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Journal of Banking & Finance 22 (1998) 535±563
Sensitivity of the bank stock returns

distribution to changes in the level and
volatility of interest rate: A GARCH-M model
a,* b,1
Elyas Elyasiani , Iqbal Mansur
a
Department of Finance, School of Business & Management, Temple University, Speakman Hall,
Philadelphia, PA 19122, USA
b
School of Management, Widener University, One University Place, Chester, PA 19013, USA
Received 11 March 1995; accepted 12 January 1998
Abstract
The objective of this paper is to employ the generalized autoregressive conditionally

heteroskedastic in the mean (GARCH-M) methodology to investigate the eect of inte-
rest rate and its volatility on the bank stock return generation process. This framework
discards the restrictive assumptions of linearity, independence, and constant conditional
variance in modeling bank stock returns. The model presented here allows for shifts in
the volatility equation in response to the changes in monetary policy regime in 1979 and
1982 to be estimated. ARCH, GARCH, and volatility feed back eects are found to be
signi®cant. Interest rate and interest rate volatility are found to directly impact the ®rst
and the second moments of the bank stock returns distribution, respectively. The latter
also aects the risk premia indirectly. The degree of persistence in shocks is substantial
for all the three bank portfolios and sensitive to the nature of the bank portfolio and the
prevailing monetary policy regime. Ó 1998 Elsevier Science B.V. All rights reserved.
JEL classi®cation: G12; G21; C52
Keywords: Bank stocks; GARCH; Interest rate risk
*
Corresponding author. Tel.: 1 215 204 5881; fax: 1 215 204 5698; e-mail: v5582e@vm.tem-
ple.edu.
1
Tel.: 1 610 499 4321.
0378-4266/98/$19.00 Ó 1998 Elsevier Science B.V. All rights reserved.

PII S 0 3 7 8 - 4 2 6 6 ( 9 8 ) 0 0 0 0 3 - X
536 E. Elyasiani, I. Mansur / Journal of Banking & Finance 22 (1998) 535±563
1. Introduction
The issue of interest rate risk is of major interest to the banking, regulatory,
and academic communities. In the 1970s and 1980s this issue attracted a
tremendous amount of attention because of the near collapse of the S&L indus-
try and numerous bank failures brought about largely by high volatility of
interest rates and strong interest rate sensitivity of the banking institutions.
More recently, this issue has found new signi®cance because bank portfolios
have shifted away from commercial loans and toward securities at a dramatic
pace. 2
As a step toward reducing their interest rate risk exposure, banks have
shortened their duration gaps, securitized loans, switched to o balance sheet
activities, and taken positions in derivative products, changing the nature of
the banking enterprise in the process. Concerns of the regulators over interest
rate risk culminated in the passage of the FDIC Improvement Act (FDICIA)
of 1991 which requires a revision of the risk-based capital standards to take ad-
equate account of the interest rate risk. 3 Concomitant with these develop-
ments, academic research assessing the interest rate risk exposure of
depository institutions has proliferated. Although the literature in this area is
vast, the ®ndings are dissimilar in terms of both magnitude and direction of
the eect. Akella and Chen (1990) have attributed the dissimilarities in ®ndings
of the extant studies to dierences in the choice of the interest rate variable and
sample period, model speci®cation, and/or structural shifts. However, it is also
possible that these dierences have resulted from the limitations of the asset
pricing frameworks adopted, including restrictive assumptions concerning
the functional form and distributional properties of the ®rst and second
moments of the return generating process. For example, the assumptions of
linearity and returns independence, made in the extant studies, are challenged
by Tinic and West (1986), Carroll and Wei (1988), and Akgiray (1989), while
Perry (1982), Pindyck (1984), Poterba and Summers (1986), Akgiray and
Booth (1988), and Carroll et al. (1992), present evidence inconsistent with
the assumption of constant conditional variance of returns over time.
Relaxation of these restrictive assumptions has been shown to alter the
conclusions reached concerning the properties of the return generating
process in general (Akgiray, 1989) and may have a similar eect in the banking
sector.
The objective of this paper is to employ the generalized autoregressive con-
ditionally heteroskedastic in the mean (GARCH-M) methodology to investi-
2
Neuberger (1993) reports that between 1990 and 1993 holdings of securities grew over 35%
while loans to businesses actually declined.
3
This provision is included in Section 305 of FDICIA.
E. Elyasiani, I. Mansur / Journal of Banking & Finance 22 (1998) 535±563 537
gate the eect of interest rate and its volatility on the bank stock return gener-
ation process. This framework discards the restrictive assumptions of linearity,
independence, and constant conditional variance. In addition, this framework
allows an extension of the literature by investigating the eect of changes in the
interest rate volatility on the second, and indirectly on the ®rst, moment of the
return generating process and delineating the time-varying nature of risk pre-
mia. These eects are generally overlooked in the banking literature. 4 Al-
though the analysis of the interest rate eect on bank stock returns without
considering its eect on bank riskiness can produce misleading policy conclu-
sions, the latter eect is also overlooked in the banking literature. The paper
unfolds as follows. In Section 2 the literature on interest sensitivity of bank
stock returns is reviewed. Section 3 presents the data and the methodology,
and Section 4 is allocated to discussion of empirical results. Section 5 presents
the conclusions.
2. Literature review
Early studies of bank interest rate sensitivity include the works of Stone
(1974), Lloyd and Shick (1977), Chance and Lane (1980), Lynge and Zumwalt
(1980), Flannery and James (1984), Booth and Ocer (1985), Scott and Peter-
son (1986), and Bae (1990). These authors all apply a two-index model (market
and interest rate factors) to bank equity returns under the assumption of con-
stant variance error terms. The ®ndings of these studies are dissimilar in terms
of both the magnitude and direction of the eects.
Some of the recent studies provide evidence against constancy of the condi-
tional variance and in favor of time-varying risk premia. Using a switching re-
gression technique, Kane and Unal (1988) report that interest rate sensitivity of
bank stock returns varies signi®cantly over time. In particular, they ®nd that
the interest rate beta shifted down sharply in the early 1980s and went back
up a few years later. Kwan (1991) develops a two-index random coecient
model of bank stock returns to investigate the time-varying interest rate sensi-
tivity of banks. He reports that bank stock returns are related to unanticipated
changes in the level of interest rate and that the time-varying magnitude of the
eect can be explained by the maturity composition of bank assets and liabil-
ities.
Saunders and Yourougou (1990) and Yourougou (1990) contrast the
eect of interest rate changes on bank and non-bank ®rms during periods of rel-
ative interest rate stability (pre-October 1979) and high interest rate volatility
4
For a detailed review of ARCH type modeling in ®nance, see Bollesrev et al. (1992).
(post-October 1979) and report that interest rate eects vary substantially over
time. Speci®cally, Yourougou (1990) ®nds that, during the period of relative
interest rate stability, interest rate sensitivity was low and insigni®cant for both
banks and non-bank ®rms, while in the post-October 1979 period, interest rate
risk exerted a signi®cant impact on common stocks of ®nancial intermediaries
but not the industrial ®rms. Choi et al. (1992) extend the existing models to in-
clude exchange rate risk and ®nd that interest rate and exchange rate sensitiv-
ities dier in the pre- and post-1979 periods. Wetmore and Brick (1994), using
the Choi et al. (1992) methodology also ®nd that the coecients of market risk,
interest rate risk, and foreign exchange risk are time dependent and dier by
bank type.
Song (1994) was the ®rst study to employ the ARCH-type methodology in
banking. Song ®nds that ARCH-type modeling is the appropriate framework
for analysis of bank stock returns. According to his results, market and interest
rate risk measures of banks do vary signi®cantly over time; while these mea-
sures did not change signi®cantly around October 1979 in response to the shift
in the monetary policy strategy, they did increase around the end of 1982 when
the Fed switched to targeting borrowed reserve. Neuberger (1994) employs a
GARCH model to estimate factor volatilities as determinants of risk premia.
He estimates a ®ve-factor model of individual bank holding company stock re-
turns, where the factors are proxied by sub-sample portfolios of assets as well
as excess returns on market and interest rates. Neuberger's paper is based on
the econometric model put forward by Engle et al. (1990b) and Ng et al.
(1992) and allows for a system estimation of returns on a number of assets.
He ®nds evidence in favor of equity market contagion pervading bank stocks.
Especially, he ®nds evidence of strong industry eects in the market for bank
equities indicating prevalence of common risks among banking ®rms and a
cross-over eect mostly from large banks to smaller banks.
Flannery et al. (1997) demonstrate that both the market risk and interest
rate risk are priced factors. However, the eect of the interest rate risk is found
to be less strong when the authors test the joint hypotheses that the linear fac-
tor pricing is valid and that interest rate risk is priced. In addition, these au-
thors ®nd that the market factor volatility varies signi®cantly through time
and its variation is priced into the expected returns of dierent securities.
The equilibrium price for bearing interest rate risk is also found to vary over
time in tandem with interest rate volatility.
The work of Kane and Unal (1988), Kwan (1991), Yourougou (1990), Song
(1994), Neuberger (1994) and Flannery et al. (1997) provide strong evidence
that the bank stock return generating process is time-dependent and should
be modeled as such. Hence, to avoid possible bias and inconsistency in model
parameters, risk measures should be allowed to vary over time and to be re¯ec-
tive of the observed time variations in bank stock volatility. The GARCH-M
modeling followed here satis®es this requirement. The advantages of this mod-
el over the ARCH and GARCH techniques will be discussed in the next sec-
tion. 5
3. Data and methodology
3.1. Data description
The sample consists of 56 commercial bank stocks traded on the New York
and American stock exchanges. The time period of the study is from January
1970 to December 1992. Monthly returns, including dividend yields, are ob-
tained from the Compustat PDE tapes. The ten-year Treasury Composite yield
is utilized as the long-term interest rate index and is obtained from the Citibase
data tape. Interest rate volatility is measured by the conditional variance of the
long-term interest rate which is generated using an ARCH(1) model. The order
of the ARCH process is determined by a procedure based on the Lagrange
multiplier principle, proposed by Engle (1983). 6
Along the lines followed by Song (1994), the sample is disaggregated by size
into three portfolios ± the Money Center bank portfolio (10 banks), the Large
bank portfolio (14 banks) and the Regional bank portfolio (32 banks). 7 For-
mation of portfolios provides an ecient way for condensing a substantial
amount of information about bank stock return behavior and it has the advan-
tage of smoothing out the noisiness in the data, due to transitory shocks to in-
dividual ®rms. These shocks may, otherwise, distort the results signi®cantly.
The disadvantage of this approach, however, is that it masks the dissimilarities
among banks within each portfolio. The advantages of using monthly data are
twofold. First, with monthly data a longer historical period may be manage-
ably included in the sample and that tends to better re¯ect long-term move-
ments in volatility. Second, with monthly data, settlements and clearing
5
Neuberger and Flannery et al. studies were unpublished when this paper was written. The latter
was published at the time of the ®nal submission of this paper.
6
To construct the conditional variance of the interest rate, the interest rate index is modeled as
an ARCH process. An AR(12) model is determined to be optimal as the mean equation for this
process. The residuals from this process are free from serial correlation, as shown by statistically
insigni®cant v2 values (the v2 values are: Q(12) 2.24, Q(18) 8.81, and Q(24) 18.09).
Additionally, the skewness, kurtosis and Jarque and Bera (1981) Lagrange Multiplier values are
all signi®cant. The skewness and kurtosis values are 5.45 and 44.69, respectively. Jarque and Bera
(1981) Lagrange Multiplier value is found to be 20429. The order of the ARCH process is
determined by the procedure, based on the Lagrange Multiplier principle, proposed by Engle
(1983). The test values for orders 1, 4, 8, and 12 are 6.85, 27.34, 30.37, and 37.02, respectively.
Based on these results, the conditional variance of interest rate is modeled as an ARCH(1) process.
7
Appendix A contains the bank names.
delays, which are found to be a signi®cant determinant of returns in the daily

