Does the Stock Market Value Bank Diversification?
Tilburg University - Department of Finance
Olivier De Jonghe
Tilburg University - Department of Finance; Tilburg University - European Banking Center
Rudi Vander Vennet
Ghent University-Universiteit Gent - Department of Financial Economics
August 10, 2006
This paper investigates whether or not functionally diversified banks have a comparative advantage in terms of long-term performance/risk profile compared to their specialized competitors. To that end, this study uses market-based measures of return potential and bank risk. We calculate the franchise value over time of European banks as a measure of their long-run performance potential. In addition, we measure risk as both the systematic and the idiosyncratic risk sensitivities derived from a bank stock return model. Finally, we analyze the return/risk trade-off implied in different functional diversification strategies using a panel data analysis over the period 1989-2004. A higher share of non-interest income in total income affects banks' franchise values positively. Diversification of revenue streams from distinct financial activities increases the systematic risk of banks while the effect on the idiosyncratic risk component is non-linear and predominantly downward-sloping. These findings have conflicting implications for different stakeholders, such as investors, bank shareholders, bank managers and bank supervisors.
Number of Pages in PDF File: 29
Keywords: Second Banking Directive, diversification, bank stock returns, charter value, risk factors
JEL Classification: G21, G28, L25
Date posted: February 22, 2006