Is There a Too‐Big‐to‐Fail Discount in Excess Returns on German Banks’ Stocks?

• Author: Thomas Nitschka
• Published date: 01 December 2016
• Date: 01 December 2016
• DOI: http://doi.org/10.1111/infi.12097

Is There a Too-Big-to-Fail

Discount in Excess Returns on

German Banks’Stocks?

Thomas Nitschka

Senior Economist, Monetary Policy Analysis, Swiss National Bank,

Zurich, Switzerland.

Abstract

Since the global financial crisis, German and other European banks’stocks

have underperformed compared with the overall euro-area stock market. Does

this observation reflect the explicit state guarantee for too-big-to-fail (TBTF)

banks? In that case, investors have an incentive to hold stocks of systemically

important banks because they provide insurance against disaster risk through

the state guarantee. Indeed, recent studies reveal a TBTF discount in large US

banks’stock returns. Does this finding pertain to German (representing

continental European) banks too? The main results of this paper suggest that

it does. Risk-adjusted returns on a German bank stock index were negative in

the period from 1973 to 2014. The key driver of this finding is an unantici-

pated, adverse shock to the German banking sector at the beginning of the

global financial crisis. This shock increased the probability of a bank default

and thus the insurance value of government support.

I. Introduction

Financial institutions that are considered to be ‘too big’or ‘to o systemically

important’to fail enjoy lower funding costs tha n suggested by measures of th eir

International Finance 19:3, 2016: pp. 292–310

DOI: 10.1111/infi.12097

© 2016 John Wiley & Sons Ltd

credit and default risks . This stylized f act is the consequ ence of implicit or explici t

government guarantees (Rime 2005, Tsesmelidakis and Merton 2012, Ueda and

Weder di Mauro 2013, International Monetary Fund 2014). Creditors assume that

governments will support bi g, systemically imp ortant financial institutions if they

come under existential threat.

Recent US evid ence (Gand hi and Lust ig 2015) even s uggests th at the too-bi g-

to-fail(TBTF)statusofbigbanksisnotonlyvisibleincomparativelylow-

funding costs but is also reflected i n abnorma lly low ret urns on th eir stock s.

There is a siz e premium in retu rns on stock s of US commerc ial banks . Large

banks’stocks offer lowe r returns th an suggest ed by their ex posures to sta ndard

risk factors. This finding does not apply to stocks of small commercial banks.

Gandhi and Lustig (2015) rationalize this bank size effect in a disaster risk

model. Inves tors accept l ow average retu rns on big banks’stocks because they

provide insurance against an economic disaster. The insurance value of big

banks’stocks is relate d to government sub sidies. Sm all banks d o not enjoy such

a subsidy.

Do we observe su ch a TBTF discou nt in stock retu rns of other econom ies’

banks? This is a vital question for asset managers and po licy makers because t he

presence of a TBTF discount might i nduce investors to hold such stocks . Stocks of

TBTF banks offer i nsurance valu e against econ omic disasters b ecause of the

government guarantee. Moreover, a TBTF discount in returns on bank s’stocks

suggests that banks’costs of equ ity are lower than commonly t hought. The costs-

of-equity calculation typically assumes that the Sharpe (1964) and Lintner (1965)

capital asset pricing model (CAPM) is an adequate description of a firm’sstock

returns. In this model, the estimated cost of equity is the stock return’ssensitivity

to the CAPM market return multipl ied by the market return. Th is calculation doe s

not consider the risk-a djusted return or assumes th at it is indistin guishable from

zero.

Answers to the question of wh ether low returns on ban ks’stocks reflect a TBTF

discount are particul arly important for poli cy makers in the euro area, wh ere in

recent years various polic y measures have been introdu ced to foster the provisi on of

bank credit to the real economy. Despite these measures, ban ks in the euro area still

face multiple headwi nds to improve their resilience aga inst adverse shocks (Euro-

pean Central Bank 2015). The performance of bank stocks in the euro area seems to

reflect these h eadwinds. As il lustrated in Figu re 1, stocks of euro-a rea banks have

underperformed in comp arison to the overall euro-area stoc k market since the

global financial crisis.

However, publicly listed banks in the euro area are t ypically big. D o the price

dynamics of banks’stocks then reflect a TBTF dis count for large financial institu-

tions rather than, for example dim profitability prospe cts? The polic y implications of

the two explanat ions for the dynam ics of banks’stock returns are fundamentally

different. If a TBTF discount ration alizes the comparatively l ow returns on banking-

TBTF Discount in Excess Returns on German Banks’Stocks? 293

© 2016 John Wiley & Sons Ltd