Understanding Bank Risk Through Market Measures

53 Pages Posted: 24 Aug 2018

See all articles by Natasha Sarin

Natasha Sarin

University of Pennsylvania Law School

Lawrence H. Summers

Harvard University; National Bureau of Economic Research (NBER); Harvard University - Harvard Kennedy School (HKS)

Date Written: September 10, 2016

Abstract

Since the financial crisis, there have been major changes in the regulation of large banks directed at reducing their risk. Measures of regulatory capital have substantially increased; leverage ratios have been reduced; and stress-testing has sought to further assure safety by raising levels of capital and reducing risk-taking. Standard financial theories predict that such changes would lead to substantial declines in financial market measures of risk. For major banks in the United States and around the world and for midsized banks in the United States, we test this proposition using information on stock price volatility, option-based estimates of future volatility, beta, credit default swaps, price — earnings ratios, and preferred stock yields. To our surprise, we find that financial market information does not bear out the predictions of financial theory. Measures of volatility and risk premiums today are no lower and perhaps somewhat higher than they were prior to the financial crisis. We examine a number of possible explanations for our findings. While financial markets underestimated risk prior to the crisis and regulatory measures of capital are flawed, we believe that the most important explanation for our findings is the dramatic decline in the franchise value of major banks. We highlight that the ratio of the market value of common equity to assets on both a risk-adjusted and risk-unadjusted basis has declined significantly from the precrisis period to the current period for most major banks. As a consequence, banks are more vulnerable to adverse shocks. We argue for taking a dynamic view of capital that recognizes future profits as a source of capital, and urge approaches to financial regulation supervision that will reliably force rapid capital replenishment in difficult times — something that did not take place in the United States in 2008 and is not taking place in Europe today.

Keywords: financial regulation

JEL Classification: G21, G28

Suggested Citation

Sarin, Natasha and Summers, Lawrence H., Understanding Bank Risk Through Market Measures (September 10, 2016). Brookings Papers on Economic Activity, Fall 2016. Available at SSRN: https://ssrn.com/abstract=3230766

Natasha Sarin (Contact Author)

University of Pennsylvania Law School ( email )

3501 Sansom Street
Philadelphia, PA 19104
United States

Lawrence H. Summers

Harvard University ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States
617-495-1502 (Phone)
617-495-8550 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Harvard University - Harvard Kennedy School (HKS) ( email )

79 John F. Kennedy Street
Cambridge, MA 02138
United States

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