RDP 9302: A Decade of Australian Banking Risk: Evidence from Share Prices 1. Introduction

Problems in the banking sector traditionally have been a concern of public policy. Part of this concern arises from the likely macro economic effects of banking sector contractions and the consequences of sudden and unanticipated withdrawals of bank credit (see for example Bernanke (1983)). An additional source of the concern is potential public sector (and taxpayer) liability which may be thought to arise from the deposit protection provisions of the Banking Act, or in some cases the direct guarantees of the Commonwealth and state governments.^[1] Because of these depositor protection provision requirements, severe losses by financial institutions may lead to calls for direct expenditures by the public sector, or at the very least increase the probability, and therefore the expected value, of such expenditures.

Both the macro economic effects and the public sector budget effects are greatest in cases in which a bank ‘fails’ in the economic sense, that is when the present value of the bank's assets fall short of the present value of its liabilities, thereby exhausting the bank's own economic capital. In such cases an institution must close, or must receive assistance if it is to continue operating. The likelihood of this type of failure depends on the probability that the bank will suffer seriously damaging losses. This probability in turn depends on two factors: (i) the variability of bank income, and (ii) the capacity of the bank to absorb losses in the short run.

The first factor, the variability of bank income, primarily reflects the variability of the rate of return on bank assets, referred to as the ‘volatility’ of the bank's asset portfolio. Volatility can be quantified by the statistical standard deviation of percentage changes in the value of bank assets. A bank with higher asset volatility is more likely to fail for any given capital ratio. The second factor, the bank's ability to withstand potential losses, depends on the its net worth or equity capital. For a given level of asset volatility, the probability that a bank will fail varies inversely with its capital.^[2] Capitalisation is expressed most conveniently and most commonly in terms of the capital ratio (the ratio of capital to total assets), with a higher capital ratio implying lower risk, all else equal.

Estimates of asset volatilities and capital ratios can be computed from figures reported under standard accounting conventions. However, these figures may not correspond to the relevant economic concepts. Economic capital ratios are based on the economic values of assets and liabilities, reflecting discounted future flows of economic earnings. Similarly, the relevant volatilities are the volatilities of the actual economic returns on the assets; these returns may be very different from the observable accounting returns on the book value of assets. This problem often is resolved in financial economics by using market values as proxies for economic values, but most bank assets and liabilities do not trade regularly in markets.

One piece of market-based information is observable for many Australian banks: the value of shareholder equity. In an efficient share market, the total market value of a bank's equity shares reflects the present value of total assets net of total liabilities, although if the share market is less than perfectly efficient the reflection may be imperfect as well. A model that correctly specifies the relationship between equity and asset values can be used to infer the latter from the former. In addition, the volatility of equity reflects the unobservable volatility of the underlying assets, again suggesting the possibility of inferring one from the other.

In this paper, we calculate Australian bank asset volatilities and capital ratios from share price data, for the period January 1983 to March 1992. The connections between share prices and the value of bank assets are developed more formally in the next section, and the conceptual foundation of the computational methods is discussed in Section 3. Section 4 describes the data, addresses some issues relating to the values of key parameters, and discusses details of the estimation. Section 5 contains the key results, and Section 6 concludes.

Footnotes

The Commonwealth Government does not formally guarantee bank deposits. Rather the Banking Act places a duty on the Reserve Bank to exercise its powers and functions for the protection of depositors of banks authorised under the Act (with the exception of foreign bank branches). The Act contains a number of specific provisions to protect the position of depositors. In particular, where a bank is likely to become unable to meet its obligations, the Act confers power on the Reserve Bank to investigate the bank's affairs and assume control of the bank for the benefit of its depositors. The Act also provides that the assets of the bank in Australia shall be available to meet its deposit liabilities in Australia in priority to all its other liabilities. This protection applies regardless of the amount of the deposit. [1]

In this formulation, capital is the difference between the economic values of assets and liabilities, exclusive of the benefits of any real or perceived guarantee of deposits. [2]