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Can the Book-to-Market Ratio Signal Banks’ Earnings and Default Risk? Evidence Around the Great Recession

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Abstract

We examine the association between the book-to-market (B/M) ratio and the subsequent earnings and default risk of US banks in the period around the Great Recession. We find that banks with higher B/M ratios have consistently lower future earnings and greater earnings volatility. In addition, these banks have higher loan delinquency, more charge-offs, and lower Z-scores. We show that the B/M ratio signals information about a bank’s earnings and default risk about four to nine quarters before actual poor performance. Thus, the results show that the B/M ratio can provide advance signals for market monitoring of banks.

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Notes

  1. While only a relatively small number of banking firms are publicly traded, these firms constitute more than 70% of banking assets.

  2. Charter value is typically proxied by Tobin’s-Q or market-to-book (M/B) ratio (Keeley 1990), which is the inverse of B/M ratio. Besides competition (Keeley 1990), sources of charter value could include barriers to entry, favorable economic conditions, proportion of core deposits, non-interest income, and improved efficiency. However, charter value is not derived from an increase in option value of deposit insurance for too-big-to-fail banks (Furlong and Kwan 2006).

  3. Boyd and De Nicolo (2005) do not suggest that low competition drives banks to increase risk-taking. Rather they suggest banks’ asset-side risks, which need to be monitored by regulators, increases through a different channel.

  4. For example, banks that concentrate in speculative commercial real estate or subprime lending are likely to provide higher returns during periods of real estate inflation regardless of the inherent riskiness of such activities.

  5. Our primary goal is to ascertain the monitoring ability of the B/M ratio for realized performance measures, all of which are accounting based. Our overall default risk measure, the Z-score, is also based on banks’ key financial measures, such as earnings and capital, and is a proxy for distance-to-default.

  6. Please see Flannery and Nikolova (2004) for a review of this literature.

  7. BOPEC is the supervisory rating of bank holding companies, and CAMELS is the supervisory rating of banks.

  8. In addition, Barber and Lyon (1997) also rule out that survivorship bias, data-snooping (Black 1993; MacKinlay 1995), and selection bias (Kothari et al. 1995) affect their results.

  9. They use a switching regression model to examine how book and market values diverge. They show that the on-balance sheet and off-balance sheet values have offsetting signs for interest and market risks.

  10. The bank charter value literature focuses on the M/B ratio. In this paper, we adopt the inverse of M/B ratio, which is the focus of the asset-pricing literature investigating the B/M effect. We acknowledge that one concern with using the B/M ratio is that as the market value (M) becomes exceedingly small, the B/M could potentially explode towards infinity. We confirm that our conclusions are the same if the M/B ratio is used instead of the B/M ratio.

  11. For example, Black et al. (2016) find capital constrained banks are less likely to issue capital particularly during a crisis, but banks with better financial and trading characteristics still do so. Li et al. (2016) show that new capital issuance for regulated firms such as banks provide positive information to the markets and that the effects are more pronounced after the passage of Dodd-Frank Act, 2010. Khan and Vyas (2015) find SEOs are more actively pursued by banks that participated in the Capital Purchase Program (CPP), primarily to bring the banks out of the constraints imposed by the CPP.

  12. The FR Y-9C reporting requirements are limited to banks with assets of at least $500 million following the first quarter of 2006, prior to which the threshold was $150 million. For consistency, our sample includes BHCs with assets of $500 million for the entire sample period of 2003–2014.

  13. We also consider core deposits to total liabilities, instead of total deposits in the denominator. Our conclusions do not change. We prefer core deposits to total deposits because it does not include subordinated bonds, which is a Tier 2 capital security.

  14. In unreported tests, we replace ROA with Pre-provision Net Revenue (PPNR) ratio, which is commonly used by regulators (including in DFAST and CCAR stress tests), to gauge bank profitability not adjusted by provisioning and taxes. We find similar results.

  15. We calculate this using the standard deviation of the B/M ratio, which is 0.86. For ROA, 0.86*0.285 = 0.0.245 and 0.245/1.02 = 24%. For Std. (ROA), 0.86*.0.218 = 0.187 and 0.187/1.04 = 18%.

  16. We conduct tests by replacing Z-score with the Merton’s distance to default (DD) measure. Z-score is an accounting based default measure and DD is a market price based default measure. We do not report the results using DD, Results using DD as the measure of default risk lead to same conclusions. Results are available on request.

