Tilburg University. Bank Activity and Funding Strategies Demirgüc-Kunt, A.; Huizinga, Harry. Publication date: Link to publication - PDF

Tilburg University Bank Activity and Funding Strategies Demirgüc-Kunt, A.; Huizinga, Harry Publication date: 2009 Link to publication Citation for published version (APA): Demirgüc-Kunt, A., & Huizinga,

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Tilburg University Bank Activity and Funding Strategies Demirgüc-Kunt, A.; Huizinga, Harry Publication date: 2009 Link to publication Citation for published version (APA): Demirgüc-Kunt, A., & Huizinga, H. P. (2009). Bank Activity and Funding Strategies: The Impact on Risk and Return. (CentER Discussion Paper; Vol ). Tilburg: Macroeconomics. General rights Copyright and moral rights for the publications made accessible in the public portal are retained by the authors and/or other copyright owners and it is a condition of accessing publications that users recognise and abide by the legal requirements associated with these rights.? Users may download and print one copy of any publication from the public portal for the purpose of private study or research? You may not further distribute the material or use it for any profit-making activity or commercial gain? You may freely distribute the URL identifying the publication in the public portal Take down policy If you believe that this document breaches copyright, please contact us providing details, and we will remove access to the work immediately and investigate your claim. Download date: 11. mei. 2016 BANK ACTIVITY AND FUNDING STRATEGIES: THE IMPACT ON RISK AND RETURN By Asli Demirgüç-Kunt, Harry Huizinga January 2009 European Banking Center Discussion Paper No This is also a CentER Discussion Paper No ISSN Bank Activity and Funding Strategies: The Impact on Risk and Return Asli Demirgüç-Kunt 1 World Bank Harry Huizinga * Tilburg University and CEPR This draft: January 2009 Abstract: This paper examines the implications of bank activity and short-term funding strategies for bank risk and return using an international sample of 1334 banks in 101 countries leading up to the 2007 financial crisis. Expansion into non-interest income generating activities such as trading increases the rate of return on assets, and it may offer some risk diversification benefits at very low levels. Non-deposit, wholesale funding in contrast lowers the rate of return on assets, while it can offer some risk reduction at commonly observed low levels of non-deposit funding. A sizeable proportion of banks, however, attract most of their short-term funding in the form of non-deposits at a cost of enhanced bank fragility. Overall, banking strategies that rely prominently on generating non-interest income or attracting non-deposit funding are very risky, consistent with the demise of the U.S. investment banking sector. Key words: non-interest income share, wholesale funding, diversification, universal banking, bank fragility, financial crisis JEL classifications: G01, G21, G28 1 We thank Wolf Wagner and participants of a seminar at the Nake Day 2008 for comments. This paper s findings, interpretations, and conclusions are entirely those of the authors and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent. 1. Introduction The recent financial crisis has important implications for feasibility of different banking models. On the funding side, the crisis has clearly exposed the dangers of a bank s excessive reliance on wholesale funding. Starting in August 2007, interbank money market rates in the U.S. rose dramatically reflecting perceptions of increased counter-party risk (see Taylor and Williams, 2008; Caprio, Demirguc-Kunt and Kane, 2008). By October 2008, interbank lending in the U.S. and in Europe had come to a virtual stand-still. To ward off a generalized bank liquidity crisis, authorities worldwide have taken unprecedented steps of providing extensive liquidity, giving assurances to bank depositors and creditors in the form of guarantees on interbank lending and in some cases blanket guarantees. Similarly on the asset side, the crisis exposed weaknesses in different business models of banks. In trying to cope with the crisis, large U.S. investment banks have completely disappeared from the banking scene through bankruptcy (Lehman Brothers), takeovers (of Bear Stearns by JP Morgan Chase and of Merrill Lynch by Bank of America) and conversions into commercial banks (JP Morgan and Goldman Sachs). Indeed, after the crisis, the U.S. has now come full circle, from the separation of commercial and investment banking through the Glass-Steagall Act of 1933, to the reintroduction of universal banking by way of the Gramm-Leach-Bliley in 1999, and, finally, to the disappearance of large independent investment banks all together in All over the world, perceived costs and benefits of combining bank activities of various kinds have given rise to a wide variation in allowed bank activities. 