Empirical Essays on the Stock Returns, Risk Management, and Liquidity Creation of Banks

This thesis consists of three studies that respectively investigate the stock returns, risk management, and liquidity creation of banks. Chapter 2 focuses on the cross-section of bank stock returns and found that pricing factors such as leverage and beta, shown to be irrelevant to nonfinancial stocks, are important for pricing bank stocks. During the two decades prior to the subprime crisis, banks with high leverage have high stock returns. Beta appears to have a strong and convex relationship with bank stock returns. This chapter generally suggests that bank stocks seem to respond to a different set of pricing factors than other industries. Chapter 3 examines the drivers behind banks’ use of derivatives for hedging. Covering virtually all banks in the U.S. that have used derivative, one key finding of this chapter is that off-balance sheet loan commitment contracts, rather than on-balance sheet loans, determines the use of derivatives for hedging. Since loan commitment contracts are the primary channel of financing for commercial and industrial borrowers, this finding is consistent with the observation during the subprime crisis that the illiquidity of the financial market makes it difficult for firms to refinance their existing loans. Finally the last chapter of this thesis examines the liquidity creation of European banks and its relationship with bank equity capital, market power, and institutional context. Using a unique and comprehensive sample of European banks, this chapter shows that the impact of stronger capital base on bank liquidity creation is strictly negative. This means that capital regulations such as the Basel II Accord are likely to curtail banking activities and slow down economic recovery and growth. Next, this chapter shows that stronger creditor rights coupled with stronger market power reduces liquidity creation in developing countries, and vice versa for developed countries. This finding suggests that due to the less developed legal infrastructure, stronger creditor rights could be counterproductive in facilitating bank liquidity creation in developing countries.

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