TOO
RISK TO FAIL? SIZE AND RISK IN BANKING
Mitchell Stan, The Open
University
Michael L. McIntyre, Carleton
University
In general, people usually feel safer
when they invest or keep their money in the larger bank than in the smaller
one. The reason is that the bank system which is controlled by majority of a
chain of large banks plays a crucial role in economic development in each
country. Once a big bank is collapsed, it will lead to serious consequences for
an economy. In order to prevent it happening, the government is ready for a
bailout plan to rescue these banks. Therefore, they think that it would be hard
for these large banks collapse. Many scholars are deeply concerned about the
relationship between size of a bank and risk. Some studies affirmed that the
smaller the bank is, the riskier it is. This concept applies to both private as
well as publicly-traded companies. In contrast, other studies tried to prove
that the larger bank is riskier than the smaller one in different aspects. Separately, this study emphasizes the risk
index to examine a risk in diversity sizes of banks. In the past, there were
some research about the risk index; however, they were still incomplete when
the collected data in different periods resulted in variety conclusions (Ennis
& Malek 2005). Some studies used the risk index to analyze the relationship
between risk and involvement in non-bank activities (Boyd & Graham 1996),
or a positive relationship between bank risk-taking and the spreads over the
default free rate (Hannan &Hanweck 1988).
This study measures the risk by using
the risk index and its subcomponents which are returns on assets, variances of
those returns and capital levels for various sizes of banks. The higher the
risk index is, the lower the risk is. The author used the accounting data and
total assets to measure the returns. Accounting data is a reliable source since
it is required to report firmly in standard. Total assets are utilized instead
of equity because it is more independent on the leverage. The formula of the
risk index is:
Risk index=(¶/A +K/A )/((σ¶)/A)
With ¶: net income, A: total assets and
K: total regulatory capital held by the bank. “The risk index incorporates
profitability, return volatility and leverage into one measure.” (Mitchell and
Michael, 2012) Although the risk index has some backwards, it is still an
effective tool for measuring between groups of the risky banks. It is used
popularly as a proxy for risk in the financial and non-financial literature
since Roy (1952). Basing on four hypotheses (H1-H4), the authors conducted the
examination the connection between the risk and size of the banks, from the
largest banks to the smallest banks, which are both of publicly-traded and
privately-owned institutions.
H1:
total risk, measured by the risk index, is higher for the larger banks than for
the smaller ones
H2:
returns measured relative to total assets are higher for the larger banks than
for the smaller ones.
H3:
Volatility risk, measured by the standard deviation of return on assets, is
higher for the larger banks than for the smaller ones.
H4:
The capital-asset ratio is lower for the larger banks than for the smaller.
(Mitchell
and Michael, 2012)
These four hypotheses are analyzed
thanks to the data in the FDIC database, which has 7,369 banks from JPMorgan
Chase Bank, the largest bank, to Oakwood State Bank, the smallest one, at a
point of time when this study happened. After analyzing them, the authors
strongly affirmed that larger banks are riskier than the smaller ones due to
the lower levels of capital relative to assets factor during the period 2001 to
2008.
The finding in this study is obviously
different to Boyd & Gertler (1994) who pointed out that during the period
1984-1991 larger banks had lower returns on assets than the smaller ones.
Whereas it is agreeable with Ennis & Malek (2005) during the period
1992-2003 returns on assets had a correlation to the size of the banks.
The regulators and bank supervisors may
find this outcome useful for their works. It will help the supervisors make a
decision in allocating the supervisory resources as well as set up the policies
clearly and exactly. For the regulators, this study helps them manage risks to
banks more effectively and efficiently since now they deeply understand in the
relationship between risks and return characteristics of banks.
Doesn't this have everything to do with moral hazard? Of course, bigger banks will be riskier because they know the government will bail them out. This was one of the leading causes of the '08 financial crisis. And the government did bail out a majority of the big banks who took on too much risk. Up until everything fell apart big banks were taking big risks and getting a usually large return.
ReplyDeleteIndeed, accounting data is a reliable source -- provided it is accurately reported and carefully audited. However, the biggest defect of accounting data is its characteristic of being a lagging indicator. That is to say, it would be appropriate for you to use accounting data to review what had happened in previous periods; however, you should be cautious when using it to predict the future performance. All the accounting data are recorded and reported under some specific constraints and assumptions -- which may change as time passes. It is a pitfall that financial statements users rely merely on accounting reports to predict the future.
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