2 But after the crisis, the universal banking model, which allows banks to combine a wide range of financial activities, including 2 Universal banking model is common in Europe and in many other countries around the world. In the European Union, the Second Banking Directive of 1989 allows universal banking. A worldwide summary of restrictions on activities in securities markets, insurance, and real estate facing banks is contained in Barth et al. (2004). 2 commercial banking, investment banking and insurance, has emerged as a more desirable structure for a financial institution from the viewpoint of policymakers due to its resilience to adverse shocks. In this paper, we examine the implications of a bank s activity mix and funding strategy for its risk and return. We represent a bank s activity mix by the share of non-interest income in the form of fees, commissions and trading income in total operating income. On the liability side, we distinguish between deposits and other non-deposit short-term funding in the form of money market instruments such as CDs and interbank loans. Our goal is to shed light on the risk-return trade-offs involved in the choice of different activity and funding strategies employed by banks. Theory provides conflicting predictions about a bank s optimal asset or activity mix, its optimal financing, and the optimal match between bank assets and liabilities. Banks gain information on their customers in the provision of one financial service that may prove useful in the provision of other financial services to these same customers. This suggests that banks optimally combine activities of various kinds, for instance loan making with securities underwriting (Diamond, 1991; Rajan, 1992; Saunders and Walter, 1994; and Stein, 2002). Hence, combining different types of activities non-interesting earning, as well as interest-earning assets may increase return as well as diversify risks, therefore boosting performance. The extent of risk diversification benefits of combining income-generating activities of various kinds further depend on the co-movements of the risky incomes from these activities. However, the optimal size and scope of the banking firm in addition reflect finance-specific technologies and potential agency problems that arise within the banking firm if it becomes too complex (Jensen, 1986; Jensen and Meckling, 1986). Hence, even if further diversification into different activities may not be optimal in terms of the overall risk-return trade-offs the institution faces, insiders may still support this diversification as long as it enhances their ability to extract 3 private benefits which are sufficiently large. Another argument why differences in asset mix may impact an institution is that asset liquidity may enhance opportunities for bank managers to trade against the bank s interest (Myers and Rajan, 1998). Therefore, diversifying into more liquid nontraditional banking activities such as trading activities that generate non-interest income may end up increasing bank fragility and reduce overall performance. On the funding side, information acquisition is equally important in determining the optimal mix of a bank s deposit and non-deposit funding. It is theoretically well-established that banks need to be partially equity-financed to provide bankers with appropriate incentives to monitor the projects they finance (Diamond,1984). 3 But a bank s composition of debt and its ability to fund itself in wholesale capital markets provides signals of bank creditworthiness that are relevant to potential depositors at the bank as well. For example, Calomiris (1999) discusses how holders of subordinated debt can perform the function of monitoring a bank if sub-debt is credibly excluded from deposit insurance. Hence, non-deposit funding in a bank s funding mix can actually reduce bank fragility through better monitoring. But deposit and non-deposit funding tend to carry different risks in causing a potential liquidity crisis through a bank run or a sudden halting of wholesale funding. For example, Huang and Ratnovski (2008) provide a model of the dark side of relying on wholesale funding in that wholesale financiers may have an incentive to withdraw funding on the basis of cheap and noisy signals of bank solvency, thereby causing solvent banks to fail. Deposit and non-deposit funding are also different in terms of the speed and size of changes in funding costs. The volume and price of wholesale funding, in particular, may adjust more quickly to reflect a bank s riskiness not least because customer deposits tend to be covered by deposit insurance. Rajan (1992) juxtaposes 3 Making a distinction between bank equity and demandable debt, Calomiris and Kahn (1991) argue that demandable debt provides depositors with appropriate incentives to monitor banks and force liquidation of insolvent ones. 4 informed and arm s length debt to find that holders of informed debt in this case wholesale financiers- may duly foreclose on a firm with negative present value projects, but at a cost of suddenly demanding a rather high interest rate if the project is continued. Other models consider the simultaneous