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Abstract
Purpose – This paper attempts to summarize the information contained in bank financial statements
on the risk management capabilities of banks and then ascertains the sensitivity of bank stocks to risk
management.
Design/methodology/approach – The theoretical framework is derived from a bank’s accounting
identities. The paper interprets the selected accounting ratios as risk management variables and
attempts to gauge the overall risk management capability of banks by summarizing these accounting
ratios as scores through the application of multivariate statistical techniques. Finally, the paper
analyzes the impact of these risk management scores on stock returns through regression analysis.
Findings – The results based on data for Indian banks reveal that banks’ risk management
capabilities have been improving over time except for in the last two years. Returns on the banks’
stocks appear to be sensitive to risk management capability of banks.
Practical implications – The results suggest that banks that want to enhance shareholder wealth
have to focus on successfully managing various underlying risks. The findings have implications for
investors who may benefit by going long on shares of banks that are better risk managers. The
findings are useful for the regulator in developing quantitative indicators of soundness of the banking
system.
Originality/value – First, this study suggests a novel way of looking at bank financial statements,
i.e. from the risk management perspective. Second, the study develops summary scores of risk
management capabilities of banks. Third, risk management is shown to be an important determinant
of stock returns of banks.
Keywords Banks, Risk management, Financial reporting, Stock returns
Paper type Research paper
Introduction
Commercial banking is a combination of related activities such as providing products
and services to the customers, engaging in financial intermediation and management
of risk. In recent years, risk management has received increasing focus as a central
activity of commercial banks. The justification for studying banks’ activities by
focusing on risk management can be traced to Merton (1995) who argued that financial
systems should be analyzed in terms of a “functional perspective” rather than an
An earlier version of this paper was accepted for presentation at the 12th Finsia-Melbourne
The Journal of Risk Finance
Centre for Financial Studies Banking and Finance Conference. The authors gratefully Vol. 10 No. 1, 2009
acknowledge the useful comments received from anonymous referees of the above conference pp. 7-22
q Emerald Group Publishing Limited
and this journal. They are also grateful to G. K. Shukla for his insightful comments. Any 1526-5943
remaining errors are the authors’ responsibility. DOI 10.1108/15265940910924463
JRF “institutional perspective” since over long periods of time functions have been much
10,1 more stable than institutions[1]. Research on financial services has followed this
functional approach by relating banks’ activities to the functions performed by them.
Merton (1989) suggested that, inter alia, the central function of a financial institution is
its ability to distribute risk across different participants. According to Saunders and
Cornett (2006), modern financial institutions are in the risk management business as
8 they undertake the functions of bearing and managing risks on behalf of their
customers through the pooling of risks and the sale of their services as risk specialists.
Given the importance of risk management in a bank’s functioning, the efficiency of a
bank’s risk management is expected to significantly influence its financial
performance (Harker and Satvros, 1998). An extensive body of banking literature
(Santomero and Babbel, 1997) argues that risk management matters for financial
performance of banking firms. According to Pagano (2001), risk management is an
important function of financial institutions in creating value for shareholders and
customers. The corporate finance literature has linked the importance of risk
management with the shareholder value maximization hypothesis. This suggests that
a firm will engage in risk management policies if it enhances shareholder value
(Ali and Luft, 2002). Thus, effective risk management either in non-banking firms or in
banking entities is expected to enhance the value of the firm and shareholder wealth.
The objective of this paper is to provide empirical evidence for the above arguments by
examining the impact of banks’ risk management capabilities on the banks’ stock
returns.
We chose Indian banking as a case study for our analysis. Our choice is driven by
the recent emphasis on risk management in Indian banking driven by the central bank
viz. the Reserve Bank of India (RBI)’s guidelines as well as banks’ own recent
initiatives towards risk management (RBI, 2007). This recent emphasis can be
attributed to several reasons. Prior to 1992, Indian banks were subject to a regime of
strict control enforced by the RBI. A process of financial liberalization was initiated in
1992 to make the banking system profitable, efficient, and resilient. The liberalization
measures consisted of deregulation of entry, interest rates, and branch licensing, as
well as encouragement to state owned banks to get listed on stock exchanges. While
banks took some time to adjust to the new operating environment, the year 1998 saw a
second phase of reforms in the banking industry marked by the introduction of several
prudential measures and the first set of comprehensive guidelines for Asset-Liability
management and risk management. Thus, the period after 1998 in Indian banking
offers a suitable set-up for an analysis of risk management and its impact on banks’
stock returns. During this period, the RBI also issued a comprehensive framework for
implementation of integrative risk management systems and lately Indian banks have
been preparing for the implementation of Basel-II norms, which includes a move
towards better risk management practices.
