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Are banks special? The separation of banking from commerce and interest rate risk
J ECO BUSN 1990; 42:171-182
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Are Banks Special? The Separation of Banking from Commerce and Interest Rate Risk Anthony Saunders* and Pierre Yourougou** This paper derives some insights into the monetary policy specialness of banking firms, relative to commercial firms, from an analysis of the sensitivity of their stock returns to monetary policy changes. The results indicate that banks are "special" in the sense that the activity/balance-sheet regulation forces them to bear unnecessary interest rate risk. The evidence supports the view that eliminating the separation of banking from commerce would produce a banking system that is less sensitive to interest rate risk.
I. Introduction In recent years there has been considerable regulatory interest in the question of whether banks are special. Proponents of specialness, such as Corrigan (1982) and Volcker (1983), have paid considerable attention to the importance of banks in the transmission mechanism of monetary policy. 1 That is, banks have been seen as special institutions for transmitting monetary policy changes from the Central bank, via the stock of inside money and associated asset allocation decisions, to the commercial sector of the economy. Since the stock of inside money is an endogenously produced quantity of the banking system, considerably larger than the stock of outside (or high-powered) money directly under Central bank control, it has been argued that bank activities need to be regulated in order to produce a finite and relatively predictable money supply. In particular, it has been argued that an unregulated and competitive banking system would have a tendency to overproduce inside money, with resulting problems for financial and commercial sector stability. This view argues that there is a public policy rationale for the imposition of regulations (and restrictions) on bank activities in the form of reserve requirements, portfolio investment restrictions, activity regulations, and deposit contract constraints, to more easily attain money supply objectives or targets. 2 *Professor of Finance, Stern School of Business, New York University, and Research Advisor, Federal Reserve Bank of Philadelphia. **Assistant Professor of Finance, Laval University, Quebec, Canada. Address reprint requests to Pierre Yourougou, Universit6 Laval, Sainte-Foy (Qu6bec) Canada G1K 7P4. ~There are two other reasons why banks may be viewed as special. First, banks provide transaction accounts, i.e., the media of exchange. Second, banks can be viewed as insiders (or a third party monitor) to the firms. Thus, in providing new loans and renewing loans, they transmit important default risk information to outside debtholders and equityholders. 2 It should be noted here that there is a considerable body of existing literature (see, for example, Patinkin (1961), Fama (1980), and Goodfriend and King (1987)) that disputes the need for micro bank regulation in order to achieve money supply control.
Journal of Economics and Business
© 1990 Temple University
0148-6195/90/$03.50
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A. Saunders and P. Yourougou In the institutional context of the U.S. banking system, this (micro) bank regulation approach to monetary policy has produced a class of organizations that specialize in the holding of nominal financial assets and liabilities and exhibit a maturity structure in which the duration of these assets is longer than their liabilities. Thus, a direct result of what might be called the (bank) regulation approach to monetary policy has been the emergence of a banking system increasingly susceptible to interest rate risk. For example, both Flannery and James (1984a, 1984b) and Aharony, Saunders, and Swary (1986) have found evidence showing a negative relationship between nominal interest rate shocks and bank equity returns, which gets stronger the larger the duration mismatch of a bank's nominal assets and liabilities. Further, Merton (1977), Brickley and James (1986), and Aharony, Saunders, and Swary (1986) have argued that there is a potentially positive relationship between bank equity returns and interest rate volatility resulting from limited liability and the mispriced deposit insurance contract provided by regulators as part of the micro-regulatory umbrella] The outcome of the bank regulation approach to monetary policy has been to restrict the access of nonbank firms, especially commercial firms, to certain markets for nominal assets and liabilities such as deposits. As a result, commercial firms have largely specialized in assets and liabilities denominated in real terms rather than nominal terms, and, in contrast to banking firms, are likely to be better insulated from nominal interest rate shocks, as long as the real rate component of nominal rate fluctuations has been sufficiently small. 4 The objectives of this paper are, first, to examine the magnitude of the differences in the nominal interest rate exposure of banking organizations and commercial firms as a result of the bank regulation approach to monetary policy and the associated separation of banking from commerce. 5 The approach followed uses an augmented, three-factor, market model to investigate these differences. Since the relative degree of exposure is likely to be affected by the type of monetary policy strategy followed by the Central bank, we investigated these differences under two policy regimes. Under the first regime, pre-October 1979, the Fed was targeting interest rates, and the degree of interest rate uncertainty was relatively low. In the second regime, post-October 1979, the Fed was targeting non-borrowed reserves, and the degree of interest rate uncertainty was high. (See Saunders and Urich (1988) for evidence on interest rate volatility over these periods.) The second objective of the paper is to examine what would have been banking organizations' (holding companies') interest rate exposure if they had been freed from microbank regulation and allowed to optimize their portfolio of activities-- encompassing both banking and commercial--under these different monetary policy regimes. 6 We constructed hybrid portfolios of bank and commercial firm stocks in order to derive global minimum variance portfolios of bank and commercial firm stocks, and then to exam3 Buser, Chen, and Kane (1981) and others suggest that this effect mightbe mitigated, since higher volatility implies increased probability of bank insolvencyand early closure by bank regulator. 4 Shocks to nominal in,rest rates could emanate from either unanticipated inflation and/or unanticipated real rate changes. However, since real rates tend to be relatively stable in the sort run (e.g., a month), the inflation componentto nominal rate shocks will tend to dominate over the short term. 5 This separation is perhaps best exemplified by the 1956 Bank HoldingCompanyAct and its 1970 Amendments, which limit bank holding company activities to those closely related to banking. It should be noted that all the following tests use stock return data for bank holding companies only (rather than banks which are subsidiaries of the holding companies). 6 In what follows the term "bank" is used shorthand for banking organizationsor bank holding companies.
Banking vs. Commerce and Interest Rate Risk
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ine the total risk and interest rate risk of such hybrid portfolios compared to portfolios of bank stocks alone. Such an approach provides important insights into the question of whether the bank regulation approach to monetary policy actually results in a less, rather than more, stable banking system in terms of exposure. In section II the data and test methodology are described. In section III results relating to the relative interest rate sensitivity of commercial farm and bank return generating processes are examined. In section IV global minimum variance portfolios for combined bank and commercial firms portfolios are derived and their total return and interest rate risks examined. Finally, section V is a summary and conclusion.
II. Methodology and Data To examine the relative sensitivity of bank and commercial stock returns to unanticipated interest rate shocks and variability, a three-factor return-generating model is specified: 7
kit = ~oi + [3miRmt + [31iOIt + ~uiA~'t + ~it,
(1)
where
kit kmt
rate of return of portfolio i in week t, rate of return on CRSP value-weighted index of all common stocks on NYSE and AMEX in week t, OIt = unexpected change in interest rate levels in week t, A I/t = change in interest rate volatili~ in week t, and ~oi : E(Rit) - - [ ~ m i E ( k m t ) - - [31iE(UIt) -- [JviE( A ["t). : :
The sample period runs from October 21, 1977 to December 24, 1981, and includes both commercial bank and savings bank (S&L) holding companies stock returns, s Because of the low trading activity of some banks and S&Ls, weekly, instead of daily, data are used. For the banks and S&Ls listed on the University of Chicago NYSE/ASE CRSP daily return tape, the series of weekly returns was computed by compounding the daily returns for each calendar week. For the firms not available on this CRSP tape, successive end-of-week daily bid prices and dividend and stock split data were obtained from various issues of the O T C ' s Daily Stock Record published by Standard and Poor. 9 Weekly returns were then computed with adjustments made for dividends and stock splits. In all, the banking group comprised 83 banks and 32 S&Ls (115 stocks).
