Banks’ equity performance and the term structure of interest rates

• DOI: http://doi.org/10.1111/fmii.12125
• Date: 01 May 2020
• Author: Elena Kalotychou,Panos K. Pouliasis,Sotiris K. Staikouras,Elyas Elyasiani,Iftekhar Hasan
• Published date: 01 May 2020

DOI: 10.1111/fmii.12125

ORIGINAL ARTICLE

Banks’ equity performance and the term structure

of interest rates

Elyas Elyasiani1Iftekhar Hasan2Elena Kalotychou3

Panos K. Pouliasis4Sotiris K. Staikouras5

1FoxSchool of Business & Management, Temple

University

2FordhamUniversity, Bank of Finland, and

University of Sydney

3Cyprus University of Technology

4Cass Business School, City,University of London

5Cass Business School, City,University of London

Correspondence

SotirisK. Staikouras, Cass Business School, City,

Universityof London, 106 Bunhill Row, London

EC2Y8TZ, UK.

Email:sks@city.ac.uk

Abstract

Using an extensive global sample, this paper investigates the impact

of the term structure of interest rates on bank equity returns.

Decomposing the yield curve to its three constituents (level, slope

and curvature), the paper evaluates the time-varying sensitivity of

the bank’s equity returns to these constituents by using a diagonal

dynamic conditional correlation multivariate GARCH framework.

Evidence reveals that the empirical proxies for the three factors

explain the variations in equity returns above and beyond the

market-wideeffect. More specifically, shocks to the long-term (level)

and short-term (slope) factors have a statistically significant impact

on equity returns, while those on the medium-term (curvature)

factor are less clear-cut. Bank size plays an important role in the

sense that exposures are higher for SIFIs and large banks compared

to medium and small banks. Moreover, banks exhibit greater sen-

sitivities to all risk factors during the crisis and post-crisis periods

compared to the pre-crisis period; though these sensitivities do not

differ for market-oriented and bank-oriented financialsystems.

KEYWORDS

Banks, Economic Cycles, Equity Return, Interest Rate Risk, Yield

Curve

JEL CLASSIFICATION

C32, E43, G21

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and repro-

duction in anymedium, provided the original work is properly cited.

c

2020 The Authors. Financial Markets, Institutions & Instruments published by New York University Salomon Center and Wiley

Periodicals LLC

Financial Markets,Inst. & Inst. 2020;29:43–64. wileyonlinelibrary.com/journal/fmii 43

44 ELYASIANI ET AL.

1INTRODUCTION

The specialness of financial intermediaries and banking in particular is well discussed in the finance literature with

emphasis on the unique structure of the bank’s balance sheet (Beston, 2004; Saunders & Cornett, 2017). The “new”

originate-to-distribute model, adopted by banks, has enabled them to tap into new funding channels (e.g., asset-

backed securities, derivatives, etc.), which in turn has broadened their investment activities via the creation of new

asset classes such as collateralised asset obligations and other structured products (Purnanandam, 2011; Shin, 2009).

Recent findings on the causes of the 2007 financial crisis point to the balance sheet structure of the banking firm

(Brunnermeier & Oehmke,2013; Farhi & Tirole, 2012), while the inherent leverage-adjusted duration/ convexity gap of

the bank’s assets and liabilities underlines its exposure to interest ratefluctuations (Anderson & Cakici, 1999; English,

Vanden Heuvel, & Zakrajsek, 2018; Entrop, Memmel, Wilkens, & Zeisler, 2008, Alessandri & Nelson, 2015; Flannery &

James, 1984a).

The significance of interest rate changes was documented much earlier by Merton (1973) and Long (1974) where,

under the assumption of a stochastic risk-free rate, investors are exposed to another kind of risk, namely,the risk of

unfavorable shifts in the investmentopportunity set. In reality, the bank’s portfolio (assets/liabilities) contains a wide

range of instruments with different maturities and, thus, broader yield curve features highlight the evolution of mar-

ket expectation in response to changing economic conditions andthe bank’s risk exposure. This point is reinforced by

the recent Basel Committee on Banking Supervision (2016) where banks are required to measure their 12-month net

interest income while balancing the multiple maturities in their portfolio.

Yield curve properties have a distinctive influence on the investors’ perception about risk-return relationships as

they are linked to business cycle conditions (Aguigar-Conraria, Martins, & Soares, 2012; Dewachter & Lyrio, 2006;

Diebold, Rudebusch, & Aruoba, 2006) and consequently to the bank’s equity performance. Thus, using a single point

of the yields’ distribution (e.g., three-month T-bill) overlooks the impactof the whole spectrum of yield changes on the

market value of the bank’s overall portfolio. This issue becomes nontrivial when investmentportfolios with expected

and contingent cash flows of different maturities are considered. Therefore, the limitations of analysing bank equity’s

yield sensitivity on the basis of yield point changes, as opposed to yield curve changes, become economically relevant

(see surveys byStaikouras (2003, 2006) on financial intermediaries’ interest rate risk exposure).

Thecurrent paper investigates the potential exposure of banks’ stock returns to interest rate risk by explicitly taking

into account the level,slope and curvature of the entire term structure of interest rates (yield curve). More specifically,

the present study contributes to the literature in four fronts. First, it deploys the level,slope and curvature of the term

structure of interest rates, derived from a three-factor interest rate model, to examine the exposureof bank’s equity

to yield curve fluctuations across all maturities. These three-factors are used as independent risk factors in the banks’

equity return generating process. The decomposition of the yield curve into its three components provides a research

design that aims to overcome the caveats of earlier work focusing on fixed maturity yield changes and ignoring the

effect of changes in the shape of the term structure or that of a “twist” in the yield curve1. Previous empirical studies

have tried to resolve the issue by considering multiple yield measures with different maturities and/orterm spreads

with the exception of Czaja, Scholz, and Wilkens (2009). Yet, an important consideration is that yield changes across

different maturities are not perfectly correlated and, thus, using different maturities in isolation can lead to mislead-

ing results. Second, the paper sheds light on the interface between the dynamics of the wider economy and the yield

curve exposure of thebanking firm by incorporating a period long enough to embrace different phases of the business

cycle, as well as both the crisis and non-crisis periods. One stylized fact of the yield curve is that its shape is intimately

connected to the cyclical dynamics of the economy (Diebold et al., 2006). The yield curvetends to be steeper near the

trough of the business cycle, while relatively flat near its peak. This feature directly influences banks’ risk profile, since

their leverage and credit generating capacity (balance-sheet size) are determined by the interest rate environment

where they operate2. Thus, when the yield curve is upward sloping during an economic boom, banks expandtheir bal-

ance sheet through leverage, subject to regulatory capital requirement, to takeadvantage of the carry spread (Adrian

& Shin, 2008). On the other hand, during an economic downturn, banks may experience difficulties to rollover these

debts as a result of shortage in funding liquidity (Acharya & Viswanathan, 2011). Using a dataset covering both the