In this paper, we attempt to take an overall view of the risk management
capabilities of banks that encompasses different aspects of risks being managed by a
bank. A commercial bank deals with five important categories of risks, viz credit risk,
interest rate risk, liquidity risk, solvency risk, and operational risk. Risk management
refers to the overall process that a bank follows in identifying the risks to which
it is exposed, quantifying those risks and controlling them. While there may be
several factors representing risk management capabilities, we follow what we believe
is a novel approach by deriving indicators of risk management capability based on Are bank stocks
the basic accounting framework of a bank. While traditional studies of bank sensitive to risk
performance (Berger and Humphrey, 1997; Leightner and Lovell, 1998) have addressed
the performance and efficiency of banks from production and cost function approaches, management?
our emphasis is on the performance of risk management practices followed by banks.
While our approach can be related to some of the existing approaches in the literature
on risk management (Sinkey, 1997; Hannan and Hanweck, 1988), we differ in the way 9
we derive our measures from basic identities of bank’s financial statements and build
a framework for evaluating risk management performance of commercial banks by
using accounting ratios.
We study four indicators of risk management by observing their trends, proposing
summary measures of risk management based on them, and finally examining
implications of risk management for shareholder wealth. Such summary measures also
assumes importance in view of the fact that the existing attempts of developing overall
risk measures in the banking literature have been limited to market-based measures of
risk drawing from stock market perception of the bank’s riskiness (Pagano, 2001).
Empirical studies have either considered market-based measures of risk (Baele et al.,
2004 and Baele et al., 2007) or separate risk factors in isolation. A number of studies
(Saunders et al., 1990; Schrand and Unal, 1998) in the banking literature have focused
on risk taking behavior rather than risk management behavior. Our study, on the other
hand, focuses on risk management behavior of banks. It is to our knowledge the first
attempt at developing a comprehensive measure of risk management drawing on bank
financial accounts data. It would help to point out here that we intend to measure
neither bank risk nor risk of a banking stock but simply risk management capabilities
of banks.
We adopt a two-stage approach. In the first stage, we theoretically motivate a risk
management perspective to bank performance, which we derive from balance sheet
identities. In the second stage, we conduct an empirical analysis to evaluate the
performance of banks in terms of the risk management perspective. At this latter stage,
we conduct three specific empirical studies as follows. First, we employ the
multivariate technique of factor analysis for developing risk management scores.
Secondly, as an alternative, we apply discriminant analysis technique to develop Z
scores of risk management for banks. Finally, we use regression technique to
investigate the stock market response to these risk management scores.
The rest of the paper is organized as follows. In the next section, we discuss the
basic theoretical framework wherein we derive our risk management indicators from a
commercial bank’s accounting identities. Subsequently, we present the empirical
methodology for computing risk management scores and then examine their trends.
The penultimate section studies the impact of risk management scores on bank stocks
by using regression analysis. The final section summarizes and concludes the paper.
Theoretical framework
We start outlying our basic framework with the core objective of any firm, viz
maximization of shareholders’ return or the return on equity (ROE). ROE measures
profitability from the shareholder’s perspective. We adopt the standard Du Pont
identity to decompose a bank’s ROE into operating efficiency (measured by profit
margin), asset-use efficiency (measured by asset turnover), and financial leverage
JRF (measured by equity multiplier). The product of operating efficiency and asset turnover
can be expressed as return on assets (ROA). Therefore:
10,1
Profit after tax Total assets
ROE ¼ £ ð1Þ
Total assets Equity
where the ratio of Profit after tax to total assets is the ROA, and the ratio of total assets
10 to equity is the equity multiplier (i.e. the reciprocal of the capital to assets ratio). Next,
ROA is further decomposed as follows:
II 2 IE NII 2 NIE Provisions
ROA ¼ þ 2 ð2Þ
TA TA TA
where, II – interest income, IE – interest expense, NII – non interest income, NIE –
non interest expense, TA – total assets.