7 Note that orthogonalizations of the independent variables were not employed because of the low (and statistically insignificant at the 5% level) correlations among these variables over our sample period: (i) 10/21/77-9/28/79 Rm UI
UI -0.19
AV -0.15 -0.08
(ii) 10/12/79-12/24/81 Rm UI
UI -0.17
AV -0.03 -0.18
Further, as Giliberto (1985) discusses, such orthogonalizations make little statistical difference. s These are analyzed both collectively (as the bank portfolio) as well as separately. 9 At the time of undertaking this study, the CRSP NASDAQ file for the data period of interest was not available.
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A. Saunders and P. Yourougou In addition to analyzing the returns o f the banking sector group as a whole, we also subdivided this sector into commercial banking and savings banking groups along traditional institutional lines. For the commercial firm group, a portfolio o f 100 firms was chosen. These firms were selected randomly, subject to the constraints that each industry should be represented by no more than two firms, and that included firms should not be in the utility industry and should have no subsidiaries in the financial services area. Yields on Fed funds and Treasury securities over the whole maturity spectrum were obtained from DRI. While previous authors have tended to choose two or three representative rates from the term structure to make inferences regarding the relative degree o f bank stock return sensitivity to interest rates, such an approach is necessarily incomplete since the exact maturity (duration) o f bank net asset positions is unknown. In this paper we analyzed interest rate shocks and volatility effects in the context of a whole term structure of rates from Fed funds to 30-year T bonds (11 different rate series). In order to estimate weekly observations on unexpected interest rate changes, (UI), an Auto-Regressive Integrated Moving Average, A R I M A ( p , d , q) methodology was used. Specifically, for each week t the preceding 52 weeks' observations, from week t-52 to week t-1, were used to generate an interest rate forecast for the period t, conditional on an analysis o f the estimates' p , d , q parameters over the week t-52 to week t-1 period. The estimation procedure used was the maximum likelihood method subroutine available in I M S L (International Mathematical and Statistical Library). l0 All series o f interest rate forecasts were obtained by rolling over the above procedure. The ARIMA-generated forecasting errors were then used as estimates for unexpected changes in interest rates, except for the 52 weeks immediately following the F e d ' s switch to reserve targeting on October 6, 1979. I I An unexpected change in interest rate levels is defined as U]t =?t
-E(rt),
(2)
where ?t E(rt)
= actual yield on a U.S. Treasury bond o f constant maturity in week t; and = expected yield on the same U.S. Treasury bond in week t.
to On average, the data indicate that there is no moving average parameter, the difference parameter is of order one, and the autoregressive parameter ranges from order of one to three. This implies the following model: A R I M A ( P , 1, 0): O ( B ) A Y t = (1 -- OIB - (a2B2 - dp3B3)AYt - er
where Ay~ = Yt Yr-t B is the backshift operator P=l,2or3 See Box and Jenkins (1976) for a complete description of the Auto-Regressive Integrated Moving Average (ARIMA) model. t t Because of the possibility of a structural shift in parameters following the change in monetary policy targets in October 1979, the unexpected interest rates for the 52 weeks following October 6, 1979 were estimated using parameters derived from best fitting ARIMA models estimated over the same sample period. For all interest rates series considered, the best fits were obtained using either AR(2) or AR(3). Nevertheless, because of high residual variances, no significant differences were found between the estimates from this procedure and the maximum likelihood ARIMA estimation based partly on observations prior to october 6, 1979. This may be an indication that there was a great deal of uncertainty in the financial markets about the determinants of the future course of interest rates during the weeks immediately following October 6, 1979.
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Banking vs. Commerce and Interest Rate Risk Table 1. Effect of Interest Rate Risk on Equity Returns of Commercial Firm Portfolio by Selected Maturities
Total period: 1 0 / 2 1 / 7 7 - 1 2 / 2 4 / 8 1
3-month T Bill 3-year T Note 3 0 - y e a r T Bond
218 observations
Bo
B,,,
~1
~v
R2
D. IV.
0.000 0.000 - 0.000
0.953* 0.947* 0.953*
- 0.001 - 0.003** - 0.003
- 0.006 - 0.044 0.050
0.88 0.89 0.88
1.78 1.74 1.74
Interest Rate Target Regime: 1 0 / 2 1 / 7 7 - 9 / 2 8 / 7 9
3-month T Bill 3-year T Note 30-year T Bond
~o
~
0.001 - 0.000 - 0.000
1.I01" 1.096* 1.100"
102 observations
#, - 0.000 - 0.001 0.001
B~
R~
D.W.
0.051 - 0.062 0.006
0.96 0.96 0.96
1.81 1.88 1.85
Reserve Target Regime: 1 0 / 1 2 / 7 9 - 1 2 / 2 4 / 8 1
~o 3-month T Bill 3-year T Note 30-year T Bond
0.000 0.000 0.000
115 observations
/~m
/~,
~
R2
D.W.
0.846* 0.850* 0.853*
- 0.002 - 0.004** -0.004
- 0.011 - 0.021 0.032
0.83 0.84 0.83
1.76 1.69 1.70
Note: All coefficients are rounded to three decimal places. * The t statistic is significantly different from zero at a = 1% two-tailed test. ** The t statistic is significantly different from zero at a = 5% two-tailed test.
To estimate interest rate volatility, the interest rate series were prewhitened using the ARIMA model. The square root of the mean square errors (MSE) of these white noise series obtained over the preceding 52 weeks was then used as an estimate of rate volatility. 12 The weekly change in volatility is our estimate of A V in equation (1). Finally, the equations were estimated using the seemingly unrelated regression (SUR) methodology of Zellner available in SAS.
III. Empirical Results To conserve space, and because of the general homogeneity of results across interest rate series, not all 11 different interest rate series are shown in the Tables 1-3. Instead, we show representative results for three-month Treasury bill, three-year Treasury note and thirty-year Treasury bond rates. First, let us consider the market model parameter
12 To e x a m i n e the sensitivity o f this a p p r o a c h , a n alternative measure o f rate volatility w a s used b a s e d on extreme ( h i g h - l o w ) values for Fed funds rates, as suggested by Parkinson (1980). T h e results with the two variance m e a s u r e s w e r e essentially the same.
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A. Saunders and P. Yourougou Table 2. Effect of Interest Rate Risk on Equity Returns of Banking Organizations by
Selected Maturities
Total period: 10/21/77-12/24/81
3-month T Bill 3-year T Note 30-year T Bond
0.001 0.001 0.001
218 observations
0.687* 0.700* 0.708*
-0.014" - 0.024* - 0.030*
0,052 - 0,095 0.003
0,63 0.66 0.62
Interest Rate Target Regime: 10/21/77-9/28/79
3-month T Bill 3-year T Note 30-year T Bond
- 0.002*** -0.002*** - 0.002***
0,819" 0.767* 0.786*
102 observations
- 0.012" -0.032* - 0.038*
0.021 -0.363 - 0.087
0.70 0.71 0.69
Reserve Target Regime: 10/12/79-12/24/81 ~o 3-month T Bill 3-year T Note 30-year T Bond
0.000 0.000 0.000
1.67 1.78 t .65
1.77 1.73 1.68 115 observations
~,,
/3t
0.544* 0.598* 0.600*
-0.015" -0.022* -0.030*
~0 0.191'** 0.002 0.131
RZ
D, W.
0.60 0.60 0.57
1.80 1.90 1.76
Note: All coefficients are rounded to three decimal places.
