Financial Intermediation and Stock Market Volatility in a Small Bank-Dominated Economy

Abstract

In many small developing countries, the benefits of capital market development are not realized, as banks dominate and stock markets struggle to establish a firm footing in the economy, remaining relatively illiquid and volatile. This paper examines the determinants of stock market volatility in such conditions, specifically investigating the role that banks play in engendering volatility. Although significant amounts of research have been conducted on the determinants of stock market volatility in large developed country and emerging market exchanges, the stock exchanges in small developing countries have largely been ignored, as has been the relationship between banking operations and stock market volatility. Using a Generalized Autoregressive specification, this paper investigates the conditions under which banks in conducting their core functions impact stock market volatility in a small, bank-dominated developing country. The results show that factors which affect banks' profitability, such as inefficiency, ill-advised financial transactions and overly stringent or inconsistently applied regulations, can increase stock market volatility. They also indicate that in an economy wherein most listed real-sector firms survive through a combination of equity and credit financing, the effectiveness of financial intermediation impacts stock market volatility by affecting the profitability of such firms. We show that in small bank-dominated economies, profitable, well-functioning banks are needed if capital markets are to develop. Suggestions are provided as to how banks, regulators and policymakers can aid in the reduction of stock market volatility. JEL Classifications: O16, G21

Impact of Financial Market Development, Financial Crises and Deposit Insurance on Bank Risk

“…The process also produces many uncertain factors which affect bank risk, and bank risk breeds potential crises. Therefore, regulatory authorities should also be vigilant about the transmission of adverse effects of financial market development to financial intermediaries, including banks (Noman et al, 2018;Tennant and Tracey, 2014).…”

The Effect of Regulations on Stock Market Risk (Volatility) in Nigeria

“…Brumm, Kubler, Grill and Schmedders (2014) showed that margin regulation in the aggregate economy has a depressing effect on the volatility of asset returns. Tennant and Tracey (2014) investigated the link between bank and stock market volatility in small but bank overshadowed country, using generalized autoregressive model, and found that strict regulations determine market volatility. Bleich, Fendel and Bulke (2013) studied the effect of interest rate on financial market stress proxy by market volatility.…”

Banks Intermediation and Stock Prices of Deposit Money Banks in Nigeria: VECM and Variance Decomposition Approach

“…The result revealed that KLCI, GDP and INT have positive and significant influence on bank loans but there is no counter reaction from bank loans. In relation to the foregoing is that, Tennant & Tracey (2014) had examined how banks core functions impact stock market fluctuation in Jamaica using an unconditional descriptive measure of realized volatility and Generalized Autoregressive Conditional Heteroskedasticity (GARCH) specification on quarterly data. Such data include deposit to asset, loan to asset, ratio of credit to private sector to loans, spread, liquid asset ratio in a simple autoregression with exogenous variables (ARX).…”

“…The financial crisis resuscitated studies on several issues such as banks shock transmission, financial pollution, stock return estimation and market efficiency hypotheses. Though, some studies focused on these issues (Adrian and Shin, 2010;Karkowska, 2013;Tennant and Tracey, 2014); an aspect which has received less attention is study on the influence of financial intermediation on stock price of Deposit Money Banks (DMBs) in Nigeria. This aspect is important due to the need to have an informed understanding of the banking sector features, its reflection and transmission to stock prices as well as shocks dissemination process in the economy.…”