Are The European Banks Riskier Than The Us

Published Date: 02 Nov 2017

Abstract

The purpose of this paper is to discuss who made riskier decision during 2002 to 2007, the European bank or the US bank. We find that on the former literature, they mainly discuss the risk measurement in general or in one specific economy such as US bank during financial movement. In this paper we dedicated on comparing the risk-taking level of European and US banks base on the former literature risk measurement theory with the empirical data. With comparison on liquidity level, conserve level reliance on fee-based activity we conclude that during 2002 to 2007, European banks are riskier than US banks.

Introduction

As we all know the financial crisis exploded at 2007 had already triggered a tremendous negative chain effect in the Europe financial system and the US as well. Researches about the banks behavior during incubation period of the crisis will benefit the banks on risk management in the future. The aim of this paper is to compare the risk-taking of the banks in US and Europe by assessing the risks individually. Using the bank data from 2002 to 2007, we start by analyzing the variables on the balance sheet referring to different risks that the banks are taking. For example, define "Z-score"= (100+average ROE)/SDROE, which indicates the probability of failure of a bank (Laetitia Lepetit et al 2008). With such method we can compare the risk level between US and Europe and conclude from the empirical analyze that either one is riskier.

The remainder of the paper is presented as follows. Section 2 shows a review of the former literature on bank risk-taking and risk measurement. Section 3 presents the methodology we will use in assessing the banks’ risk level and section 4 shows the results and discussion. Section 5 concludes.

Literature review

Concerns regarding to the stability of the financial system and the bank risk management is increasing recently, especially after the financial crisis. Most of the existing literature is dedicated to manage or assess the risks in general, and mainly focus on one economy specifically instead of comparison. For instance, David H. Pyle (1997) put forward a theory on bank risk management which discusses the importance of dealing risks especially about market and credit risks. The outlines of the theory offer the framework of contemporary bank risk management. Acharya et al (2010), who present a simple systematic risk model and show us that each financial institution’s contribution to systematic risk can be measured as its systematic expected shortfall, also called SES. Francisco González (2005) uses a panel database of 251 banks in 36 countries to analyze the impact of bank regulation on bank charter value and risk-taking. He suggests that banks will increase their incentives to follow risky policies in countries with stricter regulation. Unlike his research, in this paper the comparison of bank risk between European and the US through variables on the banks’ balance sheet instead of the different policies. This paper is going to extend the earlier research on bank risk measurement into empirical analyze and comparison, using the definition method of variables in Laetitia Lepetit (2008) ‘s paper.

Methodology

Definition of variables and preliminary statistics

The compute is based on the data on the balance sheet, to make our calculation and statement clearly, definitions of the variables are necessary. Due to the main purpose of the paper is comparing the risk taking between European bank and US bank, so we will estimate with country specific variables. According to Laetitia Lepetit et al (2008) and Yener Altunbas et al (2007), we here use the similar measurement method. First, we define some basic measures of risk: standard deviation of the return on average assets as SDROA; standard deviation of the return on average equity as SDROE. Second, we consider the ratio of loan loss provisions to net loans, LLP. The ratio of equity to total assets (ETA) represents capital, and the cost to income ratio (COIRC) indicates the bank efficiency. Liquid asset to total assets ratio (LAOAC) has a positive influence on the liquidity of the bank, as well as the bank efficient. DeYoung and Roland (2001) and in Stiroh (2004) suggests us to distinguish two components of non-interest income: fee and commission income and trading income, hence we define COM as a ratio of net fee and commission income to net operating income to measure the reliance on the non-interest income of the bank. In computing insolvency risk, we define ADZ=(100+average ROE)/SDROE implying the probability of failure and ADZP=ADZP1+ADZP2=(average ROA)/SDROA+ average(Total equities/Total assets )/SDROA, which ADZP1 and ADZP2 measures bank portfolio risk and leverage risk, respectively.

Data

The balance sheet is consist of the data from European and US banks, while we can see there are some information missing in this sheet. After eliminating 3523 missing information, remains 14982 valid data for our calculations. Because of the limitation of the paper, we won’t show the calculation of every variable, instead, presenting the results directly in table 1.

Table

COIRC

LLP

LAOAC

COM

ADZ

ADZP1

ADZP2

EU

bank

Mean

69.325

0.9629

0.1658

0.5730

2.1754

0.2097

3.5046

Stdev

27.099

13.980

0.1908

0.5951

US

bank

Mean

63.066

0.3533

0.0681

0.2922

3.1345

0.3509

3.4818

Stdev

23.378

3.2501

0.115449

0.5079

Result and discussion

As we can see from table 1, during 2002 to 2007, European bank had higher liquid assets to total assets (LAOAC) which referring to the liquidity of the bank. And EU bank also has higher reserve level which can be inferred from higher loan loss provision to net loans ratio (LLP). Yener Altunbas et al (2007) suggests in their research that there is a positive relationship between capital level and liquidity level during commercial banks and saving banks, which will result in high reserve level. While inversely it has opposite impact on the cooperate banks. Also, more efficient banks are riskier, and the cost to income ratio (COIRC) of European banks takes a higher level of US banks. Laetitia Lepetit et al (2008) illustrate that greater reliance on fee-based activities is associated with higher risk and higher default risk. Net fee and commission income to net operating income (COM) just reflects that European banks are more characterized by fee-based activities. Hence we can infer that European banks are riskier than US banks. Whereas, the ADZ indicates the probability of failure of a bank and the portfolio risk (ADZP1) both reveal that US bank is riskier in insolvency risk measurement. The leverage risk between US and EU banks are almost at the same level. The result is inconsistent with the former inference.

Due to the limitation of the paper size, we are unable to measure the risk between two big economies with bank specific variables, moreover, we neither analyze the different risks between different types of banks. As aforementioned, different bank might have different impacts, so that we work out the result based on the majority type of the banks are commercial and saving. In addition, on the estimation the insolvency risk, we are supposed to check for robustness, which will need the weekly returns. Considering the defective database, the result is possible deviate to the general conclusion.

Conclusion

Based on the balance sheet of the banks in Europe and America during 2002-2007, we compare the risk level by measuring the risk, which illustrates that European banks are riskier than US banks. They had higher level of liquidity and loan-loss provision, as well as the greater reliance on fee-based activities. While our estimation also has some flaws, we can have a more accurate assessment with more sufficient database.