Market Evidence on the Effective Maturity of Bank Assets and Liabilities
Author(s): Mark J. Flannery and Christopher M. James
Source: Journal of Money, Credit and Banking , Nov., 1984, Vol. 16, No. 4, Part 1 (Nov.,
1984), pp. 435-445
Published by: Ohio State University Press
Stable URL: https://www.jstor.org/stable/1992182
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MARK J. FLANNERY
CHRISTOPHER M. JAMES
Market Evidence on the Effective Maturity
of Bank Assets and Liabilities
THE RECENT YEARS' increase in interest rate volatility has
intensified concern over the exposure of commercial banks to interest rate or
"funding" risk. Since the effect of interest rate changes on the equity value of a bank
depends on the maturity or duration of the bank's assets and liabilities, assessing an
individual bank's interest rate risk exposure requires information about the maturity
composition of its portfolio. It is difficult, however, to assess a bank's risk exposure
from balance sheet data because several important asset and liability items have
theoretically ambiguous effective maturities. In a frictionless market, a security's
effective maturity will equal its stated maturity (or time to repricing). With market
imperfections (e.g., depositors' transaction or information costs), however, the
equilibrium cost of some deposit items may respond sluggishly or incompletely to
market rate changes (see Hester and Pierce 1975 or Flannery 1982). Such liabilities'
market values (discounted at market rates) would therefore fluctuate with the level
of interest rates. These liabilities are sometimes called "core deposits," which
manifest "sticky" responses to market rate changes. We define an asset or liability's
"effective maturity" as the maturity of a fixed rate, perfectly elastically supplied
security with the same market-value elasticity as the bank balance sheet item under
consideration. Naturally, a balance sheet item's effective maturity is the relevant
determinant of its contribution to the bank's overall interest rate risk sensitivity.
Kathi Martell, Diane Mayer, and Sally Collier provided excellent research assistance in conjunction
with this project. The authors also benefited from the comments of seminar participants at the University
of North Carolina, Washington University, and the Federal Reserve Bank of Philadelphia, and two
anonymous referees. A portion of this study was undertaken while the first author was research adviser
at the Federal Reserve Bank of Philadelphia and the second author was a consultant to the Comptroller
of the Currency. The views expressed here in no way represent those of the Federal Reserve Bank of
Philadelphia or the Comptroller of the Currency.
MARK J. FLANNERY is associate professor of finance, University of North Carolina.
CHRISTOPHER M. JAMES is associate professor of finance, University of Oregon.
Journal of Money, Credit, and Banking, Vol. 16, No. 4 (November 1984, Part 1)
Copyright (C) 1984 by the Ohio State University Press
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436 : MONEY, CREDIT, AND BANKING
Reported bank income and balance sheet data are inadequate for inferring individual bank liabilities' interest rate adjustment characteristics. We have therefore
employed stock price data to infer the effective maturities of four items with ambiguous stated maturities: demand deposits, regular savings accounts, small
denomination time deposits, and cash asset items. Because these items comprise a
substantial proportion of bank assets and liabilities (on net over 37 percent of total
U.S. banking assets at year-end 1981), their effective maturities play an important
role in assessing bank interest rate risk exposure. These deposit items are payable
on short notice, implying their effective maturities may be very short. On the other
hand, the core deposit concept maintains that at least some bank deposits with short
stated maturities are relatively inelastic with respect to market interest rate changes.
Their contribution to bank interest rate risk exposure may therefore resemble that of
a longer-term, fixed-rate security.
Our methodology for inferring effective maturities involves a two-stage procedure. First, we estimate the relation between interest rate changes and the common
stock returns of commercial banks. This step provides a measure of the interest rate
sensitivity of bank equity values. The second stage of our analysis documents a
highly significant cross-sectional relationship between measured interest rate sensitivities and balance sheet composition. To infer the effective maturities of our four
uncertain balance sheet items, we test hypotheses that they affect bank stock prices
in the same way as balance sheet items with known maturities. Our evidence
strongly supports the view that a substantial proportion of bank deposit balances
behave as core deposits despite their short- stated maturities.
This paper is organized as follows. Section l describes and explains the procedure
used to estimate bank interest rate sensitivity. We describe our stock price data, then
report regression results for a portfolio of banks and for the individual banks.
Section 2 explains cross-sectional variation in bank interest rate sensitivities using
balance sheet data. We test several hypotheses about the effective maturities of
demand deposits, small time deposits, savings accounts, and cash assets. The paper
concludes by discussing the implications of our results for measuring banks' interest
rate risk exposure.