* The t statistic is significantly different from zero at a = 1% two-tailed ~st. *** The t statistic is significantly different from zero at c~ = 10% two-tailed test.
coefficients across different interest rate series and monetary policy regimes for the commercial farm group. For the low interest-rate-uncertainty period, October 21, 1977 to September 28, 1979, when the Fed was pursuing interest targets, no/~I and only one ~v was significant at the 10% level in the eleven interest rate series equations. Moreover, F-tests could not reject, at the 10% level, the null hypothesis that/3i = 0 and/31 = #v = 0 for this group for all rate series. In the period of reserve targeting, October 12, 1979 to December 24, 1981, the results are not much better. First, no/3v coefficient is significant at the 10% level or better. Second, while there is some evidence of a significant Bt coefficient in 4 out of 11 interest rate equations, the absolute sizes of these coefficients were very small and the null hypothesis that/3t =/3v = 0 could not be rejected at the 10% level for this period for all rates series. 13 Table 2 reports selected results for the bank group. The first result of interest is that even in the interest-rate targeting regime, October 21, 1977 to September 28, 1979, the /~1 coefficient is statistically significant at the 10% level or better in all 11 interest rate ]3 The highest F-value for the null hypothesis that fll = f l v = 0 for this subperiod was F = 2.25 (p value of 0.1 l) for 6-month Treasury bills.
Banking vs. Commerce and Interest Rate Risk
177
Table 3. Effect of Interest Rate Risk on Equity Returns of Savings and Loans by Maturities
Reserve Target Regime: 10/12/79-12/24/81
3-month T Bill 3-year T Note 30-year T Bond
115 observations
~o
~m
~l
~v
R2
O.W.
-0.005** -0.005*** 0.005**
0.722* 0.802* 0.816'
-0.021" -0.031' -0.045*
0.444** 0.302 0.546
0.48 0.46 0.46
1.73 1.79 1.74
Note: All coefficientsare roundedto three decimalplaces. * The t statistic is significantlydifferentfromzeroat c~ = 1% two-tailedtest. ** The t statistic is significantlydifferentfromzeroat c~ = 5% two-tailedtest. *** The t statistic is significantlydifferentfromzeroat c~ = 10% two-tailedtest. series equations. Further, the coefficients are correctly signed (negative) and generally have magnitudes at least 10 times greater than the corresponding values for the commercial firm group. Second,/~v was uniformly insignificant throughout the spectrum of rates. Finally, for all interest rate series the null hypothesis that ~t = 0 could be rejected at the 10% level, whereas F tests could not reject the hypothesis that ~v = 0 in this period. Similar results are apparent for the reserve targeting regime, October 12, 1979 to December 24, 1981. Again, all ~t coefficients were negatively signed and statistically significant (now at the 1% level). However, 2 out of the 11 coefficients on A V were also significant (both positive) for 3-month and 6-month Treasury bills. Interestingly, when the savings bank (or S&L) group was separated from the commercial bank group, the S & L ' s return-generating process appeared to reflect even stronger interest rate sensitivity. In particular, during the post-October 1979 reserve targeting regime (see Table 3 for selected maturities), 4 out of the 11 ~ r coefficients were significantly positive at the 10% level or better, with F tests rejecting the null hypothesis that Be = 0 for 4 out of 11 interest rate series and 8 out of 11 at the 20% level. These results are consistent with the view held by Benston (1985), among others, that because thrifts have a greater duration gap than commercial banks, the value of deposit insurance subsidies has been particularly large for S&L stockholders, especially in periods of relatively high rate volatility, such as those that occurred during the post-October 1979 reserve targeting regime. One possible criticism of the test methodology employed above is that it fails to adjust for differences in market risk among the banking and commercial firm groups. For example, in the post-October 1979 period,/3m lies in the 0.846-0.858 range for the commercial firm group. Thus an interesting question arises as to whether the banking group would exhibit even more interest rate sensitivity, relative to the commercial firm group, if both groups had the same systematic or market risk exposures. To examine this question, first, each bank's market beta (/3m) was calculated using a two-factor variant of equation (1). 14 These/3rn'S were then ranked by increasing order t4 In this section we analyze a two-factor variant of equation (1) by setting Br, = 0, since the results in Tables 1 and 2 indicated zero explanatory power for this variable in the commercial firm group regressions and low power in the bank group regressions.
178
A. Saunders and P. Yourougou of size. Second, the whole sample bank group stocks (83 commercial banks and 32 thrifts) was divided into 58 low- and 57 high-/sin stocks, and the market betas for the low and high sub-group portfolios were estimated. We use/3^Lmn to symbolize the market beta estimated from the low beta bank portfolio subgroup, and/3 I-1 m B for the market beta estimated from the high beta bank portfolio subgroup. Third, an optimal weight was chosen such that: ^H ^L / •COMM m = W/$mB + (1 -- W)~mB,
(3)
where fi COMM is the market beta for the commercial firm portfolio. Using the weight w obtained in equation (3), a return series on a portfolio of bank stocks having the same ~m as the commercial firm group can be derived: gp, = wRHt -4- (1 - w ) R L
(4)
where R L = I o w ~sin bank portfolio stock in week t, Rtn--high/sin bank portfolio stock return in week t, and Rpt =return on a portfolio of bank stocks having the same/$m as commercial firms. The return, Rpt, in equation (4) can be viewed as the return from taking a long position in a portfolio of high Bm stocks and a short position in a portfolio of low/sin stocks. We also repeated this procedure for the 83 commercial banks alone (42 sorted into low- and 41 sorted into the high-/sin groups) vis-h-vis the/sin of the commercial firm group. These return series are then used to estimate a/$I coefficient for a bank group with the same/sin as commercial firms. The results of these tests are reported in Table 4.15 As can be seen from Table 4 for the whole sample period, the commercial firm portfolio/sin was 0.948 and its interest rate sensitivity coefficient,/$I, was - 0 . 0 0 3 . For bank portfolios with an equivalent market risk (i.e., /sin = 0.948), we find that/st for the whole bank portfolio is now - 0 . 0 3 3 (compared to - 0 . 0 2 4 in Table 2) and for the commercial bank portfolio alone is - 0 . 0 3 1 . Adjusting for ~/m differences tends to increase even more the relative interest rate sensitivity of bank stock returns. Further, F tests clearly reject the null hypothesis o f / s t equality between commercial firm and banking groups. 16 Similar results are evident in the two monetary-regime subperiods (see Table 4).
IV. R e m o v i n g B a n k - C o m m e r c i a l Firm Separateness The results from section III above are clearly consistent with the hypothesis that, ceteris paribus, banks have faced greater interest rate risk exposure than commercial firms. In recent years many commercial banks as well as commercial firms have been advoJ5Only the three-year T-Note series results are reported, due to space considerations. This was the rate series to which commercial firm returns were most rate sensitive. t6 F = 38.97 for the null hypothesis of Bt equality among all banks and commercial firms, and F = 27.11 among commercial firms and commercial banks alone.
Banking vs. Commerce and Interest Rate Risk
179
Table 4. Bank and Commercial Firm Interest Rate Sensitivity when/3m's Are the Same (3-year Treasury Note Rate) •~p, = ~o,, + ~.,fi,~, + ~,,,OI, + 6, Total period: 10/21/77-12/24/81
218 observations ~o
Commercial Firm portfolio (CF) Commercial Bank portfolio (CB) All Bank and S&L portfolio (B) Ftest
0.000 0.000 -0.001
/3,~
~1
R2
D.W.
0.948* 0.948* 0.948*
-0.003** -0.033* -0.031"
0.89 0.44 0.56
1.74 1.87 1.74
H0: B ca = BzcF,
F = 27.11 [0.00]
B~ = B cr,
F = 39.97 [0.00]
Interest Rate Target Regime: 10/21/77-9/28/79
102 observations
Bo Commercial Firm portfolio (CF) Commercial Bank portfolio (CB) All Bank and S&L portfolio (B) Ftest
/3,~
- 0.000 0.000 0.003
1.098" 1.098" 1.098*
H0: B cB = BcF,
BI -0.001 -0.066* - 0.046*
R2
D.W.
