CFA Institute Journal Review summarizes "Are the Largest Banks Valued More Highly?," by Bernadette A. Minton, René M. Stulz, and Alvaro G. Taboada, published in The Review of Financial Studies, December 2019.
The value of too-big-to-fail (TBTF) banks is shown to be negatively related to asset size, especially in normal times. Breaching the TBTF threshold by acquisition is costly to shareholders. This relationship is partially explained by the market’s discounting of a bank’s trading activities.
What Is the Investment Issue?
A significant legacy of the 2008–09 global financial crisis (GFC) is more stringent banking regulation, generating an ongoing policy debate in the United States about the effects of such key rules as Dodd–Frank (DF) on industry structure and performance. Offering a systematic assessment of the extended period spanning the antecedents of and aftereffects from the GFC, the authors concentrate on large US banks.
Their research aim is to determine if enhanced DF supervision provides its intended regulatory target any valuation benefit, with increased size conferring a TBTF subsidy via strengthened safety net access to public resources. Further probing the implications of size, the authors also assess whether this safety net incentivizes banks to become riskier or to increase leverage as they exceed DF thresholds. Finally, in explaining their research results, the authors describe salient distinctions between large and small banks in terms of their operations, financial profiles, and stock returns.
How Did the Authors Conduct This Research?
The study examines a sample from the Federal Reserve’s comprehensive 1986–2017 annual financial and stock price data for all large US publicly traded bank holding companies. The analysis focuses on banks with assets above US$10 billion in 2010 dollars and a deposits-to-assets ratio of at least 10%, representing 80% of total banking system assets as of 2017. The TBTF subset of the largest institutions has a lower bound of US$50 billion in total asset book value in 2010 dollars.
The authors assess valuation effects using Tobin’s q and market-to-book (MB). They infer riskiness and probability of distress from a bank’s Z-score and measure the systematic risks of banks through a market model beta. Return on assets (ROA) and return on equity (ROE) indicate operational performance. The authors use statistical methods, including piecewise linear models and non-parametric tests, to explore bank valuation and size in the cross-section, paying special attention to the pre-GFC period to identify potential origins of TBTF effects.
What Are the Findings and Implications for Investors and Investment Professionals?
The authors find no evidence that large banks are valued more highly or that these banks’ valuations increase with size. Although large bank valuations are found to be negatively related to size over the entire 1987–2017 period (most significantly through 2010), during the DF era, the relation weakens in the cross-section and disappears for within-bank increases in size. The Tobin’s q and MB metrics do not show large banks are valued similarly to other banks except for a premium resulting from a TBTF guarantee. But the authors acknowledge the possibility that banks could be valued even lower without TBTF.
Among their secondary findings, the authors reject the hypothesis that risk overall increases proportionately with bank size, although they do find that equity volatility and tail risk increase with size among small banks. Using a bank Z-score as a proxy for distress probability, the authors show distress risk decreases for large banks. Although leverage is unrelated to size for small banks, it increases with size for large banks. However, the systematic risk of banks, implied by the market model beta, increases with bank size for both small and large banks.
In explaining the inverse bank value-to-size relationship, the authors reject the notion that the relation is attributable to a decline in operational performance (ROA or ROE), stock returns, or the non-interest income share of profits. Rather, it is large banks’ sizable share of trading assets that is shown to be a negative factor for valuation ratios, together with activities outside the purview of small banks but that generally lead to less equity value.