Download The volatility of banks in the financial crisis

The volatility of banks in the financial crisis
B.Sc. Thesis
Date: 2011-05-27
Dirk Croonen
263382
Literature review
Abstract
In this paper, I will explain why the volatility of banks’ stocks increased during the last financial
crisis. I will investigate how economic growth, the interest rate, the exchange rate and other
macro-economic variables have an influence on the volatility of stocks in general. Later on, I
will focus specifically on the volatility of banks’ stocks and volatility in crises. These factors
have an influence on the price of stocks and therefore also on the risks of stocks. That is why
these factors have a great influence on the volatility and it is interesting to see how exactly these
factors cause change in the volatility.
Introduction
Currently we are recovering from a financial crisis that started in 2008 in the United States and
then hit Europe. The consequences of this crisis were enormous. For instance; the housing
market collapsed, stock prices decreased significantly, the employment rate increased, banks
went bankrupt and so did some other companies. In particular banks had a very important role in
determining the crisis. This role was mainly caused by the great problems banks faced. In the
US, Lehman Brothers collapsed and in the Netherlands ABN Amro almost did. The problems
banks faced were due to great uncertainty from customers. That is, the customers’ trust in banks
decreased and that had a great impact on the banks’ returns and stock price. Stocks became more
risky which in term increased banks’ stock volatility.
In finance, volatility refers to the standard deviation of the continuously compounded
returns of a financial instrument within a specific time horizon. Thus, that return fluctuates over
time and is therefore an important determinant for prices of stocks. That is because volatility
shows the standard deviation of the returns of stocks and is influenced by the risk those stocks
hold. As a result an increase in volatility drives down stock prices and vice versa. But why did
the volatility increase during the last financial crisis and what were the main drivers of that?
This is the main question I will focus on throughout the paper. Since the volatility is an important
factor in the economy, it is important to see what happened to it in economic crises and
recessions. Moreover the volatility can be seen as an indicator of the economy as well. That is
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why it behaves differently during crises. Banks’ volatility is even more interesting because banks
are very important in an economy. That is also why it is interesting to look at volatility of banks
and more specifically at the drivers of it. The drivers cause volatility to increase in recessions
and to decrease in economically better years. But why is that and what are the drivers of that?
And how are they related? This leads to the main problem statement:
What caused the volatility of banks to increase in a crisis or recession?
In order to answer this question, I will firstly show that in fact volatility increases in a financial
crisis or a recession and then look at the influences of the interest rate, the exchange rate and the
GDP 2 growth rate. I will show that each factor will have a different affect on banks’ volatility
and that all have a negative relation with volatility. We will see that the GDP growth rate has the
biggest influence on banks’ volatility and the exchange rate will eventually be not significant and
therefore does not have a great impact on the volatility of banks. Furthermore we will see that the
interest rate comes somewhere in between and that it is hardly significant. So we will see the
interest rate does have an impact on banks’ volatility.
Before going specific into the problem statement it is important to see what already has
been written about the banks’ volatility and also related to the financial crisis. I will show what
has been examined of the time varying volatility in general and its determinants. In addition I
will look into papers of stock volatility and financial crises and recessions. And finally on what
has been written on banks, volatility and crises. After that I will do my own research in order to
solve the problem statement.
The paper is organized as follows; firstly in section 1 it is important to see how volatility in
general varies over time. Moreover it is important to see what the drivers of volatility are.
Section 2 investigates the volatility specifically during depressions and in the financial crises. It
also takes a look at how it behaved considering the OPEC oil shock during 1973-1974 and
during the Great Depression of 1929-1939. Section 3 will then focus on banks, volatility and the
crisis more specifically. In section 4 there will be the empirical research. And finally section 5
will be the summary and conclusion.
2
GDP = Gross domestic product
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1. Time varying volatility and its determinants
Volatility is traditionally understood as the standard deviation of returns from a financial
instrument and hence it is a measure of its risk. Thus, volatility is not a fixed number and
therefore it fluctuates over time. French, Schwert and Stambaugh (1987) i show that stock
volatility is highly persistent and that, on average, unexpected increases in volatility are
associated with negative stock returns. However, there are more drivers of these fluctuations. For
instance, Officer (1973)ii relates these changes of the volatility to macroeconomic variables. He
states that business fluctuations and changes in the quantity of money have an impact on the
volatility. Finally, William Schwert (1988)
iii
relates stock volatility with real and nominal
macroeconomic volatility, financial leverage, stock trading activity, default risk and firms
profitability using monthly data from 1857-1986. Schwert has written many papers on stock
volatility and thus it is important to go deeper into his vision.
