Interest Rate Sensitivity of Bank Stock Returns:
Re-examination since Basel Accords
Adam J. Fagan
University of Alaska Anchorage
E-mail: asajf8@uaa.alaska.edu
Suresh C. Srivastava
University of Alaska Anchorage
3211 Providence Drive, Anchorage, AK 99508
E-mail: afscs@uaa.alaska.edu
Edward Forrest
University of Alaska Anchorage
E-mail: asajf8@uaa.alaska.edu
EXPANDED ABSTRACT
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Corresponding author: Suresh Srivastava
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Interest Rate Sensitivity of Bank Stock Returns:
Re-examination since Basel Accords
Abstract
The Basel I and Basel II accords have been known as a source of speculation regarding their
overall impact on the banking industry. As the Basel I accord has been, and currently is, still in
effect to help try and regulate credit risk many believe that this policy has had an effect on the
interest rate that can be felt through changing returns on bank stocks. With talks of a newly
reformed Basel II accord currently underway and slated to be in place by 2008 it is speculated
that it will also have as much, if not more, of an impact on the industry as Basel I. Specifically,
this paper examines the returns on bank stocks to determine whether the implementation of the
Basel I accord or the announcement on the Basel II accord have had any discernable impacts
I. Introduction
The Basel I and subsequently the Basel II accords are a series of regulations passed by the
Basel Committee (BCBS) to try and better regulate the banking industry. The Basel I accord,
established in 1988, was the first of it’s kind and was initially established as a way to reach an
agreement among the G-10 central banks to recognize common minimum capital standards. The
standards set forth dealt primarily with the issue of credit risk and the need for a universal
structure to determine said risk. “Assets of banks were classified and grouped in five categories
according to credit risk, carrying risk weights of zero (for example home country sovereign, ten,
twenty, fifty, and up to one hundred percent. Banks with international presence are required to
hold capital equal to 8 % of the risk-weighted assets.” The Basel accord was then deemed to be
enforceable by law and required to be adopted by the G-10 countries by 1992. The Basel II
accord is essentially a much expanded upon and updated version of the aforementioned Basel I.
The Basel II was brought about to try and make some much needed amendments to the Basel I
which many felt was now outdated. Furthermore regulators felt that the Basel I was too risk
insensitive and could be easily circumvented if given the right conditions. As a result
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deliberations began on the Basel II in January of 2001 in an attempt to mitigate the earlier Basel
I’s shortcomings. To do so it was determined that the Basel II would have to encapsulate the
three following ideals, ensuring that capital allocation is more risk sensitive, separating
operational risk from credit risk, and attempting to align economic and regulatory capital more
closely to reduce the scope of regulatory arbitrage. These changes are projected to have wide
sweeping effects on the banking industry when the Basel II accord is finally put into action. It
should be noted that although the Basel II accord is not currently in action it is, and has since it’s
initial announcement, already had an effect on the banking industry as these institutions begin to
make strides in an effort to be ready for this change over.
II. Interest Rate Risk
Interest rate sensitivity of commercial bank stock returns has been the subject of
considerable research. Stone (1974) proposed a two-factor model incorporating both the market
return and interest rate variables as return generating factors. While some studies have found the
interest rate factor to be an important determinant of common stock returns of banks [Fama and
Schwert (1977), Lynge and Zumwalt (1980), Christie (1981), Flannery and James (1984), Booth
and Officer (1985)], others have found the returns to be insensitive [Chance and Lane, (1980)] or
only marginally explained by the interest rate factor [Lloyd and Shick (1977)]. A review of the
early literature can be found in Unal and Kane (1988). Sweeney and Warga (1986) used the
APT framework and concluded that the interest rate risk premium exists but varies over time.
Flannery, Hameed and Harjes (1997) tested a two-factor model for a broad class of security
returns and found the effect of interest rate risk on security returns to be rather weak. Bae (1990)
examined the interest rate sensitivity of depository and nondepository firms using three different
maturity interest rate indices. His results indicate that depository institutions’ stocks are sensitive
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to actual and unexpected interest rate changes, and the sensitivity increases for longer-maturity
interest rate variables. Song (1994) examined the two-factor model using time-varying betas. His
results show that both market beta and interest rate beta varied over the period 1977-87.
