Factors determining European bank risk

Abstract

We investigate bank capital, charter value, off-balance sheet activities, dividend payout ratio and size as determinants of bank equity risk (systematic risk, total risk, interest rate risk and idiosyncratic risk) and credit risk. Using information for 117 financial institutions across 15 European countries over the period 1996–2010, we find evidence of a convex (U-shaped) relation between bank capital and bank systematic risk and credit risk. We find mixed evidence on the relation between charter value and our measures of bank risk. The results also show a positive association between off-balance sheet activities and bank risk. It is also evident that dividend payout ratio is negatively related to all risk measures. We find large banks reflect higher total risk and lower credit risk. Following the creation of the Economic Monetary Union, we also observe an increase in bank risk sensitivity to both bank capital and off-balance sheet activities and a decrease in the sensitivity of bank risk to charter value. Finally, with regard to the impact of the recent global financial crisis, we find that the largest decline in the coefficient value is observed for bank capital relative to credit risk. These results are robust to various model specifications.