According to Schwert, the real economic activity is one of the major determinants of stock
volatility. The change in the level of risk about future macroeconomic factors would cause a
proportional change in the volatility of stocks. Real economic activity has an influence on both
the expected future cash flows and the future discount rate. For example, an increase in real
economic activity will drive up the future cash flows and will decrease the discount rate. Thus,
the changes in the volatility of stocks can be explained if information is provided about the
volatility of either expected future cash flows or future discount rates. On the one hand, an
increase of the expected future cash flows will decrease the volatility, while on the other hand an
increase in the discount rate will cause an increase of the volatility. If future cash flows are
expected to rise, the prices of those instruments are going to rise as well. An increase of the
stocks’ price goes hand in hand with a decrease of its volatility. That is because a rise in a price
of an instrument happens because customers have faith in that instrument. This drives down its
risk, which means that it drives down the volatility. For the discount rate it is the other way
around. An increase in the discount rate leads to a decrease in the stocks’ price. This descend
emphasizes greater uncertainty of the stock and therefore increases the volatility. So the real
economic activity has a major impact on the stocks volatility.
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Whereas the real economic activity always has a major impact on volatility, financial
leverages’ impact depends on the state of the economy. To clarify, financial leverage is the
degree to which an investor or business is using borrowed money. Highly leveraged companies
may be at risk of bankruptcy if they cannot meet payments on their debt. Moreover those
companies may be unable to find new lenders in the future. Thus, corporations with high
financial leverage carry more risk than normal companies. Especially in a crisis this is a very
important factor considering stocks volatility. In a crisis high financial leverage tends to increase
the stocks volatility because then there is more risk on the markets. In a boom it is differently.
During a boom of the economy, there is positivity in the market and therefore there exists less
risk. Consequently it can be concluded that during booms high financial leverage has a minor
influence on the volatility of stocks. During crises, financial leverage shows the riskiness of
companies and has a great influence on stock volatility. However financial leverage is not all bad.
Namely it can increase the shareholders’ return on investments and often there are tax
advantages associated with borrowing. As a consequence the shareholders’ earnings on the
stocks will increase, which will drive up the price of those stocks. This also depends on the
health of the economy. For instance, in a crisis the stock price increase due to an increase in
earnings will be softer than during a boom. Thus an increase in earnings will lower the volatility
more during a boom than during a crisis. So as a consequence of the advantages and
disadvantages of financial leverage, its influence on volatility will depend on whether we are in
crisis or in a boom.
Furthermore interest rate and corporate bond return is correlated with stock volatility. An
increase in interest rate will cause an increase in volatility, because an increase in the interest rate
will lead to a decrease in stock prices. And as seen before lower stock prices tend to have a
negative relation with volatility, which thus will increase. This implies that the interest rate is
positively correlated with volatility; corporate bond return however is negatively correlated.
When bond returns increase, it makes those bonds more attractive for investors, which drives up
the price. More valuable bonds will have lower volatility.
Finally the stock market volatility is related to the general health of the economy. The level
of health of an economy is indicated by several factors. A leading one is stock prices. In
economic good years, stock prices tend to be high and in worse years, the prices are likely to be
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low. High prices will cause low volatility and low prices cause high volatility. As we have seen
before this is due to the risk involved. Another good indicator of the state of the economy is the
dividend yield. The dividend yield shows how much a company is paying out in dividend
relative to the stock price to the stockholders each year. In order words, the dividend yield is the
return on investment for a particular stock. Its formula is:
This indicator also has an effect on the volatility of the stock market. Since the dividend yield
indicates how much investors can earn on a particular investment, it is reasonably a driver of the
stocks prices and thus also of the volatility. In the dividend yield increases, investors can make
more money on that investment and consequently investors are going to buy those stocks. This
increase in demand will lead to an increase in its price, which indicates a lower volatility and
vice versa. Increases of the dividend yield and the stock prices can be caused by corporate
profitability. High profits of corporations mean higher dividend yield and higher stock prices
because it is a saver investment. So the state of the economy is major determinant of volatility.
To sum up the time varying volatility, it is important to note that stock prices are likely to be
negatively correlated with stocks volatility. Therefore, the volatility of stocks is continuously
fluctuating over time. The volatility is the standard deviation of an instrument and thus contains
the risk of those instruments. Changes in the risk of stocks will cause changes in volatility.
Volatility has many more drivers. As mentioned, the drivers of stocks prices will influence the
volatility as well. Those stock prices are dependent on many other factors, for example the state
of the economy, real economic activity, the interest rate and several other. Thus it can be
concluded that volatility is time varying and that this time variation is related to several factors.
2. Stock market volatility during recessions and in the financial crises
Stock volatility increases during recessions and financial crises. This reinforces the idea that
stock prices are an important indicator of the business cycle. Stock prices fall during recessions
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and major financial crises and thus, the volatility is expected to increase. Schwert (1989) iv
showed that this was in fact true during the period 1834-1987.
During recessions and financial crises, the economy is depreciating. This depreciation
starts because of higher uncertainty in markets. Gorton (1987)v in fact showed that bank failures
and financial crises are associated with greater risk. This uncertainty about the economy means
that there is less consumer spending. For companies, this has some huge consequences. For
example, the prices are declining because the demands for their products or services fall. As a
consequence of the price fall and the decline in demand, the profits of corporations will fall.
