Parametric and nonparametric analysis of interest rate exposures of Spanish banks.
| Autor | Laura Ballester Miquel - Román Ferrer Lapeña - Cristóbal González Baixauli |
| Cargo | Universidad de Castilla-La Mancha - Universidad de Valencia - Universidad de Valencia |
| Páginas | 3-53 |
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Interest rate risk (IRR, hereafter) is broadly acknowledged as one of the most important financial risks faced by companies. This is due to the fact that changes in interest rates affect both the firm’s expected future cash flows and the discount rates used to value these cash flows. Moreover, the high volatility in interest rates and financial market conditions in recent years along with the significant degree of financial leverage for most of the companies have also contributed to the growing importance of interest rate exposure.
The bulk of the research on corporate exposure to IRR has been concentrated on financial institutions because of the particularly interest rate sensitive nature of the banking business. Specifically, financial assets and liabilities represent a substantial portion of the total assets of financial firms and it is generally admitted that there exists a maturity mismatch between banks’ assets and liabilities. The most common approach consists of measuring interest rate exposure as the sensitivity of bank stock returns to movements in interest rates using traditional linear regression models (e.g., Flannery and James, 1984; Madura and Zarruk, 1995; Faff and Howard, 1999; Fraser et al., 2002; or Au Yong and Faff, 2008).
There are, however, several reasons to suspect that the relationship between interest rates and market value of banks may be of nonlinear nature. On the one hand, since bank stock prices depend on interest rates through the discount factor and through the impact of interest rate changes on expected cash flows, it seems reasonable to assume that the link between interest rates and bank equity values may not be strictly linear. On the other hand, the risk management policy followed by banks may also play a major role in explaining the presence of nonlinearity in interest rate exposure. In addition, the response of bank stock returns to interest rate shocks may depend upon the sign or the magnitude of the shock, thus generating an asymmetric exposure to IRR. Specifically, interest rate rises and falls may affect bank value differently (sign asymmetry). Similarly, larger interest rate fluctuations may have a differential effect on bank value than smaller interest rate changes (size or magnitude asymmetry). Lastly, it is also possible that the relationship between interest rates and stock prices does not follow a time invariant functional form. Obviously, should these cases exist the
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conventional linear model would not be appropriate for estimating interest rate exposure of banks.
This study aims to provide a comprehensive analysis of the interest rate exposure of the Spanish banking industry both at the portfolio and firm level. To this end, the degree of interest rate exposure is assessed not only by employing the standard linear model used in most studies, but examining the possible existence of nonlinear exposure through alternative nonlinear parametric and nonparametric approaches as well. The primary contribution of the paper lies in the fact that it represents, to the best of our knowledge, the first attempt to estimate interest rate exposure using nonparametric regression methods. This new perspective helps to improve the understanding of the effect of IRR on banking firms and how it can be measured, which is an essential prerequisite for effective hedging decisions.
Nonparametric estimation techniques provide a flexible approach to model the relationship between interest rates and stock prices. Unlike parametric regression analysis, this method allows estimating a different functional form for each firm and also permits this function to vary over time. The comparison of the results of the alternative empirical techniques allows us to assess the extent to which the assumptions regarding the functional relationship between interest rates and bank stock prices may influence the conclusions over the level of interest rate exposure.
The Spanish banking sector provides an excellent context to investigate whether the introduction of the euro as a common currency in January 1999, with its implications in terms of greater financial stability and deepening and broadening of capital markets, has significantly affected the nature and magnitude of interest rate exposure of Spanish banks.
The empirical evidence in this study reveals some interesting points. In general, the Spanish banking system is characterized by a remarkable exposure to IRR during the sample period. It must be noted, however, that the extent of IRR faced by Spanish banks has noticeably decreased after the adoption of the euro. Furthermore, a distinctive feature of the Spanish case is that a pattern of positive interest rate exposure seems to emerge during the post-euro period, reflecting a sharp change in the nature of the impact of IRR on bank stocks. A significant nonlinear component is also detected in the link
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between interest rates and bank stock prices, confirming the importance of nonlinearity. This implies that using only the conventional linear model to measure interest rate exposure may underestimate the true degree of exposure.
The evidence of a lower exposure to interest rate changes in the more stable environment associated to the European Monetary Union can be relevant results for other countries which are currently involved in a process of rapid development and deep transformations just like the one occurred in Spain over the past two decades. This is the case, for example, of the Central and Eastern European countries which have joined the European Union and have adopted the Euro recently or are expected to do so in the following years.
The knowledge of the impact of interest rate fluctuations on the value of banking firms is essential not only for purposes of IRR management, but also for other areas of finance such as asset allocation, portfolio management, implementation of monetary policy, and banking regulation.
The rest of the paper is organized as follows. Section 2 offers a brief survey of previous literature regarding banks’ exposure to interest rate risk. Section 3 describes the data used. Section 4 discusses the model specifications employed in the analysis. Section 5 reports the major empirical results. Finally, Section 6 provides some concluding remarks.
A large number of empirical studies have examined the impact of IRR on the value of firms since the early 1980s. Most of this research has adopted a stock market approach within the framework of the two-index linear regression model developed by Stone (1974), which includes an interest rate change factor in addition to the traditional market index for explaining stock returns of firms. This literature is primarily focused on financial institutions because of the special nature of the business of financial intermediation (e.g., Flannery and James, 1984; Elyasiani and Mansur, 1998; Fraser et
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al., 2002; or Czaja et al, 2009 and 2010).1Further, prior studies investigating the exposure of banks to IRR have limited to a few developed countries, principally the US, and only more recently Japan, the UK, Germany, or Australia. Three main results emerge from this line of work. First, a significant negative effect of movements in interest rates on the stock returns of financial firms is generally documented, which has commonly been attributed to the maturity mismatch between banks’ assets and liabilities. Since banks tend to borrow short and lend long, the average maturity of the assets is usually longer than the average maturity of the liabilities. Thus, a rise in interest rates not only adversely affects a bank’s net worth (the value of its assets falls more than the value of its liabilities), but also bank profits are reduced (the cost of its liabilities increases more rapidly than the yield on its assets). Second, bank stock returns typically exhibit more sensitivity to changes in long-term interest rates than to changes in short-term rates (e.g., Akella and Chen, 1990; Faff and Howard, 1999; Bartram, 2002; Saporoschenko, 2002; or Czaja et al., 2009). Third, as pointed out by Faff and Howard (1999), Benink and Wolff (2000), Ryan and Worthington (2004), and Joseph and Vezos (2006), among others, the interest rate sensitivity of stock returns of financial institutions has declined over time, possibly as a result of the increasing availability of more advanced tools and techniques for measuring and managing IRR.
Moreover, it is worth mentioning that the implicit assumption underlying almost all the literature on corporate exposure to IRR is that interest rate exposure is linear. Much less attention has been paid, however, to other possible interest rate risk profiles. In fact, the vast majority of studies of exposure to macroeconomic risks (such as exchange rate, interest rate, or inflation risk) that investigate the presence of nonlinear or asymmetric exposure components focus on exchange rate risk (e.g., Di Iorio and Faff, 2000; Koutmos and Martin, 2003; Bartram, 2004; Tai, 2005; and Priestley and Odegaard; 2007).
One critical reason why the standard approach based on a linear exposure pattern has been subject to persistent criticism is that using the same functional form for all the firms can be too restrictive, leading to understate the level of interest rate exposure. In this regard, it is widely accepted that the degree of exposure depends on firm and
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industry...
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