Bank risks and the business cycle

This paper investigates the return/risk behavior of European banks in the economic downturn of 2000-2003 in order to investigate the sources of bank resilience during the economic slowdown. We identify banks with different strategies and different characteristics before the slowdown and investigate their risk profile before and during the downturn with market-based measures such as the Q-ratio, the Sharpe ratio and the betas for relevant risk exposures. We find that bank returns and risks differ across countries and institutional types. Diversified banks were hit harder than their specialized peers. Banks with a focus on local lending and banks with relatively high interest margins seem to have benefited from that focus. Banks with higher levels of capital are not only viewed by the stock market as less risky, they also produce superior returns during a downturn. This underscores the importance of Basle-type capital adequacy rules for the systemic stability of the banking system. Finally, we find that neither size nor hedging offer a structural protection against adverse economic conditions.