data, are less relevant and can be safely ignored (Baillie and DeGennaro, 1990).
The sample consists of the largest US banks with complete data over the
sample period. As a result, it excludes ®rms which failed, were acquired, or
have missing data during this period. A survivorship bias may exist in the data
if the excluded banks are the failing and poorly performing ®rms. This is be-
cause in this case the returns on the high performance banks are and those
of the failed banks are not included in the sample. Mergers and acquisitions
of large banks in the 1980s, however, were neither limited to nor dominated
by acquisition of poorly performing banks. On the contrary, many banks were
acquired exactly because they were performing well and many more were ac-
quired mostly for the purposes of cost economies, complementarities, market
diversi®cation, and strength to withstand domestic and global competition. 8
Under this condition, it is likely that stock returns of the high and low perfor-
mance banks acquired during this period average out, making the magnitude
of the bias scant and ignorable. In addition, many ®rms have missing data
for reasons quite unrelated to size, performance, and hence, survivorship bias.
In any case, since no precision can be attached to survivorship bias, making
assumptions about the behavioral patterns of the bias and how it aects
performance may be as bad as ignoring it (Blitzer, 1995; Garcia and Gould,
1993).
3.2. Methodology
3.2.1. Features of ARCH and GARCH type models

A growing body of research has recently been directed towards investigation
of conditional variance models of stock market behavior. These models include
the autoregressive conditional heteroskedastic model (ARCH) introduced by
Engle (1982), the generalized autoregressive conditional heteroskedastic model
(GARCH) proposed by Bollerslev (1986), and the ARCH and GARCH in the
mean (ARCH-M, GARCH-M) extensions introduced by Engle et al. (1987).
The general GARCH (p, q)-M model can be described by the system of
equations (1)±(3) below:
yt /xt cht et ; 1
8
It is generally agreed that survivorship bias is particularly relevant to the small and poorly
performing ®rms. For example, Malkiel (1995) points out that in analysis of the mutual funds
industry, survival bias is mostly due to attrition of small funds that performed poorly and were shut
down or merged into other funds. Consolidation of healthy large ®rms in recent years (outside the
sample) includes the merger of Chemical and Chase. Along these lines, Blitzer (1995) points out
that ``many of the best stocks of the 1980s, in performance terms, cannot be bought in the 1990s
because they were taken over in mergers and LBOs''.
X
p X
q
h t a0 ai e2tÿi bi htÿi ; 2
i1 i1
ej;t jXtÿ1 N 0; ht ; 3
where yt is the excess return or risk premium, xt is an exogenous, or predeter-

