Bank risk factors and changing risk exposures: Capital market evidence before and during the financial crisis

We analyze the capital market assessment of bank risk factors in Europe and the United States for the 1990–2011 period. The focus is on bank stock returns in a multi-factor framework that includes interest rate risk and market risk as well as credit risk, real estate risk, sovereign risk, and foreign exchange risk. Our findings indicate that bank risk exposures are multi-dimensional and time-varying but well reflected in bank stock returns. Dynamic beta exposures and time-varying variance shares accompany structural changes in the banking industry and the recent financial crisis. During the last two decades, interest rate risk has changed but credit risk still represents a major factor for explaining bank stock returns. For the recent financial crisis we provide evidence of a change in the capital market's assessment of bank risk exposures with a significant revaluation of real estate and sovereign risks. Overall, our factor model offers a parsimonious approach for modeling the risk dynamics in the banking industry and provides evidence for the capital market's ability to assess bank risk exposures.