determination of bank activities and bank funding, - the asset-liability matching problem - and provide a rationale for why traditional lending and deposit taking services are likely to be observed within the same firm. One argument is that opaqueness of relationship lending enhances bank fragility since it makes it difficult for bank liability holders to assess bank solvency. Therefore, to reduce bank fragility, banks making relationship loans are financed relatively heavily by core deposits, which are unlikely to be withdrawn prematurely since they are held for their liquidity services (Song and Thakor, 2007) 4. Another reason lending and deposit taking services can be provided within the same banking firm is because both financial services entail the provision of liquidity to bank customers, which in turn improves the institution s own liquidity management (Kashyap, Rajan and Stein, 2002). These models would predict a high correlation between reliance on activities that generate interest income and deposit funding. The purpose of this paper is three-fold. First, we document trends in the relative importance of non-traditional banking activities and non-deposit funding in banks asset and funding mix for a large sample of international banks over the period. This is interesting as it illustrates the changes in asset and funding mix for different types of financial institutions prior to the latest crisis. Second, we present empirical evidence on the determinants of the fee income and non-deposit funding shares, by examining how these variables are related to a range of bank-level, macroeconomic and institutional indicators. Finally, we assess how different activity mixes and 4 Retail or core deposits tend to differ from other forms of bank funding in that they are primarily held for their liquidity services and in that they are covered by deposit insurance. Flannery (1982) argues that retail deposits can be seen as a quasi-fixed factor of production of a bank on account of their sluggish adjustment, and that this explains the tendency of banks to insulate deposit interest rates from changes in market interest rates. Billett, Garfinkel and O Neall (1998) further find that banks tend to raise their use of insured deposits following increases in risk, as proxied empirically by Moody s downgrades. 5 funding patterns are associated with bank risk and return. We measure a bank s return by its return on assets. Our main measure of bank risk, in turn, is the distance to default or Z-score, defined as the number of standard deviations that a bank s return on assets has to fall for the bank to become insolvent. On average, financial institutions are shown to substantially combine interest generating and other income generating activities, with a mean fee income share of But this figure masks large differences across different types of institutions while commercial banks, which make up the bulk of the sample, obtain around one third of their income from fee-generating activities, for investment banks this figure is over 75 percent. Moreover, fee income share has been rising for all institutions over the sample period, with particularly steep increases in 2007 for investment banks, non-bank credit institutions and other financial institutions such as real estate mortgage banks and savings banks. Most banks, instead, attract only a small share of their short-term funding in the form of nondeposits, with a mean non-deposit funding share of The distribution of the non-deposit funding share, however, has a fat tail of banks raising more than half of their short-term funding in the form of non-deposits. And again, reliance on non-deposit funding has been increasing significantly for investment banks, non-bank credit institutions and other financial institutions such as real estate mortgage banks and savings banks, and markedly so in Furthermore, we see that fee-income share and non-deposit funding share of institutions are indeed correlated, as suggested by assetliability matching models, but the correlation is around 35 percent. Controlling for institutional differences, we see that greater reliance on fee-income generating activities and non-deposit funding are associated with larger, fast-growing institutions. Reliance on non-deposit funding is also more common in developed countries, whereas developing country 6 banks rely significantly more on fee-generating activities. We find, among other things, that institutional factors that constrain banks asset mix and reduce its reliance on fee-generating activities- for example through regulations on activity restrictions- are also associated with increases in non-deposit funding, suggesting that banks may be circumventing such restrictions on their asset composition by adjusting their funding mix to increase their risk-taking. We find that both a bank s rate of return and its risk increase with its fee income share, suggesting trade-offs. However, estimated coefficients also suggest that increasing the fee income share can yield some risk diversification benefits albeit at