0.96 0.59 0.64
1.84 1.63 1.94
F = 13.87 [0.00]
B~ = Bcr,
F =
9.77 [0.00l
Reserve Target Regime: 10/12/79-12/24/81
Commercial Firm portfolio (CF) Commercial Bank portfolio (C8) All Bank and S&L portfolio (B) F test
115 observations
~o
~m
BI
R2
D. IV.
0.000 0.000 -0.005***
0.850* 0.850* 0.850*
-0.004** - 0.035* -0.035*
0.84 0.29 0.44
1.69 1.99 1.72
/-to: ~ B
= ~F,
/3~ = ~cF,
F = 11.81 [0.00] F = 22.57 [0.00]
[ ] indicates p-value for the F test. * Statistically different from zero at c~ = ! %. ** Statistically different from zero at ct = 5%. *** Statistically different from zero at a = 10%.
cating, to both the Fed and Congress, elimination of regulatory barriers separating the banking and commercial (real) sectors so as to allow these banks to engage more fully in real-sector activities and commercial firms to engage more fully in banking activities. Currently, the major regulatory barrier to this process is the 1956 Bank Holding Company Act and its 1970 Amendment which placed restrictions on commercial firm ownership of such banking organizations as well as on the range of bank holding company non-banking activities. As already discussed in section I, micro bank regulation appears to have been designed (at least in the view of advocates of regulation) to create a more stable banking system through which monetary policy is transmitted. However,
A. Saunders and P. Yourougou
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Table 5. Portfolio Weights (w*) and Comparisons among the Standard Deviations [a] of the
GMVP, Commercial Bank and Commercial Firm Portfolios Standard Deviations [o]
Whole Sample Period Interest Rate Target Regime Reserve Target Regime
Weight of Bank Stock in GMVP, w*
Minimum Variance Portfolios
Banks
Commercial Firms
0.79 t.26 0.58
0.0178 0.0131 0.0186
0.0180 0.0134 0.0197
0.0209 0.0197 0.0207
the evidence from section III suggests that the bank regulatory approach to monetary policy might have a perverse effect on the banking system by inhibiting constituent firms from managing their return and interest rate risk in an optimal fashion; that is, some part of interest rate risk that is potentially diversifiable may be rendered undiversifiable by unnecessary portfolio and activity restrictions. Indeed, over the whole sample period, the correlation coefficient, p, among commercial firm and commercial bank portfolio returns was 0.75; over the interest rate target subperiod, p = 0.82, and over the reserve target subperiod, p = 0.70. This suggests that there may be some potential risk reduction by combining banking and commercial firm activities within one organization. To examine this potential, we first derive the global minimum variance portfolio ( G M V P ) - - s e e Roll (1977)--over all commercial bank and commercial firm stocks in our sample. This can be viewed as a "universal" bank portfolio. 17 Let w* be the weight of bank stock in the GMVP. Then w* -- V - 1L 1/c, where c --- L ' V- ~ , V is the variance-covariance matrix of bank and commercial firm portfolio returns, and L is a vector of ones. The value of w* was calculated for the whole sample period and for each of the monetary regime subperiods, and the results are reported in Table 5 along with the standard deviation of returns from the G M V P and the commercial bank and commercial firm portfolios. For the whole sample period the optimal G M V P or universal bank portfolio would have had 79% of the commercial bank portfolio and 21% of the commercial firm portfolio. Interestingly, for the low interest rate risk subperiod (pre-October 1979) it would have been suboptimal for banks to expand into any commercial firm activities. That is, given w* = 1.26 and no short sales, then the (total return) risk-minimizing universal bank is the commercial bank (w = 1). In direct contrast, for the subperiod under reserve targets (the post-October 1979 period) the G M V P suggests that the optimal riskminimizing portfolio composition would have been 58% commercial banking and 42% commercial firm activities, and that this universal banking portfolio would have reduced total return risk ~r, relative to commercial banking risk, by 5.9% over this period; see Table 5. Next, using these G M V P portfolios to generate returns series, we estimated the ~z's for the whole period (w* = .79) and for the reserve-targeting subperiod (w* = .58). 18 17We do not include savings banks here. Subsequent to the 1968 Savings and Loan Holding Company Act commercial firms can acquire one--but not more than one--S&L as part of a holding company. Thus holding company restrictions are slightly more liberal for S&L acquisitions than bank acquisitions. ~8The/~1 's for the first subperiod are not shown since the results shown in Table 4 imply that the optimal w:l.
Banking vs. Commerce and Interest Rate Risk
181
Table 6. Interest Rate Sensitivity for GMVP vs. Commercial Bank Portfolio
Total Sample Period Interest Rate Target Regime" Reserve Target Regime
GMVP
Commercial Banks
-0.016
-0.019
- 0.012
-0.018
' No cell entry since in this period w = 1 for the G M V P , and the two groups are identical in Bi risk.
For the whole sample period the/~z for the GMVP universal bank portfolio was -0.016, compared to - 0 . 0 1 9 for commercial banks alone, and for the reserve targeting subperiod -0.012 compared to -0.018; see Table 6. In both cases F tests reject equality of the/~I's at the 1% level. These results are consistent with the view that eliminating the regulations separating banking from commerce has the potential for reducing the banking system's total (return) risk as well as its interest rate risk.
V. Summary and Conclusions This paper has sought to derive some insights into the monetary policy specialness of banking firms relative to commercial firms through an analysis of the sensitivity of their stock returns to monetary policy regime changes. A major conclusion is that banks are special in the sense that micro bank regulation forces banks to bear more interest rate risk than either commercial firms or the hybrid universal type of bank. These results are consistent with the view that the micro bank regulation approach to monetary policy, advocated by Corrigan (1982) and Volcker (1983) among others, has created a banking system that is less stable and exposed to a higher degree of systematic interest rate risk than would exist in a less restricted banking system. Consonant with a strong body of monetary theory that argues that activity/balance-sheet regulations are not needed to exercise control over the money supply (see Patinkin (1961), Fama (1980), and Goodfriend and King (1987)), the results from our paper indicate that such regulations may have produced a more risky banking system, making the efficient transmission of monetary policy more difficult than without such regulations. Indeed, we show that a hybrid commercial bank-commercial firm portfolio (the "universal" bank portfolio) serves to reduce significantly both the total and interest rate risk exposures of the banking system. These results support the case for eliminating the separation of banking from commerce, to enable banks to perform more efficiently their special function in the transmission of monetary policy from the Fed to the rest of the economy.
We would like to thank G. Benston, S. Brown, M. Flannery, G. Udell, and an anonymousreferee for their comments on earlier versions of this paper. Saunders would like to thank a Bank and Financial Analyst Fellowship and a Senior YamalchiResearch Fellowshipfor financial support.
References Aharony, J., Saunders, A., and Swary, I. May 1986. The effects of shift in monetary policy regime on the profitability and risk of commercial banks. Journal of Monetary Economics 17(1) :363-377.
