# Presentation: 297937

## Does the stock market value bank diversification?

Lieven Baele (Tilburg University)
Olivier De Jonghe (Ghent University)
Rudi Vander Vennet (Ghent University)

- Lieven Baele (Tilburg University)
**Olivier De Jonghe** (Ghent University)
- Rudi Vander Vennet (Ghent University)

## Evolution of functional diversification

## 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

- 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?**

## Diversification and profitability: theory

- Advantages
- Revenue synergies
- Cost economies of scale and scope
- Information economies
- Costs
- Agency costs
- Regulatory costs

## 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 |

## 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)

## 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 :

## Bank performance: results

## Bank risk: enhanced market model

## Method

- Panel data set-up:
- With:		yi,t is a return or risk metric
- 		X1 : functional diversification
- 			Non-interest income to total income
- 			Loans-to-assets
- 			Revenue diversity measure
- 		X2 : control variables
- 			Capital ratio
- 			Asset risk (LLP)
- 			Inefficiency (Cost-income)
- 			Size

## Results: Franchise value

-  Diversified banks
- Higher return potential
- Closer to the frontier
-  Capital (+), Efficiency (+), Size (-)
- Diversification BENEFIT
- in Financial Conglomerates in Europe

## 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

## 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

## 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

## Conclusion

**Does the stock market value bank diversification?**
-  focus on Europe
- Diversification offers potential to improve future bank profits
- Diversified banks co-vary more with the market
- 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