1. THE SENSITIVITY OF BANK STOCK PRICES
TO MARKET INTEREST RATES
Financial firms hold primarily nominal assets and liabilities: assets and liabilities
with prespecified dollar payments at predetermined future dates. ' The impact, therefore, of changes in market interest rates on the common stock value of these firms
will depend on the maturity composition (in the sense of "time to repricing") of their
assets and liabilities. As an extreme example, consider an unlevered firm whose only
asset is a consol. If all earnings are promptly paid out as dividends, the firm's stock
price should move precise;ly with the consol's market value. More generally, a
'For the banks in our sample, nominal assets account for about 98 percent of total bank assets; equity
constitutes about 6 percent.
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MARK J. FLANNERY AND CHRISTOPHER M. JAMES : 437
bank's common stock will be priced like a bond whose duration equals the average
net duration of its assets and liabilities. This observation allows us to infer the
maturity of selected bank balance sheet items, provided we have interest rate sensitivity estimates for a sample of individual banks.
.
.
We estlmate t le lnterest rate sensitivity of a bank's common stock with the
following model:
RJ, = POJ + mJRMf + ,S,JR,, + £J,, (1)
where
Rj, = the holding period return on the jth bank stock over period t
Rmt = the holding period return on an equally weighted portfolio of common
stocks over period t
R,, = the holding period return on a constant maturity index of default free
bonds over period t.
Our primary concern is with jlXlJ the estimated effect of interest rate changes on
the jth bank's stock. The coefficient on the common stock index, ,BmJ, is included
only to control for the effects of shocks other than interest rates on the bank's
market value.2
In this study, equation (1) was estimated using weekly returns data for the period
from January 1, 1976, to November 1, 1981. Weekly common stock returns were
obtained for a sample of sixty-seven commercial banking firms from the Data
Resources Incorporated (D1tI) Security Price File. Banks were included in the
sample if they met the following criteria: (1) they traded at least weekly during the
period from January 1976 through November 1981; (2) they had an identifiable lead
bank (in the case of multibank holding companies); (3) the lead bank was large
enough to file the large bank supplement to the FDIC Call Report in each sample
year. Only banks that traded every week during the sample period were included to
avoid biased coefficient estimates due to infrequent trading3 (see Dimson 1979).
Only bank holding companies with an identifiable lead bank were included in the
by ,S,,. (This situation is similar to the difference between a partial derivative and a total derivative.) To
determine if our cross-section results are sensitive to how the model (1) is specified, we orthogonalized
the bond and stock return series and reestimated (1); that is, we calculated Rmt as the residuals from
the model
Rmt = lSo + 8XRst + Ht
and then substituted Rmt for Rmt in (1). The resulting cross-section conclusions were similar to those
reported in section 2 below. The same cross-section conclusions also follow when (1) is estimated using
R,tt, and R,*, where R,* is the residuals from the model
R,, = 70 + rYlRmt + ,
3Transactions prices (as opposed to dealer quotes) were used in constructing the return series. DRI's
Securities Price File contains trading information as well as closing prices for securities traded over the
counter and on the major exchanges.
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438 : MONEY, CREDIT, AND BANKING
sample so that balance sheet items obtained from the lead bank's call report would
adequately reflect the holding company's balance sheet composition. (For bank
holding companies included in our sample, the lead bank constituted on average
about 84 percent of the holding company's total banking assets.) It was required that
the lead bank file the large bank supplement because the supplement contains
detailed information on bank asset and liability maturities.
The market portfolio return and interest rate indexes were also obtained from
DRI. The equity market index employed in this study was the weekly return on the
New York Stock Exchange (NYSE) composite index. (Substituting the National
Association of Securities Dealers Automated Quotation (NASDAQ) composite
index for the NYSE had no substantial effect on the results.) For the interest rate
index, holding period returns on United States Treasury or Federally guaranteed debt
were used in order to avoid return fluctuations due solely to changes in default
premiums. We used three alternative interest rate series to assure the robustness of
our results:
1. The return on Government National Mortgage Association (GNMA) 8 percent certificates, calculated as the weekly holding period return using the offer
price of the most recently issued GNMA 8 percent certificate at the close of
trading on Friday of each week (denoted RGNMA)
2. The weekly percentage change in yield to maturity on an index of seven-year
government bonds (denoted RG7)-4
3. The return on one-year Treasury bills, calculated as the weekly holding period
return using the offer price at the close of trading on Friday of each week
(denoted RTB )
Note that these holding period return series move inversely with the level of market
rates (calculated as yield to maturity). Of course, a bank's stock price will react
primarily to unanticipated changes in market rates, which means that the relevant
measure of RJ, should follow a white-noise process. To ensure that we include only
unanticipated bond returns, we estimated an AR(3) model for each alternative
interest rate series employed and estimated (1) using the autocorrelation model's
residuals.5 Results for the raw returns were virtually identical to those reported
here. (See Flannery and James (1984) for additional discussion of this estimation
procedure . )
Table 1 reports the results of estimating equation (1) for an equally weighted
portfolio of commercial bank stocks. These estimates strongly support our interpretation of ,X3, as a measure of interest rate sensitivity. Regardless of the bond index
used, interest rate movements are significantly correlated with the common stock
4The yield relative was calculated as the negative of [(y, - y,_ ,)/y, ,], where y, is the yield to maturity.
