples of largest banks ‣ Control for important mergers Data– or statistically inspired ‣ Winsorized sample ‣ Contemporaneous ‣ Traditional Q Risk-return trade-off: system of equations

Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe Conclusion Does the stock market value bank diversification?  focus on Europe 1)Diversification offers potential to improve future bank profits 2)Diversified banks co-vary more with the market 3)Idiosyncratic risk can be reduced! Investors face classic return/risk trade-off Bank-dependent parties mainly care about idiosyncratic risk Regulators: bank-specific and systematic risk!  Careful monitoring of financial conglomerates