mined, vector of variables, et is a random error, ht is the conditional variance of
et , and X is the information set. /, c, a0 , ai , and bi are parameter vectors or sca-
lars with appropriate dimensions, and t is a time index. The GARCH (p, q)-M
model described by Eqs. (1)±(3) allows for excess returns yt to be determined
by the vector xt and own conditional variances. The conditional variance (ht )
is linearly dependent on the past behavior of the squared errors and a moving
average of the past conditional variances. The use of squared error terms im-
plies that if innovations have been large in absolute value, they are likely to
be large also in the future. The ai values determine the weights attached to
the lagged innovations. To ensure a well de®ned process, parameters a0 , ai ,
and bi must be non-negative. The above set up is very general and allows for
a variety of heteroskedasticity parameterizations. For example, when c is set
to equal zero, the model reduces to GARCH. If, in addition, all the coecients
in Eq. (2), except the intercept term a0 , are zero (ai bi 0), the model will re-
duce to the traditional constant variance speci®cation. The parameter a0 is the
time independent component of risk and is shared by all the models discussed
above.
The common feature of ARCH and GARCH models is that they specify the
conditional variance as a function of the past shocks allowing volatility to
evolve over time and permitting volatility shocks to persist. The distinction be-
tween these two methodologies is that while ARCH incorporates a limited
number of lags in derivation of the conditional variance, GARCH allows all
lags to exert an in¯uence by including the past value of the conditional variance
itself, in addition to the past values of the squared errors. Thus, ARCH models
are considered to be short memory models while GARCH models are of the
long memory category.
In the ARCH-M and GARCH-M models the mean of the returns series is
speci®ed as an explicit function of the conditional variance of the process, allow-
ing for a ``velocity feed back'' eect and consideration of time varying risk pre-
mia. The importance of this family of models is that, unlike the basic ARCH
and GARCH models, they portray the fundamental trade-o relationship be-
tween expected returns and the volatility measure (ht ), with the coecient c cap-
turing the dynamic pattern of the changing risk premium over time. In
justi®cation of this framework, Engle et al. (1987) introduced a theoretical mod-
el that establishes a link between mean returns and the volatility measure (ht ).
Incorporation of this link in model speci®cation is clearly a step forward in
bringing the empirical models closer to asset pricing theories such as the CAPM
and the APT in which ex-ante returns are related to the conditional variance of
returns (Sharp, 1964; Lintner, 1965; Mossin, 1966; Ross, 1976). Neuberger
(1994) has pointed out that inclusion of ht in the mean equation is intuitively
appealing because investors are not indierent to the volatility of the stocks they
hold; as uncertainty in stock returns varies, the risk premia required by investors
will also change. Incorporation of this eect has also been emphasized by Pin-
dyck (1984) and French et al. (1987). The case for inclusion of ht in the mean
equation has been strengthened in the recent decades due to the fact that return
volatility has ¯uctuated over a much wider range during this period and it is es-
pecially important in banking because in this industry the high leverage ratio
and the prevalence of the contagion eect makes investors more sensitive to
changes in volatility than in the case of non-®nancial ®rms.
The trade-o parameter c is interpreted as the coecient of relative risk
aversion by Merton (1980) and Campbell and Hentschel (1992). Engle et al.
(1987) show that the sign and the magnitude of this parameter depends on util-
ity functions of the agents and the supply conditions of the assets. Hence, based
on these characteristics, c can take a positive, a negative, or a zero value. The
GARCH-M model has two advantages over the GARCH speci®cation. First,
the basic GARCH model is based on the implicit assumption that the average
risk premium is constant for the sample period. The GARCH-M speci®cation
relaxes this restriction by allowing the velocity feed back eect to become op-
erational. In this framework, when c is statistically signi®cant, volatility (ht )
does contribute to the risk premium so that the premia may dier between pe-
riods of relative instability and periods of tranquillity. Second, the GARCH-M
speci®cation is a generalization of the GARCH, ARCH, and the traditional
constant variance models commonly used. The GARCH-M model nests the
latter models as its special cases and allows a test of their validity, rather than
arbitrarily assuming that they are or are not valid. This ¯exibility feature is crit-
ical for accuracy of the results because arbitrary imposition of the restriction
(c 0) implicit in the simpler models is likely to distort the ®ndings.
The degree of persistence in shocks to volatility is an important factor in de-
termining the relationship between returns and volatility since only persistent
volatility changes warrant adjustment to the risk premium. All ARCH type
models capture the tendency for shock persistence. A succinct measure of
the shock persistence, as measured by the GARCH process, is the sum of
the coecients ai + bi which must be less than or equal to unity for stability
to hold. If the magnitude of this sum is close to unity, the process is said to
be integrated-in-variance, where the current information remains important
for the forecasts of the conditional variance for all horizons (Engle and Boller-
slev, 1986).
The economic theory explaining the intertemporal variations in conditional
variances is limited. Lamoureux and Lastrapes (1990) argue that, on the micro
level, ARCH eects are manifestations of clustering in trading volumes. On the
macro level, nominal interest rate, dividend yield, money supply, oil price, mar-
gin requirement, business cycle and information patterns have all been pro-
posed as the sources of volatility clustering (Bollesrev et al., 1992). In
particular, Engle et al. (1990a) provide two possible explanations for volatility
clustering; news arrival process, and market dynamics in response to the news.
First, if information arrives in clusters, returns may exhibit clustering even if
market incorporates the information perfectly and immediately. Second, if par-
ticipants have heterogeneous priors and take time to digest the information
shocks and to resolve their expectational dierences, market dynamics can lead
to volatility clustering. As pointed out by Bollesrev et al. (1988), ``the GARCH
speci®cation does not arise directly out of any economic theory, but as in the
traditional autoregressive and moving average time series analogue, it provides
a close parsimonious approximation to the form of heteroskedasticity typically
encountered with economic time series data''.
3.3. Model speci®cation
The capital asset pricing model (CAPM) and the arbitrage pricing theory
(APT) establish a theoretical foundation for an ex-ante trade-o relationship
between risk and excess return. In theory, risk is to be measured by the condi-
tional covariance of returns with the market, or the conditional variance of re-
turns (Sharp, 1964; Lintner, 1965; Mossin, 1966; Ross, 1976). In practice,
however, the actual (ex-post) values of excess return and risk, based on uncon-
ditional distribution of returns, are used to carry out the empirical estimation,
introducing a deviation from the theory. Application of the GARCH-M meth-
odology to capital asset pricing theories presents an improvement in speci®ca-
tion of asset pricing models as it allows measurement of the conditional
variance of returns as the measure of risk hence, permitting risk to vary over
time and delineating the interdependence of risk and return. Bollerslev et al.
(1992) consider the ARCH-M model as the ideal choice ``for handling ques-
tions in a time series context where conditional variances of asset returns are
time-varying''.
Applications of ARCH-type methodology to the ®eld of ®nance in general
and to stock return modeling in particular are abundant. Glosten et al.
(1993), Laux and Ng (1993), Campbell and Hentschel (1992), Ng et al.
(1992), Engle et al. (1990b), Baillie and DeGennaro (1990), Lamoureux and
Lastrapes (1990), Bollesrev et al. (1988), Chou (1988), Diebold and Nerlove
(1989), Mc Curdy and Morgan (1985), Milhoj (1987), and French et al.
(1987), are only some examples. Application of ARCH-type models to bank-
ing, however, remains a rarity. This paper is an attempt to ®ll the void in this
area of the literature.
The model used here relates bank stock excess returns to their conditional
variance and is consistent with the intertemporal capital asset pricing models
of Merton (1973), Merton (1980), French et al. (1987), and the APT frame-
work. Speci®cally, this model may be considered a two-factor APT model with
risk (volatility) and interest rate as its factors. Following Baillie and DeGen-
naro (1990), the GARCH(1, 1)-M speci®cation of the general model intro-
duced earlier is utilized. As Laux and Ng (1993) point out, the GARCH(1,
1)-M speci®cation achieves parsimony while simultaneously allowing for long
memory in the volatility process. Bollerslev (1987) also shows that the
GARCH(1, 1) adequately ®ts most economic time series data. The GARCH-
M model is extended here to include additional explanatory variables in the
volatility equation. The model used for estimation is as follows:
X n
ERj;t /0 /i ERj;tÿi hDrltÿ1 c log hj;t ej;t ; 4
i1
hj;t a0 d2 D2 d3 D3 a1 e2j;tÿ1 bhj;tÿ1 dCVLtÿ1 ; 5
ej;t jXtÿ1 N 0; ht : 6

