FDICJFSR 6 th Annual Bank Research Conference Faculty

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

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

FDIC/JFSR 6 th Annual Bank Research Conference Faculty of Economics Do financial conglomerates possess a comparative advantage in terms of return/risk profile? 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 Olivier De Jonghe (olivier. dejonghe@ugent. be)

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

FDIC/JFSR 6 th Annual Bank Research Conference Faculty of Economics Diversification and bank risk Portfolio theory non-correlated revenue sources Correlation between interest and non-interest income (1980 -1996) EU average -0. 09 Euro area average -0. 25 US 0. 80 Japan -0. 20 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 Olivier De Jonghe (olivier. dejonghe@ugent. be)

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

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

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

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

FDIC/JFSR 6 th Annual Bank Research Conference Faculty of Economics Method Panel data set-up: With: Olivier De Jonghe (olivier. dejonghe@ugent. be) yi, 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

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

FDIC/JFSR 6 th Annual Bank Research Conference Faculty of Economics Results: systematic risk • Diversification increases systematic risk ‣ Nonlinear, exponentially ‣ Example: D(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 Olivier De Jonghe (olivier. dejonghe@ugent. be)

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

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

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