This expression overstates the bond's holding-period return, which is (1 - e-m") [(y,, - y,)/y, ,] for
a bond initially selling at par, where m is the bond's remaining term to maturity.
sAs noted below, we used three alternative bond return series: one-year Treasury bills, GNMA
certificates, and a constant-maturity government bond. The AR(3) model was chosen because the
one-year Treasury bill returns showed that the first three autocorrelates were significantly different from
zero (at the 0.01 level). The AR(3) model was estimated for the GNMA and government bond returns
series for consistency.
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MARK J. FLANNERY AND CHRISTOPHER M. JAMES : 439
TABLE 1
ESTIMATES OF INTEREST RATE SENSITIVITY: RCB, = /30 + /3MRMt + /3SRSt + E,
Index
RGNMA
,Bo
,sm
,BS
R2
0.002 0.556 0.133
(0.001) (0.030) (0.038)
D-W
0.57
1.74
RG7
0.002
0.560
0.069
(0.001) (0.031) (0.027)
0.56
1.73
RTB
0.001
0.555
0.515
(0.001) (0.031) (0. 160)
0.57
1.73
NOTES: Standard elTors are sn parentheses. RCB,, IS the weekly return on the portfollo of commerclal bank stocks.
returns of commercial banks. (,X3, > O indicates a positive relation between bond and
stock returns or a negative relation between interest rates and stock returns.) The
magnitude of ,X3, varies with the return series employed because bond prices (and
hence weekly returns) fluctuate more the longer is the bond's maturity. The estimated ,X3ms are stable across the three regressions, and the hypothesis of zero
autocorrelation cannot be rejected.6
To obtain the dependent variables for our cross-section analysis, we estimated
(1) for each bank individually over the 1976-81 sample period. Because the dependent variable in Table 1 is the return on an equally weighted portfolio of bank
stocks, the mean interest rate coefficient for individual banks equals the ,X3, reported
in Table 1. The median ,X3IJ iS 0.507 for RTB, O. 131 for RGNMA, and 0 049 for RG7
These three sets of ,X3IJ were used in the cross-sectional analysis as alternative
measures of bank interest rate sensitivity.
2. MAKING INFERENCES FROM THE ESTIMATED ,(S,,
Grove (1974) demonstrates that the effect of an interest rate change on the value
of equity will depend on the relation between the value-weighted duration of the
firm's assets and liabilities. A short-funded bank's (i.e., a bank with value-weighted
duration of assets greater than the value-weighted duration of liabilities) equity will
move inversely with interest rates (and vice versa for a long-funded bank). There-
fore, a ceteris paribus increase in the proportion of long assets should raise ,X3IJ,
whereas an increase in the proportion of long-term liabilities will lower it. In this
paper, we assume that each bank's estimated ,X3IJ reflects the market's assessment of
its maturity gap. Using detailed data on balance sheet composition we can then
compare the uncertain balance sheet items with items whose effective maturities
are known.
Methodology
For each of the sixty-seven bank and bank holding company stocks analyzed in
section 1, we obtained balance sheet data from the March 31 FDIC Report of
6The results in Table 1 are not substantially affected if ( 1) is estimated using excess returns (above the
holding period yield on a thirty-day Treasury bill) instead of gross unadjusted returns. We also bisected
the six-year sample period and did a Chow test: the hypothesis that equation (1) is homogeneous across
the entire period could not be rejected.
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440 : MONEY, CREDIT, AND BANKING
Condition for 1976 through 1981. These data are assumed to be indicative of the
bank's balance sheet position for the entire year. A potential source of error arises
because stock price data in many instances are for the bank holding company,
whereas gap measures are computed only for the lead bank. Our sample selection
techniques should minimize the effects of this error since we included only holding
companies with a large, well-defined lead bank. To the extent that sample bank
holding companies differ systematically in their nonbanking activities, however, our
results may be affected. A second problem could arise if banks have substantial
"off-balance sheet" activities that generate fee income. Interest rate fluctuations may
then change the present value of anticipated fee income, conveying an interest
sensitivity to bank equity unrelated to its balance sheet structure. (This effect will
be small, however, if fees represent a real income flow and real interest rate changes
are relatively small.) In the ensuing analysis, we assume that the predominant reason
for cross-sectional differences in bank interest rate sensitivity is the composition of
the assets and liabilities recorded in the call reports.