In this model, ERj;t is the excess return on the jth portfolio ( j 1, 2, 3; Mon-
ey Center, Large and Regional bank portfolios, respectively), Drl is the change
in the ten-year Treasury composite yield, and D2 and D3 are dummy variables
for shifts in the volatility equation due to the changes in the monetary policy
regime in 1979 and 1982, respectively. Excess returns are de®ned as excess of
the stock returns over the one-year Treasury Bill rate. The variable (ht ) mea-
sures the stock return volatility (risk), CVL is the conditional interest rate vol-
atility, and /0 , /i , h, c, a0; a1 , b, d, d2 , and d3 are parameters. 9 In the mean
equation, the optimal lag structure is determined to be 1 (n 1) for the Money
Center bank and Large bank portfolios and to be 4 (n 4) for the Regional
bank portfolio. Akgiray (1989) also ®nds an autoregressive lag of 1 in his mod-
el. Speci®cation of volatility (ht ) in logarithmic form is based on Engle et al.
(1987) who report that log(ht ) is a better representation of risk than the stan-
dard deviation or variance. Baillie and DeGennaro (1990) use a speci®cation
quite similar to the one used here and include interest rate and volatility as fac-
tors in the mean equation.
The use of the long-term interest rate is consistent with Song (1994) and
Kane and Unal (1988) studies. Kane and Unal ®nd the stocks of commercial
banks to be more sensitive to changes in the long-term, rather than the
short-term interest rate. The use of the ®rst dierence of the long-term interest
rate follows Sweeny and Warga (1986) who employ this measure as a proxy for
9
The monthly excess return on bank portfolio, ERt , is calculated as ERt [(Pt ) Pt ÿ 1 + DIVt )/
Pt ÿ 1 ] ) RTBt , where P is the price, DIV is the level of dividends and RTB is the monthly rate for
the one-year Treasury bills.
the innovation in the interest rate. 10 The change in interest rate is introduced
with a lag in order to avoid the error in the variable problem and consequent
estimator inconsistency which may result from contemporaneous correlation of
the shocks to the ®nancial markets (the error term) and the innovations in the
interest rate. 11
The model presented here oers two advantages over the extant banking
studies. First, the use of the GARCH-M, as opposed to the basic ARCH,
GARCH, or the traditional constant variance models provides a unique frame-
work to examine whether volatility is a signi®cant factor in determination of
risk premia. Second, investigation of the eect of interest rate volatility on
bank stock volatility and risk premia provides new insights about the behavior
of banks in response to interest rate ¯uctuation. Incorporation of the interest
rate volatility eect on bank stock return distribution is important because this
variable conveys critical information about the overall volatility of the ®nancial
markets and it in¯uences the volatility of the bank stock returns also at the
micro level. In regard to the overall market volatility, interest rate volatility re-
¯ects the uncertainty about the stance of monetary policy and the eectiveness
of the Fed in hitting its interest rate target. Hence, it can serve as a good proxy
for volatility in the overall market, which is in turn a determinant of the bank
stock volatility. 12 At the micro level, Deshmukh et al. (1983) have shown the-
oretically that interest rate uncertainty leads to a reduction in the ®nancial in-
termediary's choice of risk exposure, measured here by volatility (ht ). This
eect is strengthened by a possible agency problem on the part of the bank
management. As interest rate uncertainty increases, bank managers, concerned
with a higher probability of loan default, bank insolvency, and consequent loss
of their job, will have an incentive to reduce asset risk (and/or to increase cap-
ital) to counterbalance the increased interest rate risk. Empirical signi®cance of
10
A two-index model with short-term interest rate was also tried as an alternative. The results
were not changed substantially but the order of signi®cance of some coecients was reduced. The
long-term rate produced a much better ®t.
11
We would like to thank a referee for suggesting the use of lagged instead of the
contemporaneous values. The contemporaneous value of the interest rate would not satisfy the
exogeneity requirement for the regressors because it could be aected by the shocks to the market,
which also aect the disturbance term.
12
Glosten et al. (1993) have argued that the level of risk-free interest rate can be included in the
variance equation as a proxy for the mean excess return and its inclusion incorporates the mutual
interdependence of the mean and the variance equations. Christie (1982) and Duee (1995) argue
that the level of interest rate should be included in the volatility equation on the basis of leverage.
Singleton (1989) also examines the ability of interest rate in predicting the changes in the volatility
of stock returns. For a review of the leverage issue, see Bollesrev et al. (1992). For an analysis of the
eects of interest rate volatility on bonds, see Engle et al. (1990b). For a theoretical defense of
in¯ation volatility eects, see Buono (1989). Although when shocks to volatility are transitory they
may not be priced by the market, permanent shocks are more likely to be priced.
this eect has been established by Shrieves and Dahl (1992). Yet another chan-
nel is the leverage mechanism. Increased interest rate volatility aects the pro-
cess through which information about interest rates is translated into
expectation of future interest rates and hence, the discount rate for pricing
stocks and bonds and debt and equity values (Flannery et al., 1997). The dif-
ferential eect of uncertainty on stock and bond values alters the bank leverage
ratio, which is in turn known to aect stock return volatility (Christie, 1982;
Kim and Kon, 1994).13, 14 The magnitude and the direction of the net (overall)
eect of interest rate volatility are to be determined empirically.
The shifts in the monetary policy regime which occurred during the period
of the study, may have altered the stochastic process generating bank stock re-
turns. Hence, failing to address these eects may produce unreliable results. To
avoid this problem, the model allows idiosyncratic intercepts for each policy
period by incorporating two non-overlapping time dummy variables in the vol-
atility equation and also investigates the eect of the shift on the slope of the
interest rate volatility variable. 15 Among the policy regimes distinguished, the
®rst regime runs from January 1970 to October 1979 and is used as the base.
During this period the Fed followed the federal funds rate strategy. During
the second regime (November 1979 to September 1982), the Fed engaged in
targeting monetary aggregates (non-borrowed reserves), and during the third
regime (October 1982 to December 1992) the Fed targeted borrowed reserves.
The second policy period is marked as a period of high interest rate volatility
while during the other two policy periods interest rates were relatively stable.
The second and third policy periods also witnessed a dramatic pace of bank
deregulation and ®nancial innovation, making the latter periods further dis-
13
Several other forces link interest rate volatility to the banks' stock return distribution.
Aharony et al. (1986) argue that, due to limited liability and the mispriced deposit insurance
arrangement prevailing in the US banking system during the sample period, there exists a potential
relationship between bank stock returns and interest rate volatility. Flannery et al. (1997) also
reason that, given that interest rate volatility aects expected bond returns, it must also aect the
returns on competing assets including stocks. Elyasiani et al. (1995) introduce a transaction cost
channel and demonstrate that banks adjust deposit and loan quantities in light of the expectations
of all relevant interest rates. As interest rate volatility increases, expectations change more
frequently, resulting in more frequent adjustments in deposits and loans. The transaction costs
involved in such adjustments will inevitably aect bank stock returns. It is not clear, however,
whether these forces aect the stock returns directly or through the volatility feed back mechanism.
14
It may be argued that market volatility should also be included in the information set Xtÿ1 .
However, high multicollinearity between interest rate and market volatilities makes it necessary to
exclude the latter from the volatility equation. The condition number for multicollinearity exceeds
155 indicating a sever degree of multicollinearity.
15
Lastrapes (1989) and Song (1994) follow a similar procedure in testing the eect of the
monetary policy regime changes on exchange rate volatility and stock return volatility, respectively.
tinct from the ®rst sub-period. Each dummy variable takes the unit value dur-
ing the corresponding policy regime and stands at zero otherwise.
Existing studies provide support for the inclusion of time dummy variables
in the model. For example, Lastrapes (1989) reports that incorporation of
monetary policy regime changes into the ARCH process for exchange rates
substantially decreases the persistence of shocks to volatility. Diebold
(1986) also points out that the appearance of integrated-in-variance feature
in the ARCH process may be caused by the changes in the monetary policy re-
gimes.
3.4. Hypotheses
Several hypotheses are developed and tested within the context of the model
discussed above. These hypotheses are presented below and are tested for the
Money Center, Large, and Regional bank portfolios:
H1: Volatility is not a signi®cant factor in bank asset pricing: c 0. This im-
plies that there is no intertemporal trade-o between volatility and return. This
also provides a test of non-linearity in risk premia, as ht is the second moment
of the returns.
H2: Return volatility is time invariant: a1 b d 0. Under this hypothesis,
the return distribution is homoskedistic and no ARCH or GARCH eects ex-
ist. The existing studies are generally based on this basic assumption.
H3: Return generating process follows an ARCH speci®cation: b d c 0.
In this case, volatility is time variant but it has a short memory. Only a limited
number of lags in the squared error impact the return volatility. In addition,
volatility is not a signi®cant factor in asset pricing.
H4: Return generating process follows an ARCH-M speci®cation: b d 0.
In this case also, volatility is time variant, but it is a signi®cant factor in asset
pricing.
H5: Return generating process follows a GARCH speci®cation: c d 0. Un-
der this hypothesis, the return generating process has a long memory, interest
rate volatility has no eect on returns, and volatility is not a signi®cant factor
in asset pricing.
H6: Shifts in the monetary policy strategy in 1979 and 1982 had no impact on
the bank stock risk and return: d2 d3 0. In this case, the volatility generation
process is robust to the choice of monetary policy strategy by the Fed, rather
than being strategy-speci®c.
H7: Interest rate volatility has no eect on bank stock risk and return: d 0.
In this case the GARCH-M speci®cation holds but the volatility equation is
not extended to include other factors such as interest rate volatility.
H8: There is no interest rate eects: h d 0. Under this hypothesis, changes
in the interest rate level and/or interest rate volatility have no impact on the
return generating process.
4. Empirical results
4.1. Properties of the data
To investigate the appropriateness of the GARCH framework certain prop-