Companies will have to let employees go, which increases the unemployment rate. More people
are sitting at home without a job, getting a payment from the government. But not only the
government is affected by this high unemployment rate, also the banking industry is hit. Since
more people are unemployed, there is more uncertainty whether banks’ customers can meet their
debt and mortgage payments. Furthermore, getting a loan is also becoming more difficult. And
this again has an influence on the consumer spending. In the last financial crisis we have seen
that all this led to a collapse in the housing market. People could not pay their mortgages or rent
anymore and for others buying new houses was not a feasible option either. Because investors
did not have faith in the market anymore, stocks have declined significantly. In order to save
costs, companies had to fire many employees. Some banks and companies could not be saved
anymore and went bankrupt. That led to troubles for governments as well. For example, the
governments of the U.S, England, Germany, and the Netherlands started having huge amounts of
debt. Even countries like Iceland and Greece were at the edge of going bankrupt entirely. At this
time Greece is still on that same edge. Now we are recovering from the last crises and all that is
left are huge deficits and a lot of unemployed people. But what had the volatility to do with all
this and more interestingly, how did it behave over the years of the crisis?
As mentioned earlier, the volatility is the standard deviation of stocks returns and thus is
an indicator of risk. When there is high risk, the fluctuations will be greater and thus the
volatility will be high as well. During years of crises, there is uncertainty about companies, banks
and other institutions. That leads to uncertainty in the stock market. Especially in hard times, the
stocks of companies carry a great amount of risk and its volatility will therefore be very high.
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Figure 1 shows the volatility of stocks from 1875 until 1970. William Schwert (1989)
investigated the volatility during the period of 1834-1987, which includes the great depression of
1929-1939, several bank panics, the OPEC oil crisis of 1973, wars and some other shocks in the
economy.
Figure 1: Stock from 1875-1970 volatility and the level of volatility at 9/11/2001.vi
Note: The vertical axis shows a measure of volatility derived from William Schwert’s “Indexes of US Stock
Prices from 1802 to 1987” in Journal of Business (volume 63, issue 3, 1990), which contains daily stock
returns to the Dow Jones composite portfolio from 1885 to 1927, and to the Standard and Poor’s composite
portfolio from 1928 to 1962.
The Great Depression all started on black Thursday, the 29th of October 1929. On that
day, the stock market crashed and there was a reduction of the financial system. For instance
banks started withdrawing credit lines and the interbank lending market stopped. This led to
enormously high levels of stock market volatility and a recession that was never seen before.
According to Schwert, stock prices reflect increased uncertainty about the future course of the
economy. Thus, the volatility of stock returns tends to reflect uncertainty about future cash flows
and discount rates. During the depression there was a great amount of uncertainty in the market.
Especially in the stock market, after black Thursday, there was mistrust in the economy. So
Schwert’s conclusion that the general stock return volatility increased too much during the Great
Depression can be explained by increases in the volatility of variables that reflect future cash
flows.
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The OPEC oil crisis started in October 1973. The OPEC (Organization of the Petroleum
Exporting Countries) is an intergovernmental organization of twelve developing countries made
up of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the
United Arab Emirates, and Venezuela. The oil crisis started when the Arab members of the
OPEC plus Egypt, Syria and Tunisia proclaimed an oil embargo. This complete exclusion of
business and trade was due to the decision of the U.S. to re-supply the Israeli army. The embargo
continued until March 1974 and had a number of consequences. These consequences had great
impact because industrialized economies mainly depended on crude oil and OPEC was their
largest supplier. When the OPEC did not sell anymore to the U.S, many American companies
could not buy oil anymore. As a result, the industrialized economy of the U.S, which depends a
lot on crude oil, faced some major problems. For example, companies could not go on
producing, because of this lack of oil. Consequently, there arose a sort of panic in the stock
market. So the risk of stocks increased and that is again the reason that the volatility in the stock
market increased according to Schwert. Another problem was that the price of oil per barrel
increased significantly, because at that time there were fewer suppliers. That also led to some
problems for other countries, specifically in Europe. Thus a price increase in oil, leads to a
decrease in the stock market. Consequently, the volatility in the stock market rose.
Salikhov (2009)vii discusses in his article the main factors and development of the global
financial crisis of 2008. He states that the downturn in one of the local sectors of the U.S.
economy has caused major threats to the functioning of global financial markets. Thus there is
more uncertainty in the financial markets. As noted, the increase in the risk in these markets,
increase the volatility. In figure 2, it is visible that in fact during the last financial crisis, the
volatility increases significantly. Especially at the end of 2008, the volatility was extremely high.
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Figure 2: Implied volatility over 1990 until 2009.viii
Note: the graph is represented by the implied volatility. Implied volatility of an instrument is the volatility
implied by the market price.
As it is observable in figure 2, over the last two decades the volatility has fluctuated up and
down, but did not make such a drastically change as in 2008. The main reason is that during the
financial crisis, customers mistrusted the economy and moreover did not trust banks anymore.