182
A. Saunders and P. Yourougou Benston, G. J. 1985. An analysis of the causes of savings and loan association failures. NYU Monograph Series in Finance and Economics 4/5. Box, G. and Jenkins, G. 1976. Time series analysis: Forecasting and control: San Francisco: Holden-Day. Brickley, J., and James, C. July 1986. Access to deposit insurance, insolvency rules and the stock -eturns of financial institutions. Journal of Financial Economics 16(3):345-372. Buser, A., Chen, A., and Kane, E. March 1981. Fexteral deposit insurance, regulatory policy and optimal bank capital. Journal of Finance 36(1):51-60. Corrigan, G. 1982. Are banks special? Annual Report. Minneapolis: Federal Reserve Bank. Fama, E. January 1980. Banking in the theory of finance. Journal of Monetary Economics 6( 1):39-57. Flannery, M., and James, C. November 1984a. Market evidence on the effective maturity of bank assets and liabilities: Journal of Money, Credit and Banking 16(4):435-445. Flannery, M., and James, C. September 1984b. The effect of interest rate changes on the stock returns of financial institutions. Journal of Finance 39(4): 1141-1153. Galai, D., and Masulis, M. January-March 1976. The option pricing model and the risk factor of stock. Journal of Financial Economics 3( 1-2):53-83. Giliberto, M. March 1985. Interest rate sensitivity in the common stocks of financial intermediaries: A methodological note. Journal of Financial and Quantitative Analysis 20(1):123-126. Goodfriend, M., and King, R. May 1987. Financial deregulation, monetary policy and central banking. Paper prepared for the AEI project on Financial Service Regulation. Merton, R. June 1977. An analytical derivation on the cost of deposit insurance and loan guarantees: An application of modern option pricing theory, Journal of Banking and Finance (1):3-11. Parkinson, M. January 1980. The extreme value method of estimating the variance of the rate of return. Journal of Business 53( 1):61-66. Patinkin, D. March 1961. Financial intermediaries and the logical structure of monetary theory. American Economic Review 51(1):95-116. Roll, R. March 1977. A critique of the asset pricing theory's tests, part 1: On past and potential testability of the theory. Journal of Financial Economics 4(2): 129-176. Saunders, A., and Urich, T. December 1988. The effects of shifts in monetary policy and reserve management behavior in the federal funds market. Journal of Banking and Finance 12(4):523-535. Volcker, P. A. September 13, 1983. Statement before the Committee on Banking Housing and Urban Affairs, United States Senate.
171
Are Banks Special? The Separation of Banking from Commerce and Interest Rate Risk Anthony Saunders* and Pierre Yourougou** This paper derives some insights into the monetary policy specialness of banking firms, relative to commercial firms, from an analysis of the sensitivity of their stock returns to monetary policy changes. The results indicate that banks are "special" in the sense that the activity/balance-sheet regulation forces them to bear unnecessary interest rate risk. The evidence supports the view that eliminating the separation of banking from commerce would produce a banking system that is less sensitive to interest rate risk.
I. Introduction In recent years there has been considerable regulatory interest in the question of whether banks are special. Proponents of specialness, such as Corrigan (1982) and Volcker (1983), have paid considerable attention to the importance of banks in the transmission mechanism of monetary policy. 1 That is, banks have been seen as special institutions for transmitting monetary policy changes from the Central bank, via the stock of inside money and associated asset allocation decisions, to the commercial sector of the economy. Since the stock of inside money is an endogenously produced quantity of the banking system, considerably larger than the stock of outside (or high-powered) money directly under Central bank control, it has been argued that bank activities need to be regulated in order to produce a finite and relatively predictable money supply. In particular, it has been argued that an unregulated and competitive banking system would have a tendency to overproduce inside money, with resulting problems for financial and commercial sector stability. This view argues that there is a public policy rationale for the imposition of regulations (and restrictions) on bank activities in the form of reserve requirements, portfolio investment restrictions, activity regulations, and deposit contract constraints, to more easily attain money supply objectives or targets. 2 *Professor of Finance, Stern School of Business, New York University, and Research Advisor, Federal Reserve Bank of Philadelphia. **Assistant Professor of Finance, Laval University, Quebec, Canada. Address reprint requests to Pierre Yourougou, Universit6 Laval, Sainte-Foy (Qu6bec) Canada G1K 7P4. ~There are two other reasons why banks may be viewed as special. First, banks provide transaction accounts, i.e., the media of exchange. Second, banks can be viewed as insiders (or a third party monitor) to the firms. Thus, in providing new loans and renewing loans, they transmit important default risk information to outside debtholders and equityholders. 2 It should be noted here that there is a considerable body of existing literature (see, for example, Patinkin (1961), Fama (1980), and Goodfriend and King (1987)) that disputes the need for micro bank regulation in order to achieve money supply control.
Journal of Economics and Business
© 1990 Temple University
0148-6195/90/$03.50
172
A. Saunders and P. Yourougou In the institutional context of the U.S. banking system, this (micro) bank regulation approach to monetary policy has produced a class of organizations that specialize in the holding of nominal financial assets and liabilities and exhibit a maturity structure in which the duration of these assets is longer than their liabilities. Thus, a direct result of what might be called the (bank) regulation approach to monetary policy has been the emergence of a banking system increasingly susceptible to interest rate risk. For example, both Flannery and James (1984a, 1984b) and Aharony, Saunders, and Swary (1986) have found evidence showing a negative relationship between nominal interest rate shocks and bank equity returns, which gets stronger the larger the duration mismatch of a bank's nominal assets and liabilities. Further, Merton (1977), Brickley and James (1986), and Aharony, Saunders, and Swary (1986) have argued that there is a potentially positive relationship between bank equity returns and interest rate volatility resulting from limited liability and the mispriced deposit insurance contract provided by regulators as part of the micro-regulatory umbrella] The outcome of the bank regulation approach to monetary policy has been to restrict the access of nonbank firms, especially commercial firms, to certain markets for nominal assets and liabilities such as deposits. As a result, commercial firms have largely specialized in assets and liabilities denominated in real terms rather than nominal terms, and, in contrast to banking firms, are likely to be better insulated from nominal interest rate shocks, as long as the real rate component of nominal rate fluctuations has been sufficiently small. 4 The objectives of this paper are, first, to examine the magnitude of the differences in the nominal interest rate exposure of banking organizations and commercial firms as a result of the bank regulation approach to monetary policy and the associated separation of banking from commerce. 5 The approach followed uses an augmented, three-factor, market model to investigate these differences. Since the relative degree of exposure is likely to be affected by the type of monetary policy strategy followed by the Central bank, we investigated these differences under two policy regimes. Under the first regime, pre-October 1979, the Fed was targeting interest rates, and the degree of interest rate uncertainty was relatively low. In the second regime, post-October 1979, the Fed was targeting non-borrowed reserves, and the degree of interest rate uncertainty was high. (See Saunders and Urich (1988) for evidence on interest rate volatility over these periods.) The second objective of the paper is to examine what would have been banking organizations' (holding companies') interest rate exposure if they had been freed from microbank regulation and allowed to optimize their portfolio of activities-- encompassing both banking and commercial--under these different monetary policy regimes. 6 We constructed hybrid portfolios of bank and commercial firm stocks in order to derive global minimum variance portfolios of bank and commercial firm stocks, and then to exam3 Buser, Chen, and Kane (1981) and others suggest that this effect mightbe mitigated, since higher volatility implies increased probability of bank insolvencyand early closure by bank regulator. 4 Shocks to nominal in,rest rates could emanate from either unanticipated inflation and/or unanticipated real rate changes. However, since real rates tend to be relatively stable in the sort run (e.g., a month), the inflation componentto nominal rate shocks will tend to dominate over the short term. 5 This separation is perhaps best exemplified by the 1956 Bank HoldingCompanyAct and its 1970 Amendments, which limit bank holding company activities to those closely related to banking. It should be noted that all the following tests use stock return data for bank holding companies only (rather than banks which are subsidiaries of the holding companies). 6 In what follows the term "bank" is used shorthand for banking organizationsor bank holding companies.
Banking vs. Commerce and Interest Rate Risk
173
ine the total risk and interest rate risk of such hybrid portfolios compared to portfolios of bank stocks alone. Such an approach provides important insights into the question of whether the bank regulation approach to monetary policy actually results in a less, rather than more, stable banking system in terms of exposure. In section II the data and test methodology are described. In section III results relating to the relative interest rate sensitivity of commercial farm and bank return generating processes are examined. In section IV global minimum variance portfolios for combined bank and commercial firms portfolios are derived and their total return and interest rate risks examined. Finally, section V is a summary and conclusion.