erties of the data such as normality, white noise, skewness, and kurtosis have to
be examined. The extant literature generally assumes that the error term is nor-
mal and that it follows a strict white noise process. These two assumptions are
tested here using the Lagrange multiplier (LM) test and the Box±Pierce±Ljung
portmanteau test, respectively. Descriptive statistics associated with the bank
stock excess returns and the statistics for the test procedures are presented in
Table 1.
According to the ®gures in Table 1 (and graphical displays, not shown here)
excess returns on bank stocks exhibit high volatility during the sample period
and alternate in signs over time. The annual mean excess return was 6%, 6%,
and 12%, respectively for the MCB, Large bank, and Regional banks. The vol-
atility of the returns during this period, however, was too high for statistical
signi®cance to be revealed. This is not surprising, because this sample period
was a turbulent period in banking. 16 The unconditional sample skewness mea-
sures for all three portfolios are close to zero, as is the case with the normal
distribution, but the sample kurtosis exceeds the normal value of three. The
LM test statistics for the joint hypothesis of zero skewness and zero excess
kurtosis rejects the normality assumption for each of the portfolio return series
with much of the non-normality being due to leptokurtosis. 17
The Box±Pierce±Ljung portmanteau statistics cannot reject the null hypoth-
esis of strict white noise hypothesis for any of the three portfolios, with the ex-
ception of lag 12 for the Regional bank portfolio, indicating that the series is
uncorrelated in all three cases. The rejection of the normality assumption is in-
consistent with linearity and constancy of the conditional variance which is
fundamental to the existing models of bank equity returns. The non-linear de-
pendence and the excess kurtosis exhibited by the excess return series suggest
that the appropriate framework for analyzing bank equity returns and risk is
the ARCH type modeling strategy.
16
Along these lines, Economist (1990) reported that ``1980s did not add up to the best times for
American commercial banks''. Deregulation, recession, LDC loan problems, and general market
volatility made this period one of challenge for survival for US banks, lowering their nominal
return to a mere 2% by 1987.
17
The LM statistics for the Money Center, Large, and Regional bank portfolios are 55.80, 46.95,
and 4883.58, respectively. This ®nding is consistent with Bollerslev (1987) and Lastrapes (1989),
and Cochran and Mansur (1993) whose models also failed to account for the leptokurtic
disturbances of market excess returns.
Table 1
a
Sample statistics on monthly bank portfolio excess returns
Bank Portfolios
Money center bank Large bank Regional bank
No. of observations 275.0 275.0 275.0
Mean 0.005 0.005 0.010
Variance 0.005 0.004 0.003
Minimum )0.264 )0.207 )0.231
Maximum 0.286 0.245 0.203
Skewness 0.199 0.187 )0.059

Kurtosis 1.292 1.425 1.539
LM(v2 ) 34.984
29.805
24.433

Q(12) 12.961 16.403 30.958
Q(24) 15.704 19.533 33.404
Q(36) 22.700 23.254 35.720
a
LM is a Lagrange multiplier test for normality under the null hypothesis that the coecients of
skewness and kurtosis are jointly equal to zero and three, respectively. This statistic is distributed as
a v2 with two degrees of freedom. The critical value at the 5% level is 5.99. Q is the Box±Pierce±
Ljung statistic at a lag of n, distributed as a v2 with n degrees of freedom. Critical values of 12°, 18°,
and 24° of freedom are 21.02, 28.86, and 36.41 at the 5% level. The standard errors for skewness
and kurtosis are (6/T)0:5 0.147 and (24/T)0:5 0.295, respectively, where T is the number of ob-
servations. , , and represent signi®cance at the 0.10, 0.05 and 0.01 levels, respectively.
4.2. Interpretation of the results
The coecient estimates for the model with the intercept dummy variables
in the volatility equation are presented in Table 2 and the likelihood ratio test
statistics for the hypotheses H1±H8 are displayed in Table 3. Table 4 contains
the results on slope dummy variables. The ®ndings based on these tables are
discussed below.
4.2.1. The risk±return trade-o

The hypothesis examined here is whether volatility is a signi®cant factor in
bank stock pricing or, equivalently, whether an intertemporal risk return trade-
o exists (H1: c 0). For all three bank portfolios estimated (MCB, Large, and
Regional banks), the coecient c, describing the intertemporal relation be-
tween risk and return, is found to be negative and statistically signi®cant
and to vary in magnitude across the three portfolios (Table 2). The likelihood
ratio test of the null hypothesis of c 0 is also rejected for all portfolios at the
5% level or better (Table 3). The implication of this ®nding is that volatility
risk premia are portfolio-speci®c in magnitude and display an adverse risk±re-
turn trade-o over time. As pointed out by Engle et al. (1987), the sign and
magnitude of the trade-o parameter c depends on the investors' utility func-
tion e.g. risk preference, and the net supply condition of each asset. The heter-
ogenous nature of investors' expectations about the future of MCB, Large, and
Table 2
Maximum likelihood estimates of GARCH(1, 1)-M models of excess returns level and conditional
volatility of long-term interest rate over dierent monetary policy regimes (January 1970 to Decem-
ber 1992) a
Bank portfolios
c (´10ÿ2 ) )1.31 )1.42 )1.00
()3.16) ()2.50) ()1.94)
h )26.69 )29.35 )21.49
()2.00) ()2.08) (1.32)
a0 (´10ÿ3 ) 1.35 2.07 0.87
(1.89) (5.88) (1.08)
d2 (´10ÿ3 ) 0.41 1.33 0.25
(2.17) (2.99) (0.64)
d3 (´10ÿ3 ) 0.26 0.58 0.11
(2.04) (2.62) (0.66)
a1 0.06 0.23 0.14
(1.89) (3.80) (1.96)
b 0.78 0.76 0.74
(7.50) (14.92) (6.40)
d(´10ÿ2 ) )1.38 )2.80 )0.65
()3.15) ()5.87) ()0.63)
(a1 + b) 0.84 0.99 0.85
Log likelihood 655.49 461.27 640.07
p
k (e/ h) 0.99 53.85 0.40
MSL, k 0 0.00 0.00 0.00
p
s (e/ h) 0.13 )4.96 0.40
MSL, s 0 0.37 0.00 0.00
a
The GARCH(1, 1)-M models estimated are as follows:
X
n
ERj;t /0 /i ERj;tÿi hDrltÿ1 c loghj;t ej;t ;
i1
hj;t a0 d2 D2 d3 D3 a1 e2j;tÿ1 bhj;tÿ1 dCVLtÿ1 ;
ej;t jXtÿ1 N 0; ht ;
where ERj;t is the excess return on the jth portfolio (j 1, 2 and 3; Money Center bank, Large bank
and Regional bank, respectively) at time t. ERj;tÿ1 is the lagged excess return on the jth portfolio.
The optimal lag structure for the Money Center and Large bank portfolios were determined to be 1
and the Regional bank portfolio to be 4. Drlt is the change in the long-term interest rate (10 year
Treasury Composite yield) at time t. ej;t denotes the error term which is dependent on the informa-
tion set Xtÿ1 . hj;t is the conditional variance of return at time t. The changes in monetary policy
regimes are denoted by dummy variables D2 (November 1979±September 1982) and D3 (October
1983±December 1992). CVLt is the conditional variance of long-term interest rate at time t. k
p
and s are the sample kurtosis and skewness, respectively of (e/ h). MSL denotes the marginal sig-
ni®cance level of the corresponding test statistic under the null hypothesis.
Values in parentheses are those of t statistic. , , and represent signi®cance at the 0.10, 0.05 and
0.01 levels, respectively.
Table 3
The v2 statistics for various Hypotheses tests
Hypotheses Bank portfolios
v2 values v2 values v2 values

H1: Volatility is not a signi®cant factor: 10.03 6.27 3.78
c0

H2: Return volatility is time invariant: 187.49 1517.98 170.49
a1 b d 0

H3: Return generating process follows an 67.70 258.37 48.49
ARCH speci®cation: b d c 0

H4: Return generating process follows an 59.05 242.98 46.86
ARCH-M speci®cation: b d 0

H5: Return generating process follows a 35.14 43.78 4.22
GARCH speci®cation: c d 0

H6: Shifts in the monetary policy strategy in 8.20 12.70 0.53
1979 and 1982 had no impact on the bank
stock risk and return: d2 d3 0