This mistrust in banks led to an increase in interest rates because borrowing became more
expensive, but more on that later. Besides the increase in interest rates, consumers cut back their
spending and stock prices decreased. Companies had to minimize the cost of crisis, which they
did by firing employees and paying fewer dividends to the stockholders. Due to these
consequences and uncertainty in the financial markets, investors cut back their investments.
Campello et al. (2010) ix investigated among chief financial officers their behavior during the
financial crisis of 2008. As a result they found that the inability to borrow externally caused
many firms to bypass attractive investment opportunities, with 86% of constrained U.S. CFOs
saying their investment in attractive projects was restricted during the credit crisis of 2008.
Furthermore, more than half of the respondents said they canceled or postponed their planned
investments. This behavior is exactly the reason why the volatility increased during the last
financial crisis. That is the lack of trust in the financial market increases the volatility.
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So, to sum up, one major reason that volatility increases during depressions and financial
crises is that there is an increase in uncertainty about the financial markets because of the default
risk banks hold. That can be caused by many factors, but the most important one is that there is
uncertainty about the companies, banks and maybe the government. So there exists an
uncertainty about the economy in general. Furthermore during economic uncertainty, the interest
rate rises. This is because banks are uncertain about customers and want to be compensated for
that risk. This uncertainty of banks about customers is because customers are more likely to
default during crisis. Their jobs are less certain and house prices possibly rose. An increase in the
interest rate also has a tendency to increase the volatility in the stock market. So the mistrust in
the financial markets is, during crises and depressions, the major reason of why the volatility
increases.
3. Banks, volatility and crises
Now we have seen how stock volatility varies over time and how it behaves in financial
crises and depressions. We saw that different drivers can influence stock volatility. Especially,
because volatility represents the risk that a certain instrument holds, volatility is in continuous
movement. Furthermore it became clear that volatility increases during depressions and crises
because of a greater uncertainty in financial markets. Now that we have seen these facts, we can
take a look at the volatility of banks’ stocks specifically. Schwert (2009) x noted that many
periods of high volatility (in general) correspond to business cycle recessions or crises in the
banking system. This implies that the banking industry does have an effect on the volatility in
general, but how is the volatility of the stocks of banks determined?
Firstly we need to take a look at how banks do business. Banks’ profit depends on the
difference between the interest income and the sum of its interest and transaction costs. The
revenue that banks obtain is via lending money. They provide loans to customers, who will have
to pay interest over the amount borrowed. These loans can be a simple money transaction but can
also be a mortgage loan, for example, on a house or a car. By providing the money to customers,
the banks gain a monthly interest payment. In order to be able to provide the money to the
customers, the bank needs to have that kind of money. It obtains that money, by giving the public
the opportunity to stall their money at an account of the bank against a small compensation. This
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compensation is the interest customers will gain from the bank and thus it is simultaneously the
costs of banks. Banks have to pay this compensation to the customer, because the customer bears
risk that the bank is going bankrupt. This also holds the other way around. That is customers
have to pay interest over the borrowed amount because of the risk that the customer is not paying
back. The interest customers pay is higher than the interest banks pay, so the banks make a
profit.
The price of banks stocks are determined by its profit. When a bank is doing well, the
dividend yield will be higher. For investors this is a positive fact, so the demand for those stocks
will increase. This implies an increase in the price of its stock. As we have seen for stock
volatility in general, a higher price influences the volatility to go down. That also holds for the
banks’ stock volatility. This is for the same reason as for stocks in general, that it holds less risk.
Thus profits are important when looking at banks volatility.
According to Choi et al. (1992) xi the interest rate variable is important for the valuation of
common stocks of financial institutions because the returns and costs of financial institutions are
directly dependent on interest rates. Furthermore they mention a model which states that three
different shocks affect bank’s profit during a given period namely; interest rate, exchange rate
and default shocks. Since these three factors have a great influence on the profits of banks, it has
also a great influence on its volatility of stocks.
The interest rate directly has a great influence on the volatility. Profits of banks are
determined by the interest rate. As mentioned, the revenues banks obtain are the interest
payments of customers. The costs are the payments made to the customers. So an increase in the
interest rate the banks gain will increase the banks’ profits and thus make those banks’ stocks
more attractive. Investors can get more dividends on investment but also can earn money by
buying low and selling high. So when a bank is doing well, stocks prices will increase and that
results in a saver investment. This causes a decrease in the volatility of those stocks. So an
increase in the interest rate, at which banks lend, leads to a decrease in the stock volatility and
vice versa. The interest rate at which banks ‘borrow’ has another influence on its stocks. An
increase in that interest rate will increase banks costs, and thus decrease the banks profits. That
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makes the stocks less attractive and causes a decrease in its prices. So the increase of that interest
rate causes an increase in banks stock volatility and vice versa.
The exchange rate is the rate at which you can buy a foreign currency. Grammatikos et
al. (1986) xii investigated the portfolio returns and risk associated with the aggregate foreign
currency position of U.S. banks. They found that banks have imperfectly hedged their overall
assert position in individual foreign currencies and exposed themselves to exchange rate risk.
This finding suggests that exchange rate risk may importantly influence bank stock returns.