II. Methodology and Data To examine the relative sensitivity of bank and commercial stock returns to unanticipated interest rate shocks and variability, a three-factor return-generating model is specified: 7
kit = ~oi + [3miRmt + [31iOIt + ~uiA~'t + ~it,
(1)
where
kit kmt
rate of return of portfolio i in week t, rate of return on CRSP value-weighted index of all common stocks on NYSE and AMEX in week t, OIt = unexpected change in interest rate levels in week t, A I/t = change in interest rate volatili~ in week t, and ~oi : E(Rit) - - [ ~ m i E ( k m t ) - - [31iE(UIt) -- [JviE( A ["t). : :
The sample period runs from October 21, 1977 to December 24, 1981, and includes both commercial bank and savings bank (S&L) holding companies stock returns, s Because of the low trading activity of some banks and S&Ls, weekly, instead of daily, data are used. For the banks and S&Ls listed on the University of Chicago NYSE/ASE CRSP daily return tape, the series of weekly returns was computed by compounding the daily returns for each calendar week. For the firms not available on this CRSP tape, successive end-of-week daily bid prices and dividend and stock split data were obtained from various issues of the O T C ' s Daily Stock Record published by Standard and Poor. 9 Weekly returns were then computed with adjustments made for dividends and stock splits. In all, the banking group comprised 83 banks and 32 S&Ls (115 stocks).
7 Note that orthogonalizations of the independent variables were not employed because of the low (and statistically insignificant at the 5% level) correlations among these variables over our sample period: (i) 10/21/77-9/28/79 Rm UI
UI -0.19
AV -0.15 -0.08
(ii) 10/12/79-12/24/81 Rm UI
UI -0.17
AV -0.03 -0.18
Further, as Giliberto (1985) discusses, such orthogonalizations make little statistical difference. s These are analyzed both collectively (as the bank portfolio) as well as separately. 9 At the time of undertaking this study, the CRSP NASDAQ file for the data period of interest was not available.
174
A. Saunders and P. Yourougou In addition to analyzing the returns o f the banking sector group as a whole, we also subdivided this sector into commercial banking and savings banking groups along traditional institutional lines. For the commercial firm group, a portfolio o f 100 firms was chosen. These firms were selected randomly, subject to the constraints that each industry should be represented by no more than two firms, and that included firms should not be in the utility industry and should have no subsidiaries in the financial services area. Yields on Fed funds and Treasury securities over the whole maturity spectrum were obtained from DRI. While previous authors have tended to choose two or three representative rates from the term structure to make inferences regarding the relative degree o f bank stock return sensitivity to interest rates, such an approach is necessarily incomplete since the exact maturity (duration) o f bank net asset positions is unknown. In this paper we analyzed interest rate shocks and volatility effects in the context of a whole term structure of rates from Fed funds to 30-year T bonds (11 different rate series). In order to estimate weekly observations on unexpected interest rate changes, (UI), an Auto-Regressive Integrated Moving Average, A R I M A ( p , d , q) methodology was used. Specifically, for each week t the preceding 52 weeks' observations, from week t-52 to week t-1, were used to generate an interest rate forecast for the period t, conditional on an analysis o f the estimates' p , d , q parameters over the week t-52 to week t-1 period. The estimation procedure used was the maximum likelihood method subroutine available in I M S L (International Mathematical and Statistical Library). l0 All series o f interest rate forecasts were obtained by rolling over the above procedure. The ARIMA-generated forecasting errors were then used as estimates for unexpected changes in interest rates, except for the 52 weeks immediately following the F e d ' s switch to reserve targeting on October 6, 1979. I I An unexpected change in interest rate levels is defined as U]t =?t
-E(rt),
(2)
where ?t E(rt)
= actual yield on a U.S. Treasury bond o f constant maturity in week t; and = expected yield on the same U.S. Treasury bond in week t.
to On average, the data indicate that there is no moving average parameter, the difference parameter is of order one, and the autoregressive parameter ranges from order of one to three. This implies the following model: A R I M A ( P , 1, 0): O ( B ) A Y t = (1 -- OIB - (a2B2 - dp3B3)AYt - er
where Ay~ = Yt Yr-t B is the backshift operator P=l,2or3 See Box and Jenkins (1976) for a complete description of the Auto-Regressive Integrated Moving Average (ARIMA) model. t t Because of the possibility of a structural shift in parameters following the change in monetary policy targets in October 1979, the unexpected interest rates for the 52 weeks following October 6, 1979 were estimated using parameters derived from best fitting ARIMA models estimated over the same sample period. For all interest rates series considered, the best fits were obtained using either AR(2) or AR(3). Nevertheless, because of high residual variances, no significant differences were found between the estimates from this procedure and the maximum likelihood ARIMA estimation based partly on observations prior to october 6, 1979. This may be an indication that there was a great deal of uncertainty in the financial markets about the determinants of the future course of interest rates during the weeks immediately following October 6, 1979.
175
Banking vs. Commerce and Interest Rate Risk Table 1. Effect of Interest Rate Risk on Equity Returns of Commercial Firm Portfolio by Selected Maturities
Total period: 1 0 / 2 1 / 7 7 - 1 2 / 2 4 / 8 1
3-month T Bill 3-year T Note 3 0 - y e a r T Bond
218 observations
Bo
B,,,
~1
~v
R2
D. IV.
0.000 0.000 - 0.000
0.953* 0.947* 0.953*
- 0.001 - 0.003** - 0.003
- 0.006 - 0.044 0.050
0.88 0.89 0.88
1.78 1.74 1.74
Interest Rate Target Regime: 1 0 / 2 1 / 7 7 - 9 / 2 8 / 7 9
3-month T Bill 3-year T Note 30-year T Bond
~o
~
0.001 - 0.000 - 0.000
1.I01" 1.096* 1.100"
102 observations
#, - 0.000 - 0.001 0.001
B~
R~
D.W.
0.051 - 0.062 0.006
0.96 0.96 0.96
1.81 1.88 1.85
Reserve Target Regime: 1 0 / 1 2 / 7 9 - 1 2 / 2 4 / 8 1
~o 3-month T Bill 3-year T Note 30-year T Bond
0.000 0.000 0.000
115 observations
/~m
/~,
~
R2
D.W.
0.846* 0.850* 0.853*
- 0.002 - 0.004** -0.004
- 0.011 - 0.021 0.032
0.83 0.84 0.83
1.76 1.69 1.70
Note: All coefficients are rounded to three decimal places. * The t statistic is significantly different from zero at a = 1% two-tailed test. ** The t statistic is significantly different from zero at a = 5% two-tailed test.
To estimate interest rate volatility, the interest rate series were prewhitened using the ARIMA model. The square root of the mean square errors (MSE) of these white noise series obtained over the preceding 52 weeks was then used as an estimate of rate volatility. 12 The weekly change in volatility is our estimate of A V in equation (1). Finally, the equations were estimated using the seemingly unrelated regression (SUR) methodology of Zellner available in SAS.
III. Empirical Results To conserve space, and because of the general homogeneity of results across interest rate series, not all 11 different interest rate series are shown in the Tables 1-3. Instead, we show representative results for three-month Treasury bill, three-year Treasury note and thirty-year Treasury bond rates. First, let us consider the market model parameter
12 To e x a m i n e the sensitivity o f this a p p r o a c h , a n alternative measure o f rate volatility w a s used b a s e d on extreme ( h i g h - l o w ) values for Fed funds rates, as suggested by Parkinson (1980). T h e results with the two variance m e a s u r e s w e r e essentially the same.