Yourougou (1990) found the interest rate risk to be high during a period of great interest rate
volatility (post-October 1979) but low during a period of stable interest rates (pre-October 1979).
Choi, Elyasiani and Kopecky (1992) tested a three-factor model of bank stock returns using
market, interest and exchange rate variables. Their findings about interest rate risk are consistent
with the observations of Yourougou (1990).
The issue of interest rate sensitivity remains empirically unresolved. Most of the studies
use a variety of short-term and long-term bond returns as the interest rate factor without
providing any rationale for their use. The choice of bond market index seems to affect the pricing
of the interest rate risk. Yet, there is no consensus on the choice of the interest rate factor that
should be used in testing the two-factor model. In this paper, we provide a plausible explanation
of why pricing of interest rate risk differs with the choice of interest rate variable. We also
suggest a hybrid return-generating model for bank stock returns in which the CAPM is
augmented by three APT-type factors to account for unexpected changes in the inflation
premium, the maturity-risk premium and the default-risk premium. The use of three additional
factors provides a better understanding of the interest rate sensitivity and offers a plausible
explanation for the time varying interest rate risk observed by other investigators. Our empirical
investigation covers three distinction economic and bank regulatory environments: 1974-78, a
period of increasing but only moderately volatile interest rates in a highly regulated banking
environment; (2) 1979-84, a period characterized by high level of interest rates with high
volatility, in which there was gradual deregulation of the banking industry and; and (3) 1985-90,
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a low interest rate and low-volatility period during which many regulatory changes were made in
response to enormous bank loan losses and bankruptcies. The results of the multi-factor asset-
pricing model are compared with those from the two-factor model in order to explain the time
varying interest rate risk.
The rest of this paper is divided into five sections. In Section II, we describe the two-
factor model of the bank stock return and the pricing of the interest rate risk. The multi risk-
premia model and the specification of the factors are discussed in Section III. The data for this
analysis is described in Section IV. Section V presents empirical results and Section VI
concludes the paper.
III. Two-Factor Asset Pricing Model
A. The Model
Stone (1974) proposed the following two-factor bank stock return generating model:
Rjt = αj + β1jRmt + β2jRIt + εjt (1)
where Rjt is the bank common stock return, Rmt is the market return, and RIt is the innovation in
the interest rate variable.1 Coefficients αj and β1j are analogous to the alpha and beta coefficients
of the market model, and β2j represents interest rate risk. Since then, numerous researchers have
studied the pricing of interest rate risk with varying results. While Stone (1974) and others did
not place an a priori restriction on the sign of β2j, the nominal contracting hypothesis implies that
it should be positive. This is because the maturity of bank assets is typically longer than that of
liabilities.2 Support for this hypothesis was found by Flannery and James (1984) but not by
1
Srivastava, Hamid and Choudhury (1999) present alternate ways of specifying the innovations in the
interest rate variable and its influence on the pricing of the interest rate risk. In our investigation, the error
term from the regression of interest rates on market returns is used as the orthogonal interest rate factor.
2
The sign of β2j is negative when changes in bond yields and not the bond market return are used as the
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French, Ruback and Schwert (1983).
B. Pricing of Interest Rate Risk
In addition to changes in the level of expected or unexpected inflation, changes in other
economic conditions produce effects on interest rate risk. For example, according to the
intertemporal model of the capital market [Merton (1973), Cox, Ingersoll, and Ross (1985)], a
change in interest rates alters the future investment opportunity set; as a result, investors require
additional compensation for bearing the risk of such changes. Similarly, changes in the
investor's degree of risk aversion, default risk or maturity risk of bank financial assets causes
additional shifts in the future investment opportunities for the bank stockholders. The specific
choice of the bond market index for the two-factor model determines what unexpected change is
captured by the coefficient β2j.
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