Thus, it also influences the volatility. In order to do business internationally you always need to
convert your money. That is why it is especially for banks an important factor. Companies do
business with other corporations internationally via banks. Banks hold the foreign currency
which investors and companies have to buy in order to invest or do business internationally.
Furthermore the exchange rate defines also in which country it is attractive to do investments.
For example, when the exchange rate is low for Europeans so that the euro/dollar is low, it is
attractive for Europeans to make investments in America. For European banks, this is a positive
thing because European investors are now buying dollars from the bank. Since investors have to
pay fees for that and banks have more money to lend out, the profits are raising which means that
the volatility is decreasing. So an increase in the exchange rate decreases the volatility.
Default shocks are according to Choi et al. the last determinant of the banks profit and
thus banks stock volatility. Default occurs when a debtor has not met his or her legal obligations
according to the debt contract. This can be that he has not made a scheduled payment, or has
violated a loan condition of the debt contract. A default is the failure to pay back a loan. Default
may occur if the debtor is either unwilling or unable to pay their debt. This can occur with all
debt obligations including bonds, mortgages, loans, and promissory notes. So it is an important
factor in the banking industry. When a lot of customers default, the banks have a high bad debt
expense. This leads to an increase in the volatility. Moreover if the risk of default increases, the
interest rate increases as well because banks want to be compensated for this risk. As we have
seen, an increase in the interest rate means a decrease in volatility. So shocks in default mean
shocks in volatility. This can be either up or down.
When we take a closer look at the determinants of the volatility of banks stocks, we can
see that it all depends on the state of the economy. When the economy is healthy, there is a lot of
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action in the markets as well as in the banking market. Companies are investing a lot and thus are
borrowing from banks; the housing market is doing well which means a lot of mortgage loan for
banks. Overall there is lots of business for banks which means that banks are doing well and thus
stock prices are rising, which indicates low volatility. On the contrary, during economic crises it
is the other way around which we will see in the next part.
Banks stock volatility in crisis
During economic crises, we have seen that the economy in general is depreciating, during these
years banks carry a lot of risk that customers are going to default. That is, the risk of having a lot
of bad debt expanses increases. That risk causes fluctuations in the volatility of banks. During
the last financial crisis, the housing market collapsed which caused a lot of default on mortgage
loan. Because of the increase of default the interest rate raises and the currency is becoming
cheaper. The three factors that influence the volatility of banks according to Choi et al. were all
influenced during the last financial crisis, which caused the volatility of banks to go up.
Furthermore during banking panics, the volatility also rises to high values. A banking
panic means a bank run, that occurs when a large number of customers withdraw their deposits
because they believe the bank is, or might become, insolvent. As more people withdraw their
deposits, the likelihood of default increases, and this encourages further withdrawals. This can
destabilize the bank to the point where it faces bankruptcy. So the bank carries countless
amounts of risk at that time. Because of that risk, investors are not willing to buy stocks of that
bank and investors holding the stock already, want to sell their stocks. As a result the price of its
stocks will decrease and eventually be very low. Therefore the volatility will be very high.
To sum up, we have seen that the major determinants of the banks stock volatility are the
interest rate, the exchange rate and the default shocks. More importantly, these three factors are
all indicators of the state of the economy. When the economy is doing well, the factors influence
the volatility negatively. The volatility is then thus very low. However during financial crises and
banking panics, the volatility will be driven upwards by. So the volatility of banks’ stocks is
affected by the health of the economy, which is indicated by the three factors mentioned.
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4. Empirical research
Now that we have seen some literature on the stock volatility in general and during some crises
and recessions over the last two centuries, we can take a closer look at the volatility of banks
during the sample period 1990-2010. Moreover we will take a look at the determinants of this
volatility. There are three specific factors which determine the banks volatility; the interest rate,
the exchange rate and the overall health of the economy. These factors will be given in quarterly
numbers. Firstly it is important to investigate the increase of volatility during crises. In the
literature it is assumed that the volatility in general increases when the economy is in recessions.
It is essential to see whether this is in fact true. Afterwards the determinants will be discussed
more elaborately.
In the figure 3, you can see the monthly average value weighted returns of the financial
industry over the sample period of 1990-2010. xiii During this period, the returns of banks
sometimes
fluctuated
more
than
others,
but
it
always
was
around
zero.
Figure 3: Monthly Average Value Weighted Returns of the financial industry during the period 1990-2010.
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In addition there have been three recessions over the last two decades. The Nber announced; the
July 1990 peak and the March 1991 trough, the March 2001 peak and the November 2001
trough, and finally the December 2007 peak and the June 2009 trough.xiv These periods of crisis
are indicated by the dark grey areas in the graph. During these phases, it was assumed that the
volatility increased. Remember that the volatility of a financial instrument, the standard deviation
is of its returns and is determined by the following formula:
where
are the observed daily average value weighted returns of the financial
industry during the period 1990-2010 and
is the mean value of these observations. In figure 4
is plotted the quarterly standard deviation of the daily returns of the financial industry. In this
graph too the crises are indicated by the dark grey area according to the Nber numbers.
