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Risk and Market Segmentation in Financial Intermediaries’ Returns

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  • Linda Allen
  • Julapa Jagtiani

Abstract

This study examines both the quantity and price of risk exposure for different segments of financial intermediaries in order to determine whether market segmentation exists in the financial services industry in the United States. We distinguish between depository institutions, securities firms, insurance companies, mutual funds, and other financial firms using each company s SIC code. We find evidence of market segmentation in both market risk levels and market risk premiums. The results provide little evidence of interest rate risk exposure across all types of financial intermediaries, suggesting the prevalence of hedging programs using interest rate derivatives. However, the market prices interest rate risk exposure differentially by type of financial intermediary. We find that as a market segment, insurance companies were exposed to more interest rate risk particularly in the period late 1980 s to early 1990 s. The interest rate risk premium for banks was among the highest of all financial intermediaries. Overall, we find that securities firms, as a group, have the most market risk exposure, followed in order of descending market beta, by banks, other financial firms, insurance companies, and mutual funds, although the order is reversed when examining the market risk premium. Indeed, we find support for an inverse relationship between the quantity and price for market risk, but not for interest rate risk. When we investigate the impact of two regulatory policy changes, we find that (1) the shift in the conduct of monetary policy towards targeting of monetary aggregates induced banks to take on more market risk, probably due to a decline in their charter value; (2) bank market risk-taking increased further with the introduction of riskbased capital requirements which further reduce charter value for banks; and (3) insurance companies are subject to the highest interest rate risk premiums during the 1988-1994 subperiod, following by commercial banks, probably due to interest rate risk subsidy under the risk-based capital requirements. Overall, during the period 1974-1994, banks increased their market risk exposure despite the tightening of regulatory restrictions, insurance companies increased their interest rate risk exposure over the subperiods. We create synthetic universal banks comprised of portfolios of banks, securities firms, and insurance companies. We find that the synthetic universal banks have significantly positive excess returns, with lower market and interest rate risk exposures and higher expected returns than securities firms. This paper was presented at the Financial Institutions Center's October 1996 conference on "

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Bibliographic Info

Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 96-36.

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Date of creation: Oct 1996
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Handle: RePEc:wop:pennin:96-36

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  1. Mark Flannery & Christopher James, . "Market Evidence on the Effective Maturity of Bank Assets and Liabilities," Rodney L. White Center for Financial Research Working Papers 05-83, Wharton School Rodney L. White Center for Financial Research.
  2. Jagtiani, Julapa & Saunders, Anthony & Udell, Gregory, 1995. "The effect of bank capital requirements on bank off-balance sheet financial innovations," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 647-658, June.
  3. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April.
  4. Puri, Manju, 1996. "Commercial banks in investment banking Conflict of interest or certification role?," Journal of Financial Economics, Elsevier, vol. 40(3), pages 373-401, March.
  5. Allen, Linda & Jagtiani, Julapa & Landskroner, Yoram, 1996. "Interest rate risk subsidization in international capital standards," Journal of Economics and Business, Elsevier, vol. 48(3), pages 251-267, August.
  6. Boyd, John H. & Graham, Stanley L. & Hewitt, R. Shawn, 1993. "Bank holding company mergers with nonbank financial firms: Effects on the risk of failure," Journal of Banking & Finance, Elsevier, vol. 17(1), pages 43-63, February.
  7. Harvey, Campbell R, 1995. "Predictable Risk and Returns in Emerging Markets," Review of Financial Studies, Society for Financial Studies, vol. 8(3), pages 773-816.
  8. Amsler, Christine E. & Schmidt, Peter, 1985. "A Monte Carlo investigation of the accuracy of multivariate CAPM tests," Journal of Financial Economics, Elsevier, vol. 14(3), pages 359-375, September.
  9. Amar Gande & Manju Puri & Anthony Saunders & Ingo Walter, 1995. "Bank underwriting of debt securities: modern evidence," Proceedings 481, Federal Reserve Bank of Chicago.
  10. Keeley, Michael C, 1990. "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review, American Economic Association, vol. 80(5), pages 1183-1200, December.
  11. Yourougou, Pierre, 1990. "Interest-rate risk and the pricing of depository financial intermediary common stock : Empirical evidence," Journal of Banking & Finance, Elsevier, vol. 14(4), pages 803-820, October.
  12. Fama, Eugene F & MacBeth, James D, 1973. "Risk, Return, and Equilibrium: Empirical Tests," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 607-36, May-June.
  13. Flannery, Mark J & James, Christopher M, 1984. " The Effect of Interest Rate Changes on the Common Stock Returns of Financial Institutions," Journal of Finance, American Finance Association, vol. 39(4), pages 1141-53, September.
  14. Jeff Madura & Emilio R. Zarruk, 1995. "Bank Exposure To Interest Rate Risk: A Global Perspective," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 18(1), pages 1-13, 03.
  15. Shanken, Jay, 1992. "On the Estimation of Beta-Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 5(1), pages 1-33.
  16. Ferson, Wayne E & Harvey, Campbell R, 1993. "The Risk and Predictability of International Equity Returns," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 527-66.
  17. Sweeney, Richard J & Warga, Arthur D, 1986. " The Pricing of Interest-Rate Risk: Evidence from the Stock Market," Journal of Finance, American Finance Association, vol. 41(2), pages 393-410, June.
  18. Sung C. Bae, 1990. "Interest Rate Changes And Common Stock Returns Of Financial Institutions: Revisited," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 13(1), pages 71-79, 03.
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Cited by:
  1. Muhammed Monjurul Quadir, 2012. "The Effect of Macroeconomic Variables On Stock Returns on Dhaka Stock Exchange," International Journal of Economics and Financial Issues, Econjournals, vol. 2(4), pages 480-487.
  2. Victoria Geyfman, 2005. "Banks in the securities business: market-based risk implications of section 20 subsidiaries," Working Papers 05-17, Federal Reserve Bank of Philadelphia.
  3. Pariyada Sukcharoensin, 2013. "Time-Varying Market, Interest Rate and Exchange Rate Risks of Thai Commercial Banks," Asian Academy of Management Journal of Accounting and Finance, Penerbit Universiti Sains Malaysia, vol. 9(1), pages 25-45.
  4. George Alessandria & Horag Choi, 2005. "Do sunk costs of exporting matter for net export dynamics?," Working Papers 05-20, Federal Reserve Bank of Philadelphia.
  5. Jongmoo Choi & Elyas Elyasiani, 1997. "Derivative Exposure and the Interest Rate and Exchange Rate Risks of U.S. Banks," Journal of Financial Services Research, Springer, vol. 12(2), pages 267-286, October.
  6. Victoria Geyfman, 2005. "Risk-adjusted performance measures at bank holding companies with section 20 subsidiaries," Working Papers 05-26, Federal Reserve Bank of Philadelphia.
  7. Elyasiani, Elyas & Mansur, Iqbal & Pagano, Michael S., 2007. "Convergence and risk-return linkages across financial service firms," Journal of Banking & Finance, Elsevier, vol. 31(4), pages 1167-1190, April.
  8. Chakraborty, Suparna & Allen, Linda, 2007. "Revisiting the Level Playing Field: International Lending Responses to Divergences in Japanese Bank Capital Regulations from the Basel Accord," MPRA Paper 1805, University Library of Munich, Germany.
  9. Papadamou, Stephanos & Siriopoulos, Costas, 2014. "Interest rate risk and the creation of the Monetary Policy Committee: Evidence from banks’ and life insurance companies’ stocks in the UK," Journal of Economics and Business, Elsevier, vol. 71(C), pages 45-67.

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