H7: Interest rate volatility has no eect on 9.97 34.44 0.39
bank stock risk and return: d 0

H8: There is no interest rate eects: d h 0 19.01 34.70 4.22

Signi®cant at the 0.01 level; signi®cant at the 0.05 level; and signi®cant at the 0.10 level.
Regional banks may have resulted in dierent trade-o values for the three
groups of banks. The diering c values across portfolios point to the impor-
tance of disaggregation and portfolio homogeneity. It follows that, the use
of an aggregate portfolio would mask the dierences among banks by forcing
a single speci®cation for all bank portfolios.
Concerning the sign of the parameter c, note that this measure diers from
the equilibrium price of systematic risk commonly discussed in the literature.
Since volatility is a measure of total risk, rather than the non-diversi®able sys-
tematic risk, the increase in it need not always be accompanied by an increase
in the risk premium. Indeed, if ¯uctuations in volatility are mostly due to
shocks to the unsystematic risk, the trade-o coecient c can have any sign.
Glosten et al. oer two reasons why the intertemporal trade-o between risk
and return may be negative. First, riskier periods may coincide with periods
when investors are better able to bear risk. Second, if investors want to save
more during riskier times and all assets are risky, competition may raise asset
prices and lower risk premia. In justi®cation of a negative c value for a partic-
ular sector such as banking, it can be argued that if banks are aected less
strongly by random shocks than other sectors, investors will switch to bank
stocks in response to the shocks, in order to avoid the sectors more strongly
aected. This substitution process will result in a lower bank stock premium.
The ®ndings in the extant literature about the parameter c are in general mixed.
For example, French et al. (1987), and Campbell and Hentschel (1992) ®nd a
positive relationship between conditional excess returns and conditional vari-

ance (c > 0), whereas Fama and Schwert (1977), Campbell (1987), Bree et al.
(1989), and Glosten et al. (1993) ®nd a negative association (c < 0). Baillie
and DeGennaro (1990) ®nd c to be insigni®cant in seven out of their eight spec-
i®cations, indicating the lack of a trade-o.
4.2.2. ARCH and GARCH eects and shock persistence

Results of several hypotheses tests are presented in this section. These in-
clude time-variability of return volatility and the functional forms describing
the returns generating process (ARCH, ARCH-M, and GARCH). The likeli-
hood ratio test statistics, reported in Table 3, reject the null hypothesis of time
invariability of return volatility (H2: a1 b d 0) at any traditional level of
signi®cance for all three portfolios. This ®nding, combined with rejection of a
zero value for parameter c, indicates that the appropriate model for all three
portfolios is the GARCH-M, rather the GARCH, ARCH, or time-invariant
volatility models, with the only exception being the Regional banks for which
the GARCH speci®cation is acceptable. The likelihood ratio test results also
reject the null hypotheses of ARCH, ARCH-M, and GARCH speci®cations
(H3: b d c 0, H4: b d 0, H5: c d 0) strongly, again with the excep-
tion of the Regional banks. These results make the ®ndings in the literature
based on the latter speci®cation suspect.
Note that the rejection of a hypothesis is a sucient condition for rejection
of any other hypothesis which is more restrictive in nature, namely one that im-
poses more constraints than implied by the former. Three examples of this con-
dition are applicable here. Adding the constraint a1 0 to the H3 or the H4
hypothesis, or adding the constraint a1 b 0 to the H5 hypothesis produces
the traditional constant variance model with the volatility variable ht taking
only three values to accommodate the shifts in 1979 and 1982. In this case,
the dummy coecients d2 and d3 cannot be estimated within the GARCH
framework due to the limited number of observations (3 observations). How-
ever, given that H3, H4, and H5 are rejected by the data, clearly the more re-
strictive constant variance speci®cation must be rejected as well.
The intercept term, a0 , in the volatility equation, constitutes the time-inde-
pendent component of volatility; it re¯ects the volatility measure if no ARCH
or GARCH elements, or conditioning variables are signi®cant (a1 b d 0).
As the ®gures in Table 2 show, a0 is positive for all three portfolios but insig-
ni®cant for the Regional bank portfolio, indicating that volatility of the latter
portfolio has no time-independent component. The ®nding related to the Re-
gional bank portfolio is consistent with Neuberger (1994) who also ®nds a zero
intercept in the volatility equation.
The ARCH parameter (a1 ) and the GARCH parameter (b), are positive and
signi®cant in all three portfolios, satisfying the speci®cation requirement of
non-negativity for all of the models. The magnitude of a1 , which shows the ef-
fect of the last period's shock directly, is found to be much smaller than that of
the parameter b, which embodies the eect of the previous surprises. The im-
plication is that the market has a memory longer than one period and that vol-
atility is more sensitive to its own lagged values than it is to new surprises in the
market place.
The sum (a1 + b) is the measure of volatility persistence. This sum is found
to be less than unity for all three portfolios indicating that the models are sec-
ond order stationary. The large value of the persistence measure is an evidence
that shocks to the banking sector have highly persistent eects and that the re-
sponse function of volatility decays at a relatively slow pace. For example, for
the MCB portfolio, the persistence measure (a1 + b) is approximately 0.84.
Hence, the proportion of the initial shock to these banks remaining after a
six month period is (0.84)6 or 35%. Based on these parameter values even after
one full year, still 12% of the initial shock persists. It is noteworthy that for the
Large and Regional bank portfolios shocks persist even for a longer period
than for the MCB portfolio. The latter group of banks seem to be better able
to absorb the shocks to which they are subjected. This may be explained by the
dominant role of o balance sheet activities and wholesale orientation of these
banks.
The dynamic pattern of the eect of the shocks on the risk premium can be
explained as follows. According to our ®ndings, a shock to the returns intro-
duces a change in the error term and alters the contemporaneous risk premium
in the same direction. In the next two periods, however, the risk premium will
revert back, with the magnitude of the reversion depending on the values of a1
and c in the next period, and b and c in the period after. These latter two eects
occur through the persistence mechanism introduced in the volatility equation.
4.2.3. Shifts in the monetary policy strategy

The eect of the shift in the monetary policy strategy in 1979, and 1982 on
bank stock return volatility may be manifested in the form of a one time dis-
placement in the intercept of the volatility equation or as a change in the sen-
sitivity of the stock return volatility to one or more variables on the right-hand
side. The results of the t-tests for individual intercept dummy coecients, and
the results of the likelihood ratio tests for joint signi®cance of these coecients,
are reported in Tables 2 and 3, respectively. These tests allow two sets of com-
parisons; (i) comparison of stock return volatility of each portfolio over the
three policy periods (1970±1979, 1979±1982, 1982±1992), and (ii) comparison
of the volatilities of separate portfolios during a given policy period.
Comparison of stock return volatilities (intercepts) of each of the portfolios
over the three policy periods is made by testing the hypothesis of identical
intercepts for each portfolio across policy regimes (H6: d2 d3 0). The likeli-
hood ratio test statistic for this hypothesis is found to be highly signi®cant for
all bank portfolios, indicating that the volatility generation process is sensitive
to the choice of the monetary policy strategy by the Fed. Concerning the indi-
vidual t-test results for the intercept shift, the coecients (d2 , d3 ) for the dum-
my variables are positive for all three portfolios but signi®cant only for the
MCBs and the Large banks. This indicates that although all portfolios showed
an upward shift in the intercept in response to the Fed's switch in its monetary
policy strategy, the shift for the Regional banks was not statistically signi®cant.
One possible explanation is that Regional banks were more risk averse and
hedged against interest rate ¯uctuations to a larger extent than the MCB
and the Large banks, hence remaining unaected by the switch. In terms of
the relative magnitude of the eect across bank portfolios, the shift in volatility
is found to be larger for the Large banks than the MCBs. It seems that MCBs
were better able to weather the eect of the policy switch and were more im-
mune from the Fed's choice of monetary policy strategy, than the former group
of banks. This may be due to the non-traditional nature of the MCB banking
activity and their greater access to ®nancial markets. It is noteworthy that the
composite (joint) test d2 d3 0 and the simple tests d2 0 or d3 0 discussed
above cannot be derived from one another and are not substitutes for each oth-
er Gujarati (1988).
Comparison of volatility intercepts across policy periods reveals that the
MCBs and Large bank portfolios were, ceteris paribus, more volatile during
the second period (interest rate instability) than the other two periods (interest
rate stability). In addition, these two portfolios were more volatile during the
third period (1982±1992) than the ®rst period (1970±1979). In both cases, the
dierences are statistically insigni®cant for the Regional bank portfolio. In oth-
er words, after the Fed switched back to focus on targeting borrowed reserves
in 1982, bank stock return volatility did subside, but it did not revert to the ini-
tial pre-1979 period. The dierential eect found here on the three portfolios
reinforces the ®nding earlier that the aggregate sample may produce unreliable
results; the intra-sample dissimilarity of the eects highlights the importance of
group homogeneity.
Contrasting the intercepts in the volatility models of the three bank portfo-
lios with each other during a given monetary policy strategy period reveals an-
other interesting result. The volatility of the Large bank portfolio is found to
be, ceteris paribus, more pronounced (to have a larger intercept) than that of
the MCB and Regional bank portfolios both during periods of interest rate in-
stability (1979±1982) and interest rate stability (1982±1992). The nature of the
banking activities undertaken by the MCBs (e.g. the overwhelming role of
wholesale banking and o-balance sheet activities) and risk aversion and hedg-
ing policies of the Regional banks are very likely to have contributed to this
phenomenon. Note that shifts in the stock return volatility in response to chan-
ges in the monetary policy strategy are examined for a given shock in the im-
mediate past and a given value of interest rate volatility. The eect of variations
in the interest rate volatility are discussed next. The eect of the shift in the
monetary policy strategy on the slope of the interest rate volatility will be dis-
cussed further below.
4.2.4. The interest rate eects

