FEDERAL RESERVE MEMBERSHIP TRANSITION AND THE IMPACT UPON BANK SYSTEMATIC RISK

The purpose of this dissertation is to examine the impact upon bank value of the decision to leave the Federal Reserve System and to develop alternative methods for the estimation of systematic risk in the abscence of actively traded market shares. It is hypothesized that the decision to leave the system will result not only in an increase in earnings, but will also result in an increase in the bank's systematic risk. A capital markets based valuation model allows examination of both the earnings and risk impacts upon the bank.; While enactment of the Depository Institutions Deregulation and Monetary Control Act of 1980 significantly reduced the advantages of existing outside of the System, a study of this type remains of interest at three levels: (1) from a historical perspective; (2) is nonmembership a valuable status to be retained as long as the new law allows; (3) has there been a significant cost to the banking system of the new legislation?; In the context of the study, it is proven that the decision to leave the Federal Reserve will result in a decrease in a bank's cash reserve holdings and an increase in the holdings of risky assets, specifically commercial loans. While this increase in risky assets increases earnings, it also introduces additional variance into the bank's earning asset portfolio. It is then shown, theoretically, that increasing the variance of a bank's earnings should result in an increase in the bank's market determined systematic risk. The interpretation by the market of this increased earnings variance is the subject of the dissertations empirical tests.; The market for the securities of small and medium size commercial banks is "thin" at best, making conventional methods of systematic risk estimation impossible. This study develops two alternative methods, one multivariate based and the second, regression based, for the approximation of market risk in the absence of active trading.; The multivariate methodology, Multiple Discriminant Analysis, is used to identify structural variables that indicate differing levels of systematic risk amongst banks. The results show that larger holdings of risky assets, high earnings variance, and low capital-asset ratios are characteristics of institutions with high degrees of market risk.; The regression procedure is aimed at developing an accounting based proxy for market risk. Prior literature has proven that a relationship exists between the growth in a firm's earnings and the firm's market risk parameter. In this study appropriate statistical tests were conducted to determine if the earnings growth-market risk relationship exists in commercial banking. The regression analysis shows that a risk estimate based upon growth in operating earnings before taxes was a very good proxy for the market based risk estimate, beta. These results allow the use of the operating earnings based beta for the empirical tests in the final segment of the study.; The final segment of the study partitions the effects upon bank valuation into a profitability component and a risk component. By isolating the risk component of the model it was possible to test for shifts in a bank's beta coefficient due to Federal Reserve membership transition.; The results of the tests show that a commercial bank does become riskier as it moves away from the Federal Reserve. In some cases, the increase in value due to the increase in earnings is completely offset by the increase in the bank's cost of capital. This is a strict violation of the wealth maximizing constraint under which all banking firms should operate. In many instances the financial institution would have been better off, from the valuation standpoint, if they had remained members and operated on a lower segment of the risk-return line.