Banks’ Risk Endogenous to Strategic Management Choices

Abstract

Use of variability of profits and other accounting-based ratios in order to estimate a firm's risk of insolvency is a well-established concept in management and economics. This paper argues that these measures fail to approximate the true level of risk accurately because managers consider other strategic choices and goals when making risky decisions. Instead, we propose an econometric model that incorporates current and past strategic choices to estimate risk from the profit function. Specifically, we extend the well-established multiplicative error model to allow for the endogeneity of the uncertainty component. We demonstrate the power of the model using a large sample of U.S. banks, and show that our estimates predict the accelerated bank risk that led to the subprime crisis in 2007. Our measure of risk also predicts the probability of bank default both in the period of the default, but also well in advance of this default and before conventional measures of bank risk.2

Endogenous bank risk and efficiency

“…Our work is also related to a strand of finance literature suggesting that any measurement of risk should consider its endogeneity (Danielsson and Shin, 2003;Brunnermeir and Sannikov, 2014;Delis et al, 2015). This literature stresses that the consideration of risk as exogenous within any market or industry and across different measures (e.g., from simple accounting ratios, the net present value calculated by the discounted cash flow method or economic value added, and/or value-at-risk models) produces erroneous estimates and inferences.…”

“…In 5, the difference between Π and Π* represents the deviation of the actual from expected profits ε of firms, where ε is distributed as ). 2 Using the implications of standard finance and management theory (e.g., Delis et al, 2015; and references therein), we define…”

Measuring the Behavioural Component of the S&P 500 and its Relationship to Financial Stress and Aggregated Earnings Surprises

“…We also show that our estimated behavioural component accounts for a substantial portion of the unexplained variability of market returns, even after controlling for a large number of standard financial and economic controls. In this respect, our paper is related to the management literature that focuses on the decision‐making process by considering the impact of risk, risk perception (Mitchell, ) and (more recently) behavioural factors in organizations (Delgado‐García, De La Fuente‐Sabaté and De Quevedo‐Puente, ; Delis, Hasan and Tsionas, ; Zona, ).…”

“…Delgado‐García, De La Fuente‐Sabaté and De Quevedo‐Puente () focus on the influence of emotions on strategic choices made by bank managers, showing that subjective (negative) affective traits are associated with lower propensity towards risk. Delis, Hasan and Tsionas () propose a measure of risk which includes current and past strategic choices of managers and predicts the large increase in banks' risk in 2007 that led to the sub‐prime crisis. The authors extend the multiplicative error model introduced by Engle and Russell (), allowing the variance to be an endogenous variable from the bank's profit function.…”

“…Our study contributes to the flourishing literature in management analysing the effects of risk and behavioural elements on corporate performance. On the one hand, as in Delis, Hasan and Tsionas (), our sentiment indicator is an endogenous variable that is intimately related to the market evolution. On the other hand, although based on a different methodological and empirical approach, our conclusions are consistent with those reported by Zona ().…”