Bank Risk Factors and Changing Risk Exposures of Banks: Capital Market Evidence Before and During the Financial Crisis

Abstract

Banks have been at the center-stage of the recent financial crisis due to their significant exposures to real estate and sovereign risks. In this paper we analyze the magnitude and changes in risk exposures that are reflected in bank stock returns within the European Monetary Union (EMU) and the United States (US) between 1990 and 2011. We use this period first to investigate bank risk in different economic environments including the introduction of the Euro and the recent financial and sovereign debt crisis. Second we examine whether banks have experienced a change in their risk exposures during the last two decades when the Basel regulatory framework with different bank capital regulations was introduced. In our multi-factor asset-pricing model we include the traditional bank risk factors such as interest-rate and foreign exchange rate risk. However, we extend the literature by including credit, sovereign, and real estate risk. We analyze the associated factor exposures and variance shares in a time-varying framework and draw inferences on their bank specific determinants in pooled regression setups with balance sheet characteristics. Our empirical findings indicate that banks’ risk factors are multi-dimensional but well reflected in stock prices. Sub-period analyses point towards the existence of pronounced time-variation in betas and variance shares. Changes in the banking business and in the crisis period are reflected in the form of dynamic risk exposures. Moreover, bank specific characteristics such as asset size and equity-to-asset ratios provide relevant information for identifying banks with economically significant risk exposures. Overall, our results yield valuable insights into the dynamics underlying bank risk, the associated exposures, and their reflection in equity prices. Understanding the sources of a banks’ riskiness may also help enhancing the bank supervisory process within the pillar of market discipline in the Basel regulatory framework.