Capital Adequacy, Credit Quality, Market's Performance in European Banking During the Subprime Crisis

• Autores: Valerio Pesic, Pasqualina Porretta
• Localización: Creativity and survival of the firm under uncertainty / coord. por Attilio Celant, Txomin Iturralde, 2009, ISBN 978-84-692-5174-4
• Idioma: inglés
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• Resumen

  • Capital Adequacy and Credit Quality are two fundamental topics for bank management, whether within a stable scenario or whether during a financial turmoil. In particular, during the 2007-2008 Subprime Crisis there has been an increasing attention on the capacity of banks to face the recession and the sharp decline in their profitability (Allen, Gale, 2007; Borio, Zhu, 2008; Acharya, Richardson, 2009): by this meaning, bank�s capital has become a key variable, along with credit quality measurement and other information coming from capital markets, such as stock prices, ECAI�s ratings and credit spreads (Flannery, 1998; Hancock, Kwast, 2001; Norden; Weber, 2007).

    In this paper, we research for any relationship existing between banks� risk, which we analyze through capital adequacy, credit quality, high leverage and underestimated risks, and market performances achieved by the European banking industry (Diamond, Rajan, 2005; Garlappi, Shu, Yan, 2007; Hänsel, Krahnen, 2007). In particular, by focusing our attention on a large sample of European banks, we attempt to investigate the linkage existing between the endogenous bank�s efficiency, which we measured through risk weight assets, Tier 1 capital ratio, etc., and the market performance achieved by those banks during the period from 2005 to 2008.

    Through this analysis we try to understand if it is possible to distinguish, before and during the crisis, between banks which have been more aggressive than others, because they used less capital, they used higher leverage, they suffered because of a larger amount of subprime loans. If it is possible to make this distinction, we would like to verify if market�s prices have reflected the more endogenous risk of the aggressive banks in terms of higher credit spread, ECAI�s downgrading, higher volatility or lower performance of their stock. At the same time, we want to investigate about the choices that has been realized by European banks during last months, in order to face the crisis (Diamond, Rajan 2009).

    Finally, according to a major stream of the financial literature, we consider that in an efficient market, stock prices incorporate all relevant publicly known information (Fama, 1970). By distinguishing three sets of information, market efficiency is correspondingly distinguished in strong, semi-strong and weak. Large empirical evidence presented from the end of the 1960s shows that markets are efficient, although the existence of anomalies mainly related to the prices� behaviour. In semi-strong efficiency, stock performance represents the best measure to estimate the creation of value for shareholders (Brealey and Myers, 1991), and a positive relationship exists.

    Therefore, according with this literature, we expect that aggressive strategies will be reflected in lower stock� performance, within lower external rating and higher credit spread: furthermore, through our analysis we would like also to investigate if market operators are able to correctly operate also during financial turmoil, when uncertainty becomes higher and banking activities have reduced both profitability and capital base.