# Presentation: 082764

## Bob DeYoung’s DiscussionFDIC Fall Conference, 2006

- “Does the Stock Market Value Bank Diversification?” Baele, De Jonghe, and  Vander Vennet.
- “Product Diversification in the European Banking Industry: Risk and Loan Pricing Implications,” Lepetit, Nyes, Rous, and Tarazi.

## 1. Baele, De Jonghe, and Vander Vennet

- Test whether market assessments of risk and bank value are related to “diversification.”
- Data from 17 European countries, 1989-2004.
- “Functional diversification” measures:
- NII share of revenue; Loan share of assets.
- Diversity of Revenues (NII vs. other) and Assets (Loans vs. other); measures range from 0 to 1.
- Risk measures:
- Market model parameters.
- Bank value (franchise value) measure:
- Noise-adjusted Tobin’s Q (adapted from Hughes, Lang, Mester, and Moon, 1999).

## Main results (1)

- Franchise value increases with both NII Share and Revenue Diversity.
- “Level” result and “Diversity” result are really the same result, because mean NII is well less than .50.
- Positive Q-NII relationship may be spurious. Many fee-based activities are off-balance sheet; if so, they show up in Q numerator but not in Q denominator.
- “Stock market thinks NII levels and Revenue Diversity are signals of future growth in earnings.”  Okay.  But why?  How?
- A result that is not emphasized:
- Q increases with Beta.
- This establishes a positive Risk-Return tradeoff.

## Main results (2)

- Systematic Risk _increases_ with NII.  But Idiosyncratic Risk _decreases_ with NII.
- Positive NII-Beta relationship is now a stylized fact. On average, NII increases banks’ exposure to the business cycle and macro-economy.  WHY??
- Negative NII-Idiosyncratic Risk finding less robust in this literature.  WHY??  (No explanation in paper.)
- Another under-emphasized result:
- Beta increases with Loans-to-Assets.
- WHY?  (No discussion in the paper)
- Authors remind us that implications of results vary for investors, managers, and regulators.

## Franchise Value Measure (1)

- _Objective_:  Create a more accurate measure of Q by removing “noise” from market prices.
- Q  =  Mkt Val / Bk Val
- Estimate market value frontier:
-    	ln(Mkt Val) = a + b*ln(Bk Val) + c*ln(Bk Val)2 			        + random error + ineff.
- Set random error=0, and solve for Frontier Mkt Val.
- QNA  =  Frontier Mkt Val / Bk Val*exp(ineff)
- _When ineff=0_:  exp(ineff) = 1 so franchise value Q is maximized.
- _When ineff>0_:  exp(ineff) > 1 so franchise value Q falls short of maximum.

## Franchise Value Measure (2)

- This may yield an improved measure of franchise value.  But it is very unorthodox.  Need more intuition in text to help finance reader.
- Is QNA an *ad hoc* construct?  Or can this measure be formally derived?
- QNA versus Q:
- Authors argue QNA is theoretically superior to Q.
- Authors show correlation(QNA, Q) is high.
- Can authors _demonstrate_ superiority of QNA?

## 2.  Lepetit, Nys, Rous, and Tarazi

- Test whether bank risk and loan pricing are related to “diversification.”
- Data from 11 European countries, 1996-2001.
- “Diversification” measures:
- NII, Commissions, and Trading shares of revenue.
- Risk measures:
- Accounting ratios; Market measures; Pr(insolvency).
- Loan pricing measures:
- Interest rate margins; Risk spreads.
- _A story to interpret results_: A strategic link between increased NII and lending practices.

## Main results

- Most measures of risk are _positively_ associated with NII and Commission Income.
- Uncontrolled tests, not regressions.
- QUESTION: What’s included in “Commission Income?”
- Loan interest margins are _negatively_ associated with NII (multivariate regressions).
- _Proposed Story_: These two results consistent with each other if banks are pursuing the following strategy:
- Banks use loans as a “loss leader” to attract sales of fee-based financial services.

## Loss Leader interpretation

- I am unconvinced. More proof is required:
- Is there a link between _loan customers_ and _fee-based customers_?
- Are returns from marginal fee-based activities large enough to offset reductions in infra-marginal spreads?
- Is there anecdotal or case-study evidence from bankers to corroborate the story?
- DeYoung, Hunter, Udell (2003) story:
- New technology and deregulation led to new strategy.
- Credit scoring and asset securitization  high NII.
- Loans become commodities  low loan spreads.
- Geographic freedom  provides necessary scale.

## Common to both papers (1)

- High level of NII used as a proxy for “diversification,” but this is a poor proxy.
- NII can increase _without_ a change in product mix (e.g., loan securitization, back-up credit lines).
- DeYoung and Rice (2004):  Correlation between ROE and Net Interest Income grew stronger in U.S. during 1990s, even as NII was increasing.
- Both papers produce clean statistical results, but discussion is “sterile.”
- Little interpretation of _economics_ driving the results.
- These are not standard, multi-industry finance tests.  These are industry-specific tests.
- Extant literature contains some plausible stories.

## Common to both papers (2)

- DeYoung and Roland (1999) offer a story (and some evidence) consistent with the positive NII-Beta results.
- Traditional banking:
- Bank-Borrower Relationships create switching costs that stabilize income across business cycle.
- Fee-based (transactions) banking:
- Fewer relationship-based switching costs.
- Fee-based activities can be quite pro-cyclical (e.g., securities brokerage, mortgage banking).
- Fee-based activities can require higher operating leverage, which amplifies revenue volatility.

## A conflicting result across the papers

- _Lepetit, et al_:  Positive NII-idiosyncratic result.
- Short 1996-2001 time frame.
- Uncontrolled tests.
- _Baele, et al_:  Negative NII-idiosyncratic result.
- Longer 1989-2004 time frame.
- Controlled regression tests.
- What would we expect?
- NII from market-sensitive or non-relationship-based actitivies  Risk mainly systematic  NEGATIVE.
- NNI from relationship-based activities  Risk will be less systematic  POSITIVE.

## Bob DeYoung’s DiscussionFDIC Fall Conference, 2006

- “Does the Stock Market Value Bank Diversification?” Baele, De Jonghe, and  Vander Vennet.
- “Product Diversification in the European Banking Industry: Risk and Loan Pricing Implications,” Lepetit, Nyes, Rous, and Tarazi.