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

2. Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe (olivier.dejonghe@ugent.be) Evolution of functional diversification

3. Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe (olivier.dejonghe@ugent.be)  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?

4. Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe (olivier.dejonghe@ugent.be) 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

5. Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe (olivier.dejonghe@ugent.be) Diversification and bank risk Portfolio theory  non-correlated revenue sources Correlation between interest and non-interest income (1980-1996) 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

6. Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe (olivier.dejonghe@ugent.be) 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)

7. Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe (olivier.dejonghe@ugent.be) 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 :

8. Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe (olivier.dejonghe@ugent.be) Bank performance: results

9. Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe (olivier.dejonghe@ugent.be) 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

10. Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe (olivier.dejonghe@ugent.be) 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

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

12. Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe (olivier.dejonghe@ugent.be) 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

13. Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe (olivier.dejonghe@ugent.be) 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

14. Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe (olivier.dejonghe@ugent.be) 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

15. Faculty of Economics FDIC/JFSR 6th Annual Bank Research Conference Olivier De Jonghe (olivier.dejonghe@ugent.be) 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