Faculty Research on Economic Risks and Uncertainty
Are Banks Managing Risk Better as They Grow or Is Risk Growing, Too?
Associate Professor of Finance Anna Chernobai, Ali Ozdagli (Federal Reserve Bank of Dallas) and Jianlin Wang (University of California at Berkeley) examine whether banking institutions are managing their risks better as they grow larger and more complex or whether their risks are growing, as well.
The authors look into how the level of risk changed for banks and insurance firms that were impacted by the financial deregulation in the late 1990s, as well as whether the elevated operational risk post-deregulation is a result of strategic risk taking or managerial failure.
After the financial deregulations in the late 1990s that culminated in the Gramm-Leach-Bliley Act of 1999, U.S. bank holding companies began expanding aggressively into non-banking activities. Two big areas were securities underwriting and dealing, and insurance underwriting. This increased business diversification made bank holding companies more complex as they began operating outside of the traditional business of banking. Regulators are concerned that the potential benefits of this diversification are offset by potential risk-management weaknesses.
This study uses pre- and post-deregulation periods to examine the effects of bank complexity on their operational risk and finds that the frequency and severity of operational risk events increased significantly with bank complexity. The authors use a new methodology to study the effects of business complexity on risk management that is robust to confounding effects. They use the 1990s deregulation period as a so-called natural experiment that serves as an external shock to banks’ complexity. This experiment allowed them to identify the causal effect of increased complexity on the quality of risk management.
The implications for practice show that negative externalities of operational risk events affecting other financial firms documented in recent studies imply that the higher levels of operational risk post deregulation are not socially optimal. In terms of policy implications, at the heart of current regulatory debates lies the tradeoff between potential diversification benefits and potential risk management weaknesses arising from increased complexity that can result in losses for both the financial sector and taxpayers. This study highlights that any apparent benefit of diversification may come at the expense of increased risk that is not immediately evident. The authors’ results also suggest that operational risk externalities are more likely to originate from more complex bank holding companies. Accordingly, they may warrant more stringent regulatory requirements for operational risk.
How FOMC Announcement Days Impact Higher Average Equity Market Returns
Lai Xu, assistant professor of finance, Hengjie Ai (University of Minnesota), Leyla Jianyu Han (University of Hong Kong) and Xuhui Pan(University of Oklahoma) set out to reconcile how the Federal Open Market Committee (FOMC) announcement days are associated with realizations of significantly higher average equity market returns compared to days without major macroeconomic announcements, how the capital asset pricing model (CAPM) holds on macroeconomic announcement days, why none of the known risk factors are powerful enough to overturn the CAPM on announcement days, and how firms with different levels of sensitivity to monetary policy announcements also have different expected returns on announcement days. In doing so, they developed a parsimonious equilibrium model in which FOMC announcements reveal the Federal Reserve’s interest rate target, which affects the expected growth rate of the economy. Their model accounted for the dynamic of implied variances and the cross section of the monetary policy announcement premium realized around FOMC announcement days. This research has novel findings. From an investor’s point of view, a long-short portfolio formed on the researchers’ monetary policy sensitivity measure produced an average announcement day return of 31.40 bps. In addition, the returns of expected implied variance reduction (EVR)-sorted portfolios remained significant after controlling for market beta and otherstandard risk factors. To look at why, the authors further demonstrated that the spread on the EVR-sorted portfolios reflects risk compensation for monetary policy announcements. They used measures of monetary policy announcement surprises constructed by Nakamura and Steinsson (2018) to show that the average monetary policy announcement surprises are indifferent from zero, and, therefore, rational expectations hold well in the sample period, as well as that the returns of the EVR-sorted portfolios are monotonic in their sensitivity to monetary policy surprises.
The authors’ findings showed that the FOMC announcements resolve uncertainty about the macroeconomy and monetary policy and are associated with reductions in the option-implied variance. Firms that are more sensitive to monetary policy announcements should experience a greater implied variance reduction after announcements. Expectations for the implied variance reduction can therefore measure sensitivity to monetary policy announcements. The authors found that portfolios sorted on the EVR yielded a significant spread in average returns on FOMC announcement days but not on non-FOMC trading days.
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