  17. Previous papers have estimated Z-score models for banks in a variety of ways with some including capital ratio and profitability measures on the RHS and others excluding such measures. See for example, Pathan (2009), Laeven and Levine (2009), Mercieca et al. (2007), and Uhde and Heimeshoff (2009).

  18. These estimates are derived as follows: 0.5505 = 0.86 × 0.645, 0.2838 = 0.86 × 0.33, and 0.2778 = 0.86 × 0.323.

  19. The models for ROA and Std. ROA are analogous to the specifications in columns 3 and 6 of Table 3 but with different lags for the B/M ratio and controls. Similarly, the models for the NPL ratio, charge-off ratio, and the Z-score are analogous to the specifications in columns 3, 6, and 9 of Table 4 with the varying lags.

  20. An alternative would be looking at the more broadly defined crisis period of 2007–2009 and considering whether the pre-crisis (i.e., 2006 Q4) B/M ratio rank-orders risk during the crisis period. However, Table 6 documents that B/M’s loses its information value over time and the long crisis period of 2007–2009 (i.e., 12 quarters) leads to such a test being less useful especially since several of the risk indicators are lagged indicators that peak in terms of risk in 2009 (or even later). In unreported tests, we find weaker results using a full-crisis period cross-sectional test.

  21. We also consider the possibility that a high B/M ratio could be the result of cumulative negative returns beyond one quarter. We replace the prior quarter returns with one-year and two-year prior cumulative returns respectively. Our results are qualitatively similar. We also consider whether book equity or market equity is relatively constant across banks by calculating the within bank variation in both. These tests also show that changes in both the book and market equity drive changes in the B/M ratio. The information in the B/M ratio is not a function of stock prices alone but is also a function of the banks’ decisions on their capital structures. Figure 1’s panels F-H also show similar results. Market equity / total assets is higher relative to book-equity / total assets initially but reverses post-crisis. These results are available on request.

  22. We also include a Merton’s distance to default (DD) measure in addition to equity returns, share turnover, and return volatility as controls. We still find that the B/M ratio provides incremental advance information for all the performance variables. Our DD variable is highly correlated with equity volatility so we do not report it in Table 8, but results are available on request.

  23. Prior to January 2015, there were three PCA thresholds (a new CET1 measure was added and the T1 well-capitalized level was changed in 2015). Since our analysis ends in 2014q4, we use the old PCA well-capitalized thresholds of 10%, 6%, and 5% for total risk-based capital ratio, T1 risk-based capital ratio, and T1 leverage ratio respectively.

  24. In the first two columns, where we use PCA-Breach as a dummy indicator, we use a linear probability model as the logit procedure with bank fixed effects leads to the dropping of observations. In unreported tests, we find that the logit procedure leads to similar results.

  25. We further test whether the B/M ratio’s association with PCA measures differs over the economic cycle and how far ahead of time the B/M ratio is associated with subsequent PCA measures. The results are similar to that for earnings and other default risk measures. Results are available on request.

  26. https://www.americanbanker.com/opinion/clocks-running-out-to-fix-prompt-corrective-action

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Authors and Affiliations

  1. College of Business Administration, Department of Finance, The University of Akron, 259 South Broadway Street, Akron, OH, 44325, USA

    Bhanu Balasubramnian

  2. Policy Analysis Division, Office of the Comptroller of the Currency, 400 7th Street SW, Washington, DC, 20024, USA

    Ajay A. Palvia

  3. Complex Financial Institutions, Federal Deposit Insurance Corporation, 1750 New York Ave., NW, Washington, DC, 20024, USA

    Dilip K. Patro

Authors
  1. Bhanu Balasubramnian
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  2. Ajay A. Palvia
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  3. Dilip K. Patro
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Correspondence to Ajay A. Palvia.

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The opinions expressed in this paper reflect the views of the authors only and do not reflect the views of the Office of the Comptroller of Currency, the Department of Treasury, or the Federal Deposit Insurance Corporation (FDIC). We thank Doug Robertson, James Thomson, David Malmquist, FMA 2015 conference participants, FDIC seminar participants, and an anonymous referee for many helpful suggestions.

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Balasubramnian, B., Palvia, A.A. & Patro, D.K. Can the Book-to-Market Ratio Signal Banks’ Earnings and Default Risk? Evidence Around the Great Recession. J Financ Serv Res 56, 119–143 (2019). https://doi.org/10.1007/s10693-018-0299-4

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