Impact of interest rate risk on the Spanish banking sector 7Concerning the impact of interest rate changes,θiis always negative and statis-
tically significant when long-term rates are used. Long-term rates exert the strongest
influence on bank stock portfolio returns, consistent with previous research (see,
e.g., [3, 5, 6]).
The IRR of the Spanish banking industry also seems to be directly related to
bank size. This finding may be attributed to three factors. First, the aggressive pricing
policies – especially on the asset side – introduced by larger banks over recent years
aimed to increase their market share in an environment of a sharp downward trend
of interest rates and intense competition have led to an extraordinary increase of
adjustable-rate products tied to interbank market rates. Second, the more extensive
engagement of large banks in derivative positions. Third, large banks may have an
incentive to assume higher risks induced by a moral hazard problem associated to their
too big to failstatus. As a result, the revenues and stock performance of bigger banks
are now much more affected by market conditions. In contrast, more conservative
pricing strategies of small banks, together with a minor use of derivatives and a
heavier weight of idiosyncratic factors (e.g., rumours of mergers and acquisitions),
can justify their lower exposure to IRR.
To provide greater insight into the relative importance of both market risk and IRR
for explaining the variability of bank portfolio returns, a complementary analysis has
been performed. A two-factor model as in [18] is the starting point:
Rit=ωi+λiRmt+θiIt+it (4)Since both explanatory variables are linearly independent by construction, the vari-
ance of the return of each bank stock portfolio,Var(Rit), can be written as:
Var(Rit)=λˆ^2 iVar(Rmt)+θˆi^2 Var(It)+Var(it) (5)To compare both risk factors, equation (5) has been divided byVar(Rit). Thus, the
contribution of each individual factor can be computed as the ratio of its variance over
the total variance of the bank portfolio return. As shown in Table 4, the market risk is
indisputably the most important determinant of bank returns. IRR is comparatively
less relevant, long-term rates being the ones which show greater incidence.
Ta b le 4 .Relative importance of risk factorsInterest rate changes3 months 10 years Spread
It Rmt To ta l It Rmt To ta l It Rmt To ta l
Portfolio L R^2 (%) 0.85 53.84 54.69 2.81 51.77 54.58 1.22 53.47 54.69
Portfolio M R^2 (%) 1.30 34.21 35.52 2.74 32.78 35.52 1.19 34.83 36.02
Portfolio S R^2 (%) 1.24 15.19 16.42 5.59 12.40 17.99 1.08 15.35 16.43This table shows the contribution of interest rate and market risks, measured through the factor
R^2 obtained from equation (5) in explaining the total variance of bank portfolio returns.