176
A. Saunders and P. Yourougou Table 2. Effect of Interest Rate Risk on Equity Returns of Banking Organizations by
Selected Maturities
Total period: 10/21/77-12/24/81
3-month T Bill 3-year T Note 30-year T Bond
0.001 0.001 0.001
218 observations
0.687* 0.700* 0.708*
-0.014" - 0.024* - 0.030*
0,052 - 0,095 0.003
0,63 0.66 0.62
Interest Rate Target Regime: 10/21/77-9/28/79
3-month T Bill 3-year T Note 30-year T Bond
- 0.002*** -0.002*** - 0.002***
0,819" 0.767* 0.786*
102 observations
- 0.012" -0.032* - 0.038*
0.021 -0.363 - 0.087
0.70 0.71 0.69
Reserve Target Regime: 10/12/79-12/24/81 ~o 3-month T Bill 3-year T Note 30-year T Bond
0.000 0.000 0.000
1.67 1.78 t .65
1.77 1.73 1.68 115 observations
~,,
/3t
0.544* 0.598* 0.600*
-0.015" -0.022* -0.030*
~0 0.191'** 0.002 0.131
RZ
D, W.
0.60 0.60 0.57
1.80 1.90 1.76
Note: All coefficients are rounded to three decimal places.
* The t statistic is significantly different from zero at a = 1% two-tailed ~st. *** The t statistic is significantly different from zero at c~ = 10% two-tailed test.
coefficients across different interest rate series and monetary policy regimes for the commercial farm group. For the low interest-rate-uncertainty period, October 21, 1977 to September 28, 1979, when the Fed was pursuing interest targets, no/~I and only one ~v was significant at the 10% level in the eleven interest rate series equations. Moreover, F-tests could not reject, at the 10% level, the null hypothesis that/3i = 0 and/31 = #v = 0 for this group for all rate series. In the period of reserve targeting, October 12, 1979 to December 24, 1981, the results are not much better. First, no/3v coefficient is significant at the 10% level or better. Second, while there is some evidence of a significant Bt coefficient in 4 out of 11 interest rate equations, the absolute sizes of these coefficients were very small and the null hypothesis that/3t =/3v = 0 could not be rejected at the 10% level for this period for all rates series. 13 Table 2 reports selected results for the bank group. The first result of interest is that even in the interest-rate targeting regime, October 21, 1977 to September 28, 1979, the /~1 coefficient is statistically significant at the 10% level or better in all 11 interest rate ]3 The highest F-value for the null hypothesis that fll = f l v = 0 for this subperiod was F = 2.25 (p value of 0.1 l) for 6-month Treasury bills.
Banking vs. Commerce and Interest Rate Risk
177
Table 3. Effect of Interest Rate Risk on Equity Returns of Savings and Loans by Maturities
Reserve Target Regime: 10/12/79-12/24/81
3-month T Bill 3-year T Note 30-year T Bond
115 observations
~o
~m
~l
~v
R2
O.W.
-0.005** -0.005*** 0.005**
0.722* 0.802* 0.816'
-0.021" -0.031' -0.045*
0.444** 0.302 0.546
0.48 0.46 0.46
1.73 1.79 1.74
Note: All coefficientsare roundedto three decimalplaces. * The t statistic is significantlydifferentfromzeroat c~ = 1% two-tailedtest. ** The t statistic is significantlydifferentfromzeroat c~ = 5% two-tailedtest. *** The t statistic is significantlydifferentfromzeroat c~ = 10% two-tailedtest. series equations. Further, the coefficients are correctly signed (negative) and generally have magnitudes at least 10 times greater than the corresponding values for the commercial firm group. Second,/~v was uniformly insignificant throughout the spectrum of rates. Finally, for all interest rate series the null hypothesis that ~t = 0 could be rejected at the 10% level, whereas F tests could not reject the hypothesis that ~v = 0 in this period. Similar results are apparent for the reserve targeting regime, October 12, 1979 to December 24, 1981. Again, all ~t coefficients were negatively signed and statistically significant (now at the 1% level). However, 2 out of the 11 coefficients on A V were also significant (both positive) for 3-month and 6-month Treasury bills. Interestingly, when the savings bank (or S&L) group was separated from the commercial bank group, the S & L ' s return-generating process appeared to reflect even stronger interest rate sensitivity. In particular, during the post-October 1979 reserve targeting regime (see Table 3 for selected maturities), 4 out of the 11 ~ r coefficients were significantly positive at the 10% level or better, with F tests rejecting the null hypothesis that Be = 0 for 4 out of 11 interest rate series and 8 out of 11 at the 20% level. These results are consistent with the view held by Benston (1985), among others, that because thrifts have a greater duration gap than commercial banks, the value of deposit insurance subsidies has been particularly large for S&L stockholders, especially in periods of relatively high rate volatility, such as those that occurred during the post-October 1979 reserve targeting regime. One possible criticism of the test methodology employed above is that it fails to adjust for differences in market risk among the banking and commercial firm groups. For example, in the post-October 1979 period,/3m lies in the 0.846-0.858 range for the commercial firm group. Thus an interesting question arises as to whether the banking group would exhibit even more interest rate sensitivity, relative to the commercial firm group, if both groups had the same systematic or market risk exposures. To examine this question, first, each bank's market beta (/3m) was calculated using a two-factor variant of equation (1). 14 These/3rn'S were then ranked by increasing order t4 In this section we analyze a two-factor variant of equation (1) by setting Br, = 0, since the results in Tables 1 and 2 indicated zero explanatory power for this variable in the commercial firm group regressions and low power in the bank group regressions.
178
A. Saunders and P. Yourougou of size. Second, the whole sample bank group stocks (83 commercial banks and 32 thrifts) was divided into 58 low- and 57 high-/sin stocks, and the market betas for the low and high sub-group portfolios were estimated. We use/3^Lmn to symbolize the market beta estimated from the low beta bank portfolio subgroup, and/3 I-1 m B for the market beta estimated from the high beta bank portfolio subgroup. Third, an optimal weight was chosen such that: ^H ^L / •COMM m = W/$mB + (1 -- W)~mB,
(3)
where fi COMM is the market beta for the commercial firm portfolio. Using the weight w obtained in equation (3), a return series on a portfolio of bank stocks having the same ~m as the commercial firm group can be derived: gp, = wRHt -4- (1 - w ) R L
(4)
where R L = I o w ~sin bank portfolio stock in week t, Rtn--high/sin bank portfolio stock return in week t, and Rpt =return on a portfolio of bank stocks having the same/$m as commercial firms. The return, Rpt, in equation (4) can be viewed as the return from taking a long position in a portfolio of high Bm stocks and a short position in a portfolio of low/sin stocks. We also repeated this procedure for the 83 commercial banks alone (42 sorted into low- and 41 sorted into the high-/sin groups) vis-h-vis the/sin of the commercial firm group. These return series are then used to estimate a/$I coefficient for a bank group with the same/sin as commercial firms. The results of these tests are reported in Table 4.15 As can be seen from Table 4 for the whole sample period, the commercial firm portfolio/sin was 0.948 and its interest rate sensitivity coefficient,/$I, was - 0 . 0 0 3 . For bank portfolios with an equivalent market risk (i.e., /sin = 0.948), we find that/st for the whole bank portfolio is now - 0 . 0 3 3 (compared to - 0 . 0 2 4 in Table 2) and for the commercial bank portfolio alone is - 0 . 0 3 1 . Adjusting for ~/m differences tends to increase even more the relative interest rate sensitivity of bank stock returns. Further, F tests clearly reject the null hypothesis o f / s t equality between commercial firm and banking groups. 16 Similar results are evident in the two monetary-regime subperiods (see Table 4).
IV. R e m o v i n g B a n k - C o m m e r c i a l Firm Separateness The results from section III above are clearly consistent with the hypothesis that, ceteris paribus, banks have faced greater interest rate risk exposure than commercial firms. In recent years many commercial banks as well as commercial firms have been advoJ5Only the three-year T-Note series results are reported, due to space considerations. This was the rate series to which commercial firm returns were most rate sensitive. t6 F = 38.97 for the null hypothesis of Bt equality among all banks and commercial firms, and F = 27.11 among commercial firms and commercial banks alone.
