Bank Risk Strategies and Cyclical Variation in Bank Stock Returns

Abstract

This paper investigates whether the stock returns of banks with different risk profiles exhibit different risk factor sensitivities over the business cycle. More specifically, we investigate whether or not high levels of capital adequacy or functional diversification provide banks with a structural hedge against a deterioration in the prevailing credit market conditions. Based on recent imperfect capital market theories, we develop a number of theoretical arguments for the existence of asymmetries in systematic risk across various types of banks. We use a regime-switching model to test the theoretical hypotheses empirically on a sample of European listed banks. We find that bank stock returns are strongly asymmetric; both the sensitivity to shocks and the conditional volatility are higher during business cycle troughs. Better capitalized and functionally diversified banks are perceived by investors as being better protected against a deterioration in credit market conditions compared to their relatively less capitalized and more specialized competitors.