Figure 4: Quarterly volatility of the Average Value Weighted Returns of the financial industry during the period 1990-2010.
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Thus, to check if indeed the volatility is higher during crises and recessions, we have to look at
the correlation between the volatility and the Nber which are shown in table 1.
Table 1: The correlation between the volatility of banks and the Nber
The correlation(volatility, Nber) = 0,572. This number is called R and means that volatility is for
57,2% correlated to the Nber. This positive amount proves our assumption that volatility is
higher during crises and recessions. A negative R would have meant that volatility and the Nber
have a negative relation and thus that volatility would decrease in case of a crisis. And an amount
close to zero would have meant that volatility of banks does not change during crises and
recessions. However, the result R = 0,572 shows that in fact it can be assumed that the volatility
of banks is higher during a crisis.
This can be checked by looking at the dark grey areas in figure 4. Especially during the recession
of 1990 and the last financial crisis of 2008, it holds true that the volatility is higher.
Furthermore, it is noticeable from the graph that the volatility increases in the beginning of a
crisis or just before one and that it decreases at the end of a crisis. This can be explained by the
uncertainty in the market. Just before a crisis and in the beginning, there is a lot of uncertainty in
several markets. Companies, banks and thus stocks hold more risk which increases the volatility.
At the end of a crisis, the economy is already recovering and people are already having more
confidence in the economy. Hence the risk and volatility are decreasing. Moreover, the volatility
adopted excessive proportions during the last financial crisis. This crisis was one of the hardest
over the last few decades and thus increased the volatility enormously. As a result, the
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assumption that volatility increases during financial crisis is in fact true, especially in the
beginning of a crisis.
This assumption holds true because volatility is driven up by its determinants; the interest
rate, the exchange rate and the GDP growth rate. These rates also adopt different values during a
crisis than normally. The different rates are all driven down during crises and thus have a
negative relationship with volatility. In table 2, is the correlation observable between the
volatility of banks and the interest rate.
Model Summary
Model
1
R
,367
R Square
a
Adjusted R
Std. Error of the
Square
Estimate
,135
,124
,88638
a. Predictors: (Constant), Interest_rate
Coefficients
a
Standardized
Unstandardized Coefficients
Model
1
B
Std. Error
(Constant)
1,907
,199
Interest_rate
-,173
,048
Coefficients
Beta
t
-,367
Sig.
9,568
,000
-3,577
,001
a. Dependent Variable: Volatility
Table 2: The relationship between the dependent variable and the interest rate
The relation between the dependent variable and the interest rate is -0,173. This implies that
there exists a negative relation between the two variables; if the interest rate raises, the volatility
of banks will fall and vice versa. The strength of the interest rate is also observable in table 2.
This strength is shown by R Square which is in this case 0,135. This means that 13,5% of
changes in volatility can be explained by changes in the interest rate. Thus, the interest rate is a
solid determinant of banks’ volatility. While, the significance level is 0,001 the interest rate is
also significant. Overall, the interest rate proves to be one of the major determinants of the
volatility of banks.
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Another determinant of the volatility of banks is the exchange rate. The correlation of the
exchange rate and the volatility is shown in table 3.
Model Summary
Model
1
R
,099
Adjusted R
Std. Error of the
Square
Estimate
R Square
a
,010
-,002
,94836
a. Predictors: (Constant), Exchange_rate
Coefficients
a
Standardized
Unstandardized Coefficients
Model
1
B
Coefficients
Std. Error
Beta
(Constant)
1,745
,524
Exchange_rate
-,165
,184
t
-,099
Sig.
3,333
,001
-,899
,371
a. Dependent Variable: Volatility
Table 3: The relationship between the dependent variable and the exchange rate
Also the exchange rate and the volatility hold a negative relation, namely -0,165. So, when the
exchange rate increases, the volatility of banks decreases and the other way around. Whereas the
interest has a solid influence on volatility, we see that the exchange rate has an R Square of 0,01,
which is very low and so it has a small influence. Moreover, the exchange rate has a significance
level of 0.371 and is therefore not significant. So we can conclude that the exchange rate is not a
major determinant of the banks’ volatility.
The final determinant is the GDP growth rate. This rate shows the overall growth of the
economy. Its relation with the volatility of banks is shown in table 4.
Model Summary
Model
1
R
,514
Adjusted R
Std. Error of the
Square
Estimate
R Square
a
,264
,255
,81743
a. Predictors: (Constant), GDP_Growth
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Coefficients
a
Standardized
Unstandardized Coefficients
Model
1
B
Coefficients
Std. Error
Beta
(Constant)
1,955
,152
GDP_Growth
-,263
,048
t
-,514
Sig.
12,821
,000
-5,428
,000
a. Dependent Variable: Volatility
Table 4: The relationship between the dependent variable and the GDP growth rate
This variable has the biggest affect on the volatility of banks because its R Square has the highest
value, 0,264. So changes in of the volatility can be explained for 26,4% by the changes in the
GDP growth rate. This means when the economy is doing well, the volatility will decrease
because also the GDP growth rate has a negative relation with the standard deviation.