very low levels. In contrast, non-deposit, wholesale funding lowers the rate of return on assets, while it can also offer some risk reduction benefits again at low levels. In robustness tests we also consider two alternative indices of bank return and risk: stock return volatility, another measure of risk, and a measure of risk-adjusted rate of return, the Sharpe ratio. The Sharpe ratio is given by the mean value of the return on equity divided by the standard deviation of the return on equity. Finally, we address potential endogeneity problems by presenting IV estimates that use information about banking type (as a proxy for bank-specific activity restrictions) to construct instruments for bank activity and funding mix. Based on these estimates, a higher fee income or nondeposit funding share continue to increase bank risk, and while we also find a positive impact of these variables on the rate of return, these findings are more subject to endogeneity concerns. At any rate, our IV estimates confirm that banking strategies that rely predominantly on generating noninterest income or attracting non-deposit funding are very risky. Our paper fills a gap in the literature since to our knowledge no empirical studies have considered the implications of a bank s funding strategy for bank risk and return. However, several studies have examined the implications of mixing various bank activities for bank risk using mostly 7 U.S. data. Some of these studies consider how hypothetically combining banks with other types of financial or even non-financial firms would affect the variability of accounting measures of income or stock returns. 5 Other studies look at the risk implications of actual combinations of traditional banking and other financial activities. 6 Among these, the closes to our study is Stiroh (2004) which considers how the share of non-interest income of U.S. banks has affected their risk and return. Specifically, Stiroh (2004) finds that Z-scores are highest for U.S. banks with a non-interest income share close to zero so that even a small exposure to non-traditional banking activities increases risk. Our paper goes beyond Stiroh s (2004) analysis of the relationship between fee income on bank risk by considering an international data set, by providing estimation of the determinants of the fee income share, and by subjecting the relationship between bank risk and fee income to additional robustness tests. Laeven and Levine (2008) use an international sample of 296 banks from 48 countries in 2001 to examine how bank-level risk, measured alternatively by the Z-score and stock return variability, is affected by bank-level corporate governance and national bank regulations. They show both factors affect bank risk. In this paper our focus is not on regulations but we include country fixed effects in our estimation that are meant to capture this and other time-invariant country traits. Controlling for time-invariant measures of bank regulation, we find that banks that rely on fee generating activities to a greater extent are subject to greater risk. Risk and return should be reflected in bank stock prices and thus stock market valuations can provide information about whether banks can create value by mixing different activities. DeLong (2001) considers stock price reactions to announcements of U.S. bank mergers over the See Boyd and Graham (1988), Boyd, Graham, and Hewitt (1993), Lown et al. (2000 and ), and Saunders and Walter (1994). 6 See also DeYoung and Roland (2001), Geyfman (2005), Gayle (2001), Kwast (1989), Rosen et al. (1989), and Templeton and Severiens (1992). 8 period and finds that only mergers of banks that are similar in activity and geographical location create value. Similarity in activity is defined on the basis of co-movements of stock returns of the two merging banks. Laeven and Levine (2007) instead estimate a relationship between the q-value of a banking firm and an income diversity variable that measures closeness of the non-interest income share to 0.5. In fact, by this measure firms with equal net interest and non-interest incomes are completely diversified. Using data for 43 countries over the period, the authors find that banks with highly diversified income streams tend to have low q-values relative to banks that produce the same income combination in separate, specialized firms. While the authors can not identify a single causal factor, they interpret their results as evidence of significant agency problems. Our results can be seen as consistent and complementary since we find diversification benefits accrue at relatively low levels of fee-income share, potentially providing an alternative explanation of why greater diversification may lead to a discount. In addition, the q-value measures the market value of a firm s assets relative to their replacement cost and as such summarizes market valuation of the banking firm s risky income stream. Our paper instead directly measures the impact of a bank s fee income share on its ri
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