Are bank stocks sensitive to risk management?

Abstract

Purpose - This paper attempts to summarize the information contained in bank financial statements on the risk management capabilities of banks and then ascertains the sensitivity of bank stocks to risk management. Design/methodology/approach - The theoretical framework is derived from a bank's accounting identities. The paper interprets the selected accounting ratios as risk management variables and attempts to gauge the overall risk management capability of banks by summarizing these accounting ratios as scores through the application of multivariate statistical techniques. Finally, the paper analyzes the impact of these risk management scores on stock returns through regression analysis. Findings - The results based on data for Indian banks reveal that banks' risk management capabilities have been improving over time except for in the last two years. Returns on the banks' stocks appear to be sensitive to risk management capability of banks. Practical implications - The results suggest that banks that want to enhance shareholder wealth have to focus on successfully managing various underlying risks. The findings have implications for investors who may benefit by going long on shares of banks that are better risk managers. The findings are useful for the regulator in developing quantitative indicators of soundness of the banking system. Originality/value - First, this study suggests a novel way of looking at bank financial statements, i.e. from the risk management perspective. Second, the study develops summary scores of risk management capabilities of banks. Third, risk management is shown to be an important determinant of stock returns of banks.