Identity equation (2) can be re-written as follows:
ROA ¼ Net interest margin þ Non interest margin 2 Provisions to total assets ð3Þ
Substituting identity equations (3) in (1), we obtain:
ROE ¼ ðNETIM þ NONIM 2 PROVÞ*ðEMÞ ð4Þ
where, NETIM – net interest margin, NONIM – non interest margin, PROV –
provisions to total assets, and EM – equity multiplier.
Identity equation (4) suggests that a banking firm can achieve its objective of
maximizing shareholder returns by either of the following means: maximizing NETIM,
maximizing NONIM, minimizing PROV, maximizing equity-to-assets ratio. In what
follows, we argue that each of these four factors represents a bank’s capability of
managing various risks.
Interest-rate risk
Interest rate risk refers to the risk of decline in net interest income of a bank due to change
in interest rates. Movement of interest rates would affect a bank’s NETIM and therefore
ROA and finally shareholder returns. NETIM of an asset sensitive bank declines in a
falling interest rate scenario whereas for a liability sensitive bank NETIM falls in a rising
interest rate scenario. To manage interest rate risk Indian banks have installed
asset-liability management systems, adopted duration gap analysis, and introduced risk
control measures based on value at risk techniques. Banks also use derivative contracts
like futures and swaps to mitigate interest rate risk. NETIM would reflect the resilience of
banks to interest rate risk. In this paper, the ratio of net interest income to total assets, i.e.
NETIM is taken an indicator of interest rate risk management capabilities of a bank.
Credit risk
Credit risk indicates the failure of a bank to receive interest and/or the principal
amount from loans and non-treasury securities. Credit risk also arises when a bank
gives commitment or guarantees on behalf of customers. Furthermore, credit risk is
present in all counterparty exposures like interest rate swaps. On-balance sheet
strategies for managing credit risk include increasing provisions for all anticipated
loan losses. Although, higher provisions reduce the profitability of a bank but higher
provisions as percentage of total assets also signal a bank’s efforts towards mitigating Are bank stocks
credit risk. Thus, provisions as percentage of total assets can provide an indication of sensitive to risk
the extent of credit risk management. In this paper, the percentage of provisions to
total assets, i.e. PROV is considered as a surrogate measure of credit risk management management?
capabilities of a bank.
12 RoA X A/E
negative correlation between interest rate and credit risks. Clearly such phenomena
indicate the need for combining the different risk management indicators into a single
comprehensive measure of a bank’s risk management capabilities. This is what we
intend to do before moving on to examining the implications of risk management for
shareholder wealth.
Analysis of results
Risk management indicators: trends
We begin our discussion by analyzing the trends in the risk management variables.
Figure 2 shows that NONIM exhibits a rising trend over the time period under study
except for a fall in the last two years, which may have been caused by trading losses as
this coincided with a regime of sharply rising interest rates. NETIM shows a rising
trend as well. While PROV has been rising through the period in line with the
prudential accounting norms becoming more stringent, CAR shows a rising trend
except for a fall in the last two years. The reason for the recent decline in CAR could be
a rise in risk weighted assets and rapid loan growth in the last few years.
16.0
14.0
12.0
10.0 CRAR
8.0 NETIM
6.0 PROVTA
4.0 NONIM
2.0
0.0
Figure 2.
–2.0 Trend of risk management
1999
2000
2001
2002
2003
2004
2005
2006
variables
JRF this measure shows that risk management capabilities improved during 1999-2004 but
10,1 declined subsequently (Figure 3). This may have occurred due to the recent decline in
NONIM and CAR. This finding suggests that banks’ ability in management of risks
have come down. The plausible explanation is poor natural hedging and increase in
risk-weighted assets, which reduced the capital adequacy ratio.
2000
2001
2002
2003
2004
2005
2006
Factor loadings
PRIN1 PRIN2 PRIN3 PRIN4
0.4 PRIN2
0.2
0.0
16
– 0.2
– 0.4
Figure 4.
Trend of principal – 0.6 1999
2000
2001
2002
2003
2004
2005
2006
components
Discriminant analysis
Since the principal components explain only the maximum variation in the data, we
now resort to discriminant analysis, which will enable us to classify banks into good
risk managers and poor risk managers, resulting in an overall risk management score.