Furthermore the GDP growth rate is significant and is thus the major determinant of the volatility
of banks.
So all three determinants have a negative relation with the volatility of banks, but each
one has a different amount of influence. The whole model is shown in table 5 in which all three
independent variables are set together against the dependent variable, the volatility of banks.
Model Summary
Model
1
R
,561
R Square
a
Adjusted R
Std. Error of the
Square
Estimate
,315
,289
,79863
a. Predictors: (Constant), GDP_Growth, Exchange_rate, Interest_rate
Coefficients
a
Standardized
Unstandardized Coefficients
Model
1
a.
B
Std. Error
(Constant)
2,648
,466
Interest_rate
-,096
,047
Exchange_rate
-,154
GDP_Growth
-,229
Coefficients
Beta
t
Sig.
5,679
,000
-,205
-2,065
,042
,156
-,092
-,987
,327
,050
-,448
-4,542
,000
Dependent Variable: Volatility
Table 5: The relationship between the dependent variable and the independent variables
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We see that the GDP growth rate is significant, the interest rate is hardly significant and the
exchange is not significant at all. Moreover we see that all together, they explain 31,5% of the
changes in the banks’ volatility.
So the formula of the banks volatility is:
Volatility of bankst = 2,648 – 0,096 Interest_ratet-1 – 0,154 Exchange_rate t-1 – 0,229 GDP_Growth t-1
(-2,065)
(-0,987)
(-4,542)
This formula assumes that there are no other determinants than the interest rate, the exchange
rate and the GDP growth rate. However, we know that there are some other factors that have,
albeit smaller, an influence on the volatility of banks; think for example of the default shocks
Choi et al. wrote about. The formula implies that a decrease in either one of the three major
determinants of the volatility of banks will cause an increase in that volatility. The GDP growth
rate will cause a higher increase than the interest rate, which will on itself cause a higher increase
than the exchange rate. It is possible though that one independent variable increases while
another decreases, in those cases there is not a great affect on the volatility of banks and it will be
somewhat stable.
In figure 5 the interest rate and the GDP growth rate are shown during the period 1990-2010.
Also in this graph are the periods of recession and crises indicated by the dark grey areas.
Figure 5: The 3 month US Treasury bill rate and the US GDP growth rate of 1990-2010
21
During the recessions, both rates are declining, which they already start with before the crisis.
The interest rate, in this case the 3 month US Treasury bill rate decreases because there is more
uncertainty in the markets. The Treasury bill rate is more or less the risk free rate. This shortterm debt obligation is a relatively safe investment and thus a good investment when there is
great uncertainty in the market. So, during crises, a lot of people want to have some security in
their investments and chose to invest in such a Treasury bill. As a result, the demand increases
and thus the interest rate of the 3 month US Treasury bill decreases. This means that other
investment opportunities are not taken by investors and banks’ returns are decreasing. This
makes their stocks less attractive and eventually causes the volatility of banks to increase.
Besides the more controlled investments of the public and companies, people also cut back on
spending. The insecurity in the market causes consumers to be more careful with their money.
This influences the production of companies in a negative way. The decrease in production leads
to less revenue for companies and they have to forgo investment opportunities and maybe fire
some employees, which on its turn makes consumers more careful. Furthermore, stocks are
becoming less attractive of those companies and investors become more risk averse. So overall,
there is less spending in the economy which causes the GDP growth rate to decrease. At some
points the economy is even depreciating as a whole. This overall risk the economy caries, makes
the public more suspicious which causes the overall volatility of companies to increase. Also the
banking industry is hit by this decrease in revenue and salary payments, because the default risk
of the borrowing of consumers and companies is increasing. They have less income which makes
it harder for them to pay their debt. This increases the uncertainty around banks as well, and thus
increases the volatility of banks.
We have seen that especially the GDP growth rate has an influence on the volatility and the
interest rate has a smaller influence. This is also visible in the graph: the GDP growth rate
decreases more significant than the interest rate. This is logical considering volatility reflects the
overall risk in a market and the GDP growth rate is a kind of a measure of how an economy is
doing. Especially during the last financial crisis, the two determinants decreased a lot. This crisis
was the biggest over a great amount of time and was obviously the biggest in the sample period.
In figure 4, it is observable that during this financial crisis of 2008 the volatility increased
enormously.
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The exchange rate is less obviously decreasing during crises, especially in the recessions of 1990
and 2001. In addition, we have seen that the exchange rate does not play a major role in
determining the volatility of banks. In figure 5, the movements of the exchange are visible over
the last two decades.
