Australian Banking Risk: The Stock Market’s Assessment and the Relationship Between Capital and Asset Volatility

The likelihood of a bank failing, within a given period of time, is a function of the variability in its income and its ability to withstand losses. These determinants depend, in turn, on the volatility of the return on bank assets and the bank’s level of capital. Although accounting measures of the volatility of the rate of return on bank assets and bank capital-asset ratios are published on a regular basis, market prices provide alternative risk measures. This paper uses share prices to estimate these risks measures for 15 Australian banks that were listed on the Australian Stock Exchange for all, or part of, the period 1983 to 1998. Option prices are also used to generate alternative estimates of these risk measures, the results of which corroborate those obtained from share prices. We find that the market’s assessment of the capital-asset ratio for the Australian banking sector has risen considerably over the sample period. There has also been a slight upward trend in the volatility of asset returns. These two trends have opposite effects on the market’s assessment of total bank risk: rising capital-asset ratios reduce bank risk, but rising asset volatility increases it. To uncover which trend has dominated, we examine a couple of measures of total bank risk, which summarises the net impact of movements in both the capital-asset ratio and asset volatility. These additional risk measures suggest that the riskiness of the sector has declined. In investigating the relationship between banks’ capital-asset ratio and asset volatility over time, we find that increases in the growth of the capital-asset ratio precede increases in asset volatility which, in turn, cause a slowdown in capital growth.