Banking vs. Commerce and Interest Rate Risk
179
Table 4. Bank and Commercial Firm Interest Rate Sensitivity when/3m's Are the Same (3-year Treasury Note Rate) •~p, = ~o,, + ~.,fi,~, + ~,,,OI, + 6, Total period: 10/21/77-12/24/81
218 observations ~o
Commercial Firm portfolio (CF) Commercial Bank portfolio (CB) All Bank and S&L portfolio (B) Ftest
0.000 0.000 -0.001
/3,~
~1
R2
D.W.
0.948* 0.948* 0.948*
-0.003** -0.033* -0.031"
0.89 0.44 0.56
1.74 1.87 1.74
H0: B ca = BzcF,
F = 27.11 [0.00]
B~ = B cr,
F = 39.97 [0.00]
Interest Rate Target Regime: 10/21/77-9/28/79
102 observations
Bo Commercial Firm portfolio (CF) Commercial Bank portfolio (CB) All Bank and S&L portfolio (B) Ftest
/3,~
- 0.000 0.000 0.003
1.098" 1.098" 1.098*
H0: B cB = BcF,
BI -0.001 -0.066* - 0.046*
R2
D.W.
0.96 0.59 0.64
1.84 1.63 1.94
F = 13.87 [0.00]
B~ = Bcr,
F =
9.77 [0.00l
Reserve Target Regime: 10/12/79-12/24/81
Commercial Firm portfolio (CF) Commercial Bank portfolio (C8) All Bank and S&L portfolio (B) F test
115 observations
~o
~m
BI
R2
D. IV.
0.000 0.000 -0.005***
0.850* 0.850* 0.850*
-0.004** - 0.035* -0.035*
0.84 0.29 0.44
1.69 1.99 1.72
/-to: ~ B
= ~F,
/3~ = ~cF,
F = 11.81 [0.00] F = 22.57 [0.00]
[ ] indicates p-value for the F test. * Statistically different from zero at c~ = ! %. ** Statistically different from zero at ct = 5%. *** Statistically different from zero at a = 10%.
cating, to both the Fed and Congress, elimination of regulatory barriers separating the banking and commercial (real) sectors so as to allow these banks to engage more fully in real-sector activities and commercial firms to engage more fully in banking activities. Currently, the major regulatory barrier to this process is the 1956 Bank Holding Company Act and its 1970 Amendment which placed restrictions on commercial firm ownership of such banking organizations as well as on the range of bank holding company non-banking activities. As already discussed in section I, micro bank regulation appears to have been designed (at least in the view of advocates of regulation) to create a more stable banking system through which monetary policy is transmitted. However,
A. Saunders and P. Yourougou
180
Table 5. Portfolio Weights (w*) and Comparisons among the Standard Deviations [a] of the
GMVP, Commercial Bank and Commercial Firm Portfolios Standard Deviations [o]
Whole Sample Period Interest Rate Target Regime Reserve Target Regime
Weight of Bank Stock in GMVP, w*
Minimum Variance Portfolios
Banks
Commercial Firms
0.79 t.26 0.58
0.0178 0.0131 0.0186
0.0180 0.0134 0.0197
0.0209 0.0197 0.0207
the evidence from section III suggests that the bank regulatory approach to monetary policy might have a perverse effect on the banking system by inhibiting constituent firms from managing their return and interest rate risk in an optimal fashion; that is, some part of interest rate risk that is potentially diversifiable may be rendered undiversifiable by unnecessary portfolio and activity restrictions. Indeed, over the whole sample period, the correlation coefficient, p, among commercial firm and commercial bank portfolio returns was 0.75; over the interest rate target subperiod, p = 0.82, and over the reserve target subperiod, p = 0.70. This suggests that there may be some potential risk reduction by combining banking and commercial firm activities within one organization. To examine this potential, we first derive the global minimum variance portfolio ( G M V P ) - - s e e Roll (1977)--over all commercial bank and commercial firm stocks in our sample. This can be viewed as a "universal" bank portfolio. 17 Let w* be the weight of bank stock in the GMVP. Then w* -- V - 1L 1/c, where c --- L ' V- ~ , V is the variance-covariance matrix of bank and commercial firm portfolio returns, and L is a vector of ones. The value of w* was calculated for the whole sample period and for each of the monetary regime subperiods, and the results are reported in Table 5 along with the standard deviation of returns from the G M V P and the commercial bank and commercial firm portfolios. For the whole sample period the optimal G M V P or universal bank portfolio would have had 79% of the commercial bank portfolio and 21% of the commercial firm portfolio. Interestingly, for the low interest rate risk subperiod (pre-October 1979) it would have been suboptimal for banks to expand into any commercial firm activities. That is, given w* = 1.26 and no short sales, then the (total return) risk-minimizing universal bank is the commercial bank (w = 1). In direct contrast, for the subperiod under reserve targets (the post-October 1979 period) the G M V P suggests that the optimal riskminimizing portfolio composition would have been 58% commercial banking and 42% commercial firm activities, and that this universal banking portfolio would have reduced total return risk ~r, relative to commercial banking risk, by 5.9% over this period; see Table 5. Next, using these G M V P portfolios to generate returns series, we estimated the ~z's for the whole period (w* = .79) and for the reserve-targeting subperiod (w* = .58). 18 17We do not include savings banks here. Subsequent to the 1968 Savings and Loan Holding Company Act commercial firms can acquire one--but not more than one--S&L as part of a holding company. Thus holding company restrictions are slightly more liberal for S&L acquisitions than bank acquisitions. ~8The/~1 's for the first subperiod are not shown since the results shown in Table 4 imply that the optimal w:l.
Banking vs. Commerce and Interest Rate Risk
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Table 6. Interest Rate Sensitivity for GMVP vs. Commercial Bank Portfolio
Total Sample Period Interest Rate Target Regime" Reserve Target Regime
GMVP
Commercial Banks
-0.016
-0.019
- 0.012
-0.018
' No cell entry since in this period w = 1 for the G M V P , and the two groups are identical in Bi risk.
For the whole sample period the/~z for the GMVP universal bank portfolio was -0.016, compared to - 0 . 0 1 9 for commercial banks alone, and for the reserve targeting subperiod -0.012 compared to -0.018; see Table 6. In both cases F tests reject equality of the/~I's at the 1% level. These results are consistent with the view that eliminating the regulations separating banking from commerce has the potential for reducing the banking system's total (return) risk as well as its interest rate risk.
V. Summary and Conclusions This paper has sought to derive some insights into the monetary policy specialness of banking firms relative to commercial firms through an analysis of the sensitivity of their stock returns to monetary policy regime changes. A major conclusion is that banks are special in the sense that micro bank regulation forces banks to bear more interest rate risk than either commercial firms or the hybrid universal type of bank. These results are consistent with the view that the micro bank regulation approach to monetary policy, advocated by Corrigan (1982) and Volcker (1983) among others, has created a banking system that is less stable and exposed to a higher degree of systematic interest rate risk than would exist in a less restricted banking system. Consonant with a strong body of monetary theory that argues that activity/balance-sheet regulations are not needed to exercise control over the money supply (see Patinkin (1961), Fama (1980), and Goodfriend and King (1987)), the results from our paper indicate that such regulations may have produced a more risky banking system, making the efficient transmission of monetary policy more difficult than without such regulations. Indeed, we show that a hybrid commercial bank-commercial firm portfolio (the "universal" bank portfolio) serves to reduce significantly both the total and interest rate risk exposures of the banking system. These results support the case for eliminating the separation of banking from commerce, to enable banks to perform more efficiently their special function in the transmission of monetary policy from the Fed to the rest of the economy.
We would like to thank G. Benston, S. Brown, M. Flannery, G. Udell, and an anonymousreferee for their comments on earlier versions of this paper. Saunders would like to thank a Bank and Financial Analyst Fellowship and a Senior YamalchiResearch Fellowshipfor financial support.
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