Figure 5: The US dollar-GB pound exchange rate during 1990-2010
The US dollar-GB pound exchange rate is only decreasing significantly in the last financial
crisis. The other two recessions observable in the figure are soft and short crises. During these
periods the exchange rate is not really reacting. This might be a result of the globalization of the
world’s economy. Most of the bigger companies have offices all over the world. Also banks are
operators all over the world. This is why the exchange rate did not decrease largely during the
two recessions. What is remarkable is that the dollar-pound exchange rate was very low during
the recession of 2001. This was possibly because of the announcement of the introduction of the
euro on the first of January 2002. Great-Britain was not willing to change their pounds into the
euro and that caused the exchange to be low. Since investors did not exactly know what the euro
was going to do, they decided to buy the more stable pound which drove the exchange rate
down. During the last financial crisis, the exchange rate did decrease significantly and again
increased at the end. This was because this crisis was a hard one which started in the US and then
came over to Europe. When the crisis hit the US the exchange rate decreased because the dollar
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became less worthy. Afterwards the crisis came to Europe and as a result the pound lost its value.
So the exchange rate started to increase again. However as noted, this did not have a huge affect
on the banks’ volatility.
Finally, it can be concluded that the volatility of banks did in fact increase during the
three recessions in the last twenty years and that it was influenced by the 3 month US Treasury
bill interest rate, the US dollar-GB pound exchange rate and the US GDP growth rate. Whereas
the interest rate and the GDP growth rate decreased significantly during crises and had a major
influence on the volatility of banks, the exchange rate did not make such huge declines and had a
much smaller influence. The GDP growth rate can be considered a significant determinant of the
banks’ volatility, whereas the interest rate is hardly significant and the exchange rate is not
significant at all. Additionally, it can be concluded that all determinants have a negative relation
with the volatility of banks and all have a different importance.
5. Summary and conclusions
It can be concluded that the volatility of banks is influenced by many factors in the world’s
economy. Schwert (1988) relates stock volatility with real and nominal macroeconomic volatility,
financial leverage, stock trading activity, default risk and firms profitability using monthly data
from 1857-1986, Officer (1973) relates changes of the volatility to macroeconomic variables and
Choi et al. (1992) mention a model which states that three different shocks affect bank’s profit
during a given period namely; interest rate, exchange rate and default shocks.
In the empirical part, we have seen that it was indeed true that the banks volatility
increased over the time period of a crisis especially during the last financial crisis. This increase
can be explained by the 3 month US Treasury interest rate, the US dollar-GB pound exchange
rate and the US GDP growth rate. All these rates influence the volatility if banks negatively. Its
formula is under the assumption that there are no other variables determining the banks
volatility:
Volatility of bankst = 2,648 – 0,096 Interest_ratet-1 – 0,154 Exchange_rate t-1 – 0,229 GDP_Growth t-1
(-2,065)
(-0,987)
(-4,542)
Especially the interest rate and the GDP growth cause the volatility to increase in crises since
those rates decrease significantly during these periods. The exchange rate makes less clear
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movements over time, but is in the financial crisis of 2008 also declining significantly. The
exchange rate is in general also much less important in determining the banks’ volatility whereas
the GDP growth rate is the most important one. In addition, mainly in the several crises the
correlation between the three independent variables and the volatility of banks is high. So we can
end by saying that the volatility of banks increased during the financial crisis of 2008 and that
the main driver is the GDP growth rate and that the less important drivers are the interest rate the
exchange rate.
References
i
K.R. French, G.W. Schwert and R.F. Stambaugh, 1987, ‘Expected stock return and volatility,’
Journal of financial economics
ii
R.R. Officer, 1973, ‘The Variability of the Market Factor of the New York Stock Exchange,’
Journal of business’
iii
G.W. Schwert, 1988, ‘Why does stock market volatility change over time?’ Journal of finance
iv
G.W. Schwert, 1989, ‘Business cycles, financial crises and stock volatility,’ Carnegie-Rochester
conference series on public policy
v
G. Gorton, 1987, ‘Banking Panics and Business Cycles,’ Unpublished manuscript, University
of Pennsylvania
vi
http://www.resourceinvestor.com/News/2008/6/Pages/Will-the-Credit-Crunch-Lead-toRecession-.aspx
vii
L. Grigor’ev and M. Salikhov, 2009, ‘Problems of economic transition,’ Econpapers
viii
http://www.prospercuity.com/modified-distributions.htm
ix
M. Campello, J.R. Graham and C.R. Harvey, 2010, ‘The real effects of financial constraints:
Evidence from a financial crisis,’ Elsevier
x
G.W. Schwert, 1990, ‘Stock volatility and the crash of ’87,’ review of financial studies
xi
J.J. Choi, E. Elyasiani and K.J. Kopecky, 1992, ‘The sensitivity of bank stock returns to market,
interest and exchange rate risks,’ Elsevier
xii
T. Grammatikos, A. Saunders and I. Swarv, 1986, ‘Returns and risks of U.S. bank foreign
currency activities,’ Journal of Finance
xiii
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/
xiv
http://www.nber.org/cycles/cyclesmain.html
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DataStream
http://www.investorwords.com/1952/financial_leverage.html
http://www.resourceinvestor.com/News/2008/6/Pages/Will-the-Credit-Crunch-Leadto-Recession-.aspx (graphs for part 2)
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