Of important concern to this study are the magnitude and the direction of
the eect of interest rate and its volatility on the distribution of bank stock re-
turns. These eects are tested by the hypotheses of no interest rate volatility ef-
fect (H7: d 0) and no overall interest rate eect (H8: d h 0) and the results
are reported in Tables 2 and 3. The parameter h, which measures the eect of
changes in the long-term interest rate on the risk premium, is negative in all
cases and statistically signi®cant for the MCB and Large bank portfolios. This
manifests signi®cant interest rate risk exposure of these two groups of banks
and is consistent with the ®ndings in the existing literature.
The coecient d, which measures the eect of the lagged interest rate vola-
tility on bank stock return volatility, is negative in all cases and signi®cant for
the MCB and Large bank portfolios. This indicates that, if interest rates be-
come more volatile, bank stock returns will stabilize in the following period
for the MCBs and Large banks, and remains unaected for the Regional
banks. A possible explanation for the decline in the stock return volatility of
the MCB and Large banks is that, in response to an increase in interest rate
volatility, these banks seek shelter from interest rate risk and are capable of
achieving this objective within one period (month), e.g. by holding derivatives
and matching duration's of assets and liabilities. This, in turn, results in lower
bank stock volatility in the following period. 18 This result is in accord with
Deshmukh et al. (1983) and Shrieves and Dahl (1992). In terms of the magni-
tude, the Large bank portfolio shows a stronger reaction to increased interest
rate volatility than the MCB portfolio.
The eect of interest rate volatility on risk premia can be measured indirectly
through the ``feedback eect'' parameter c. According to the ®gures displayed
in Table 2, the eect of the interest rate volatility on the risk premia is similar
in sign across bank portfolios but varies in magnitude. For the MCB and Large
bank portfolios, the risk premium will increase when interest rates become
more volatile, while for the Regional bank portfolio the risk premium will re-
main unaected. The magnitude of the eect is larger for the Large bank port-
folio than the MCBs. The results based on the likelihood ratio tests are
consistent with and reinforce the individual t-test results. The lack of signi®-
cance of the interest rate volatility eect on risk premia for the Regional banks
18
Note that this ®nding does not preclude (contemporaneous) movement of ht and CVLt in the
same direction. Indeed, if CVL is negatively autocorrelated (and d is negative) the two variables will
move together.
may indicate insigni®cant exposure to interest rate risk due to stronger risk
aversion and hedging action on the part of this group of banks.
The results concerning interest rate volatility extend the literature in two im-
portant ways. First, by showing the eect of the changes in the second moment
of the interest rate distribution on the mean bank stock returns, they highlight
the importance of incorporating the volatility eects in asset pricing models.
Second, they portray the dependence of the bank stock riskiness on the vola-
tility of the interest rate and highlight the importance of estimating the risk
and return equations jointly. Both of these eects are generally overlooked
in the literature. The interest rate eects found here also indicate that informa-
tion acquisition by investors is not a futile activity; publicly available informa-
tion can be used to carry out pro®table trades.
The slope of the interest rate volatility measure (CVL) may be non-robust to
the change in the monetary policy strategy. In order to investigate this possi-
bility, the dummy variables introduced earlier are used to test the hypothesis
of identical slopes across policy regimes. The results for this hypothesis, report-
ed in Table 4, indicate that the eect on the slope coecient for the interest rate
volatility is in the same direction as that on the intercept. More speci®cally,
stock return volatility is found to become signi®cantly more sensitive to the in-
terest rate volatility after the Fed switched to targeting monetary aggregates in
1979 and allowed interest rates to ¯uctuate. Later in 1982, when the Fed
switched backed to target borrowed reserves, the sensitivity of bank stock re-
turn volatility to interest rate volatility did moderate but it never returned to
the level prevailing prior to the 1979 regime shift. In other words, the increase
in interest rate sensitivity relative to the pre-1979 period is both larger in mag-
nitude and more stringent in terms of statistical signi®cance in the 1979±1982
period than in the post-1982 period. In terms of the order of the magnitude, the
eect was larger for the Regional banks, Large banks, and MCBs, respectively.
5. Conclusions
Application of time-varying risk models to banking is of special importance

because in recent decades both interest rate level and volatility have varied sub-
stantially as a result of the shifts in the monetary policy regime, ®nancial and
technological innovations, and international market integration. Knowledge of
the properties of the equity return process, and in particular how the process is
aected by changes in the monetary policy regime, is crucial to bank managers
in designing their interest rate risk management strategies, and to all market
participants for pricing derivatives and designing dynamic hedging strategies.
This study extends previous works in two directions. First, unlike previous
studies which limited their scope to interest rate levels, the current study intro-
duces the volatility of the interest rate into the bank stock return generating
Table 4
GARCH(1, 1)-M models of excess returns: Maximum likelihood estimates with slope dummy vari-
ables (January 1970 to December 1992) a
Bank portfolios
ÿ2
c (´10 ) )1.33 )0.89 )0.47
()2.38) ()2.16) ()1.88)
h )36.58 )29.47 )46.57
()2.62) ()2.36) ()4.03)
a0 (´10ÿ3 ) 0.83 0.71 1.02
(2.84) (3.23) (3.61)
a1 0.18 0.16 0.12
(4.10) (5.28) (3.69)
b 0.81 0.82 0.84
(19.66) (25.79) (22.56)
d1 (´10ÿ2 ) )1.13 )0.96 )1.38
()2.82) ()3.24) ()3.62)
d2 (´10ÿ2 ) 0.52 0.39 0.47
(2.21) (2.27) (3.04)
d3 (´10ÿ2 ) 0.40 0.20 0.29
(1.67) (1.86) (2.22)
(a1 + b) 0.99 0.98 0.96
Log likelihood 481.36 593.70 647.67
a
The GARCH(1, 1)-M models estimated are as follows:
X
n
ERj;t /0 /i ERj;tÿi hDrltÿ1 c loghj;t ej;t ;
i1
hj;t a0 a1 e2j;tÿ1 bhj;tÿ1 d1 CVLtÿ1 d2 CVLtÿ1 D2 d3 CVLtÿ1 D3 ;
ej;t jXtÿ1 N 0; ht ;
where ERj;t is the excess return on the jth portfolio ( j 1, 2 and 3; Money Center, Large, and Re-
gional bank, respectively) at time t. The optimal lag structure for the Money Center and Large
bank portfolios were determined to be 1 and for the Regional bank portfolio to be 4. Drlt is the
change in the long-term interest rate (ten-year Treasury Composite yield) at time t. ej;t denotes
the error term which is dependent on the information set Xtÿ1 . hj;t is the conditional variance of
return at time t. The changes in monetary policy regimes are denoted by dummy variables D2 (No-
vember 1979±September 1982) and D3 (October 1982±December 1992). CVLt is the conditional
variance of long-term interest rate at time t.
Figures in parentheses are t statistics. , , and represent signi®cance at the 0.10, 0.05 and 0.01
levels, respectively.
process. Second, this study employs a GARCH-M methodology which dis-

