Are bank stocks sensitive to risk management?

Abstract

Sound risk management practice is the backbone of present day commercial banking. A bank has to manage several risks in the course of production and delivery of various financial services. This study attempts to summarize the information contained in bank financial statements on the diverse risks faced by banks and then ascertain whether stock markets respond to risk management behaviour. To this end, we compute risk management scores for Indian commercial banks for the period 1999-2006 by summarizing accounting ratios through the application of multivariate statistical techniques. Our computed scores show that risk management performance of banks has been improving over time with a recent drop in the last few years. Finally we examine whether returns on bank stocks are sensitive to the risk management scores developed in our study. The main finding is that banks with good risk management behaviour reward their shareholders with higher wealth. This work was supported by a grant from the Indian Institute of Management (Lucknow). An earlier version of this paper was accepted for presentation at the 12th Finsia-Melbourne Centre for Financial Studies Banking and Finance Conference. We gratefully acknowledge the useful comments received from an anonymous reviewer for the above conference and from G K Shukla. Any remaining errors are our responsibility. Commercial banking is a combination of different activities such as providing products and services to the customers, engaging in financial intermediation and management of risk. In recent years, risk management has received increasing focus as a central activity of commercial banks. The justification for studying banks" activities by focusing on risk management can be traced to Merton (1995) who argues that financial systems should be analyzed in terms of a "functional perspective" rather than an "institutional perspective" since over long periods of time functions have been much more stable than institutions. Given the importance of risk management in a bank"s functioning, the efficiency of risk management is expected to significantly influence its financial performance (Harker and 1 A functional perspective is based on the services provided by the financial system, such as providing a way to transfer economic resources through time. In contrast an institutional perspective is one where the central focus is on the activities of existing institutions such as banks and insurance companies. We chose Indian banking as the case study for our analysis. Our choice is driven by the recent emphasis on risk management in Indian banking driven by the Reserve Bank of India (RBI)"s guidelines as well as banks" own concerns. This recent emphasis can be attributed to several reasons. Prior to 1992, Indian banks were subject to a regime of strict control enforced by the RBI. A process of financial liberalization was initiated in 1992 to make the banking system profitable, efficient and resilient. The liberalization measures consisted of deregulation of entry, interest rates...

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