However, we are constrained by the absence of any a priori classifying variable needed
for discriminant analysis. We attempt to resolve this problem in two ways. First, we
take the mid-point of the AVERAGE as the cut-off and classify all banks with higher
AVERAGE value than the mid-point (median value) as good risk managing banks and
those below as poor risk managing banks. Since, we endogenously derive the
benchmarks for classifying banks into risky and safe groups, we noted that our
classifications are strictly dependent on the sample being studied. The justification for
using the mid-point is that any bank with “average” risk indicators above the
mid-point should be at least better than the centrally located bank. Thus, this can be a
simple way to classify banks into risky and safe groups. Using this classification, we
estimate the Fisher’s linear discriminant function whose corresponding values we use
as our risk measurement indicator. We refer to it as the ZSCORE1 (Table II).
Alternatively, we select a capital adequacy ratio of 10 percent as the cut-off and
classify banks with higher CAR as lower risk banks and those below as higher risk
banks. This benchmark is motivated by the RBI’s recent move towards rewarding
banks with higher than 10 percent CAR with the freedom to venture into various risk
taking activities like insurance business. Thus, we follow the regulator’s benchmark of
sound banks as our classification variable. Accordingly, we re-estimate the Fisher’s
linear discriminant function whose value for each bank for each year is used as a risk
management indicator. We refer to the score thus obtained as ZSCORE2.
7
6
5
4
3
2
ZSCORE1
1 ZSCORE2
0 Figure 5.
1999
2000
2001
2002
2003
2004
2005
2006
Trend of Z scores
JRF UE is UE measured by change in profits, RISKMGMT is risk management variable or
10,1 score and 1 is a random error. To proxy for the risk management term, we return to the
four variables identified by us from the accounting framework discussed before. We
have two alternatives at this point. We can either use the four risk management
variables identified by us earlier as the regressors in the stock market regression or use
risk management scores as the regressor. We turn to each case one by one, the results
18 of which are presented in Tables III-VII. In each case, we regress bank stock returns on
systematic risk (RETmarket), UE (UE, represented by change in net profits), and risk
management variables. For systematic risk, we employ the BSE Sensex, which is the
Conclusions
This paper examines risk management capabilities of commercial banks and
investigates its impact on stock market returns. For this purpose, we tried to integrate
several issues from the accounting and financial economics literatures. We computed
risk management scores of Indian commercial banks for the period 1999-2006 by
summarizing information contained in financial statements with the help of factor
analysis technique and discriminant analysis. Our computed scores show that risk
management capabilities of banks have been improving over time with a decline only
in the last few years. Finally, we examined the impact of risk management scores on
stock market returns of banks and found that stock returns respond positively to risk
management capabilities.
This paper attempts to makes several contributions. First, it suggests a different
way of looking at bank financial statements, viz from the risk management
perspective. To this end we demonstrate a decomposition of ROE of commercial banks
into risk management variables. Second, the paper develops quantitative summaries of
risk management capabilities of banks by using several alterative multivariate
techniques. Third, risk management is shown to be an important determinant of stock
returns of banks, over and above standard factors used in the literature such as market
returns and earnings growth. Fourth, the findings of the paper suggest that those
banks that have better risk management capabilities reward shareholders with Are bank stocks
enhanced wealth. Finally, this exercise can be of value to all the different stakeholders sensitive to risk
in the banking system. Bank managers can employ the suggested approach at the
micro level for introspecting on their corporate policies, investors for developing management?
trading strategies and the regulator for developing quantitative indicators of
soundness of the banking system.
The work undertaken in this paper can be extended in several ways. Financial 21
statements can be further researched to come up with other indicators of risk
management. Alternative techniques for developing risk management scores, other
than those employed in this paper, could be explored. The analysis of this paper can be
repeated for other emerging markets and even for developed economies to examine
whether our results carry through to other samples. These remain on our agenda for
future research.
Notes
1. A functional perspective is based on the services provided by the financial system, such as
providing a way to transfer economic resources through time. In contrast, an institutional
perspective is one where the central focus is on the activities of existing institutions such as
banks and insurance companies.
2. In line with Basel norms, it is mandatory for all Indian banks to maintain a minimum capital
adequacy ratio of 9 percent of risk-weighted assets.
3. In the Indian context majority of the banks deliver these off balance sheet products by
maintaining cash margins or keeping government securities as collaterals. Hence, such
income may be considered as risk-free. As a prudent practice the income is recognized only
after netting out any losses thus leading to risk free-income. Banks also earn profits by
trading in government securities. Although, this exposes a bank to price risk but once again
as a prudent practice all losses are netted out before recognition of income.
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Corresponding author
Rudra Sensarma can be contacted at: rsensarma@gmail.com