cards some of the untenable assumptions in the existing studies, allows for vol-
atility to vary with time, and relates the risk premia to the bank stock return
volatility. The model estimates the interest rate sensitivity of bank stock returns
while simultaneously considering possible eects of the changes in monetary
policy regime on volatility. The data support the appropriateness of the
GARCH-M process indicating that volatility is a determinant of the bank

stock return. The data fail to support the irrelevance hypothesis concerning
the eect of the monetary policy strategy, suggesting that the return generating
process is not independent of the shifts in the US monetary policy regime. It
follows that monetary policy regime shifts play an important role in describing
the return generating process and should be included in empirical analysis of
bank equity returns.
According to our ®ndings, the long-term interest rate has a negative and sig-
ni®cant impact on the bank stock return. In addition, interest rate volatility is
found to be an important determinant of the bank stock return volatility and
bank stock risk premium, for the MCB and Large bank portfolios, though not
for the Regional bank portfolio. It follows that in the periods immediately fol-
lowing relatively unstable interest rate conditions, the distribution of the MCBs
and Large bank portfolio returns become less dispersed and will have a larger
mean, while that of the Regional bank stock returns remains unaltered. In oth-
er words, when interest rates become more volatile the risk premium on the
MCB and Large bank portfolios will increase with them in tandem. The degree
of persistence in shocks is sensitive to the nature of the bank portfolio. Persis-
tence is found to be stronger for the Large bank portfolio than the Regional
and MCB portfolios. For the MCBs, shocks manifest least persistence.
Acknowledgements
We would like to thank Venkat Gangadharan, Tribhuvan Puri, Jahangir

Sultan, and four anonymous referees and an associate editor of the Journal
for very helpful comments and suggestions. Any remaining errors are ours. Au-
thors' names are in alphabetic order. Please address any correspondence to the
®rst author. An earlier version of the paper was presented in the Financial
Management Association meeting of 1994 in Saint Louis.
Appendix A. Sample banks and asset size
Institution Asset size

($000 at the
end of 1991)
Money Center banks
1 BANKAMERICA CORP 115,509,000
2 BANKERS TRUST NEW YORK CORP 63,958,000
3 CHASE MANHATTAN CORP 98,197,000
4 CHEMICAL BANKING CORP 138,930,000

5 CITICORP 216,922,000
6 CONTINENTAL BANK CORP 24,008,000
7 FIRST CHICAGO CORP 48,963,000
8 MORGAN (J.P.) & CO 103,468,000
9 NATIONSBANK CORP 110,319,000
10 WELLS FARGO & CO 53,547,000
Large banks
1 BANK OF BOSTON CORP 32,700,243
2 BANK OF NEW YORK CO INC 39,426,145
3 BARNETT BANKS INC 32,720,549
4 FIRST FID BANCORPORATION 30,215,229
5 FIRST INTERSTATE BANCORP 48,922,077
6 FIRST UNION CORP (N.C.) 46,084,853
7 FLEET FINANCIAL GROUP INC 45,537,294
8 MELLON BANK CORP 29,355,000
9 NATIONAL CITY CORP 24,169,746
10 NBD BANCORP INC 29,513,459
11 NORWEST CORP 38,501,600
12 PNC FINANCIAL CORP 44,891,688
13 REPUBLIC NEW YORK CORP 31,220,805
14 WACHOVIA CORP 33,158,320
Regional banks
1 AMSOUTH BANCORPORATION 9,459,269
2 BANCORP HAWAII INC 11,409,341
3 BANPONCE CORP-NEW 8,780,282
4 BAYBANKS INC 9,515,788
5 COLORADO NATL BANKSHARES 3,000,000
6 COMERICA INC 14,450,791
7 CORESTATES FINANCIAL CORP 21,623,939
8 CRESTAR FINANCIAL CORP 11,828,261
9 DOMINION BANKSHARES CORP 9,710,955
10 EQUIMARK CORP 3,000,000
11 FIRST BANK SYSTEM INC 18,301,000
12 FIRST CITY BANCORP TEX-DEL 9,943,467
13 FIRST SECURITY CORP-UTAH 7,015,075
14 FIRST TENNESSEE NATL CORP 7,903,676
15 FIRST VIRGINIA BANKS INC 6,119,260
16 FIRSTAR CORP 12,309,000
17 KEYCORP 23,155,549
18 MERCANTILE BANCORPORATION 8,088,943
19 MICHIGAN NATIONAL CORP 10,650,231

20 MNC FINANCIAL INC 17,438,171
21 NORTHERN TRUST CORP 13,192,500
22 RIGGS NATL CORP WASH D C 5,536,680
23 SHAWMUT NATIONAL CORP 22,815,520
24 SIGNET BANKING CORP 11,238,800
25 SOCIETY CORP 15,404,528
26 STAR BANC CORP 6,645,905
27 STATE STREET BOSTON CORP 15,046,301
28 U S BANCORP 18,875,137
29 UJB FINL CORP 13,377,719
30 VALLEY NATIONAL CORP ARIZONA 10,651,659
31 U S TRUST CORP 2,917,000
32 UNION PLANTERS CORP 3,786,837
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Journal of Banking & Finance 22 (1998) 535±563

Sensitivity of the bank stock returns

The objective of this paper is to employ the generalized autoregressive conditionally

JEL classi®cation: G12; G21; C52

Keywords: Bank stocks; GARCH; Interest rate risk

0378-4266/98/$19.00 Ó 1998 Elsevier Science B.V. All rights reserved.

3. Data and methodology

3.1. Data description

delays, which are found to be a signi®cant determinant of returns in the daily

3.2.1. Features of ARCH and GARCH type models

ej;t jXtÿ1  N 0; ht ; 3

where yt is the excess return or risk premium, xt is an exogenous, or predeter-

3.3. Model speci®cation

hj;t  a0  d2 D2  d3 D3  a1 e2j;tÿ1  bhj;tÿ1  dCVLtÿ1 ; 5

ej;t jXtÿ1  N 0; ht : 6

4.1. Properties of the data

To investigate the appropriateness of the GARCH framework certain prop-

4.2. Interpretation of the results

4.2.1. The risk±return trade-o

hj;t  a0  d2 D2  d3 D3  a1 e2j;tÿ1  bhj;tÿ1  dCVLtÿ1 ;

ej;t jXtÿ1  N 0; ht ;

positive relationship between conditional excess returns and conditional vari-

4.2.2. ARCH and GARCH eects and shock persistence

4.2.3. Shifts in the monetary policy strategy

4.2.4. The interest rate eects

Application of time-varying risk models to banking is of special importance

hj;t  a0  a1 e2j;tÿ1  bhj;tÿ1  d1 CVLtÿ1  d2 CVLtÿ1 D2  d3 CVLtÿ1 D3 ;

ej;t jXtÿ1  N 0; ht ;

process. Second, this study employs a GARCH-M methodology which dis-

GARCH-M process indicating that volatility is a determinant of the bank

We would like to thank Venkat Gangadharan, Tribhuvan Puri, Jahangir

Appendix A. Sample banks and asset size

Institution Asset size

4 CHEMICAL BANKING CORP 138,930,000

19 MICHIGAN NATIONAL CORP 10,650,231

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ej;t jXtÿ1 N 0; ht ; 3

hj;t a0 d2 D2 d3 D3 a1 e2j;tÿ1 bhj;tÿ1 dCVLtÿ1 ; 5

ej;t jXtÿ1 N 0; ht : 6

4.2.1. The risk±return trade-o

hj;t a0 d2 D2 d3 D3 a1 e2j;tÿ1 bhj;tÿ1 dCVLtÿ1 ;

ej;t jXtÿ1 N 0; ht ;

4.2.2. ARCH and GARCH eects and shock persistence

4.2.4. The interest rate eects

hj;t a0 a1 e2j;tÿ1 bhj;tÿ1 d1 CVLtÿ1 d2 CVLtÿ1 D2 d3 CVLtÿ1 D3 ;

ej;t jXtÿ1 N 0; ht ;