The call report format makes it most convenient and accurate to use one year as
the dividing line between "long" and "short" securities. Any item that matures or is
repriced within one year was considered short term. Although most asset and
liability items can be sorted unambiguously into the "over one year" or "under one
year" category, several prominent items cannot. The ambiguity arises because
market imperfections might make some security supplies relatively insensitive to
changes in the market rate. The most important of these are demand deposits,
savings (passbook) accounts, time deposits under $100,000, and cash assets (including Federal Reserve and other "due from" demand balances, vault cash, and cash
items in process of collection). These four items net out to 40.2 percent of the
average sample bank's total assets, making any gap measurement extremely sensi-
tive to one's assessment of their true maturity. On the one hand, such items could
be withdrawn at any time and might therefore be considered short term and subject
to repricing within one year.7 Alternatively, the "core deposits" view asserts that
these markets are imperfect and deposit stocks sticky, giving these items a long
effective maturity.
Relating stock price interest sensitivity to balance sheet data requires an appropriate scale variable. We used two alternatives: book value of the lead bank's equity
and the bank or holding company's market value of common stock outstanding
(calculated as the average of year-end market values in 1975 and 1981). We report
only the results using book equity, though the market value deflator yielded
similar conclusions.
Our basic regression specification for testing the uncertain items' effective matu.
.
.
rltleS 1S
ZSHORT\ /DD\
3z=o+at EQ JJ+ 2tE2}y
7 Nearly all retail time deposits can be withdrawn prior to maturity, though the depositor must pay an
early withdrawal penalty.
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MARK J. FLANNERY AND CHRISTOPHER M. JAMES : 441
lSAX ZTDX /CASH tEQpy
tEQSy
t
EQ
+
J,
(2)
where
SHORT = net assets (dollar value of assets minus liabilities) subject to repricing within one year8
EQ = dollar value of the bank's book equity
DD = demand deposits
SA = regular savings deposits
TD = time deposits under $100,000
CASH = the sum of vault cash, demand balances due from other banks,
Federal Reserve balances, and CIPC.
All balance sheet items are averages of the March call report values for 1976
through 198 1.9
Each coefficient in (2) measures the impact on ,B,> of shifting funds from the
associated category into the excluded balance sheet items. '° An increase, for example, in the short-term asset share [SHORT/EQ] implies a corresponding decrease in
(omitted) longer-term assets and/or an increase in (omitted) longer-term liabilities.
A ceteris paribus increase in [SHORT/EQ] should therefore make the bank's stock
return more positively correlated with market rates, which would lower :,J. This
effect implies that [SHORT/EQ] will carry a negative cx l coefficient in (2). Using
the same reasoning, liabilities considered by the market to be short term will carry
positive coefficients in (2). Conversely, an asset or liability with an effective maturity equal to the omitted balance sheet items should have a coefficient in (2) insignificantly different from zero. Given the bank's balance sheet constraint, a decline in,
say, demand deposits implies an increase in one or more omitted liabilities. A zero
coefficient on DD would indicate that the market is indifferent to a shift between
these two liability types, implying that the effective maturity of DD is equal to the
omitted items' effective maturity.
The structure of equation (2) thus allows us to infer the four uncertain items'
effective maturities by comparing their estimated coefficients to cx,. After estimating
(2), we test the restrictions that each of the cx, (i = 2, 3, 4, 5) equals cx, and that
various combinations of the cx, all equal cx,. The null hypotheses are therefore that
8The definition of SHORT is: (net federal funds sold + investments maturing in less than one
year + predetermined rate loans maturing in less than one year + floating rate loans + trading account
securities + customers' liabilities to the bank for outstanding acceptances) - (domestic and foreign
certificates of deposit in excess of $100,000 maturing in less than one year + other liabilities for
borrowed money + the bank's liabilities on customers' acceptances outstanding). The mean value of
[SHORT/EQ] is 0.223, with a sample standard deviation of 1.87. SHORT averages 2.84 percent of bank
total assets (sample standard deviation = 0.105). About one-third of the sample banks have a negative
value for SHORT.
9To determine whether our results were robust to aggregation over different time periods, we also
estimated (1) and (2) for two subperiods (1976-78, 1979-81). The results were comparable to those
reported in the text.
'°The constant term in (2) captures the interest sensitivity of bank equity due to off-balance sheet
activities or to a maturity (duration) mismatch between the assets and liabilities within SHORT or within
the omitted items.
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442 : MONEY, CREDIT, AND BANKING
TABLE 2
^ /SHORT\ /DD / SA \ /TD
CROSS SECTION REGRESSION RESULTS: #(i'} = R° + ' EQ J + °g2VEQ , tEQJ, tEQ ,
+ (CASH) + V
Independent
Variables
,B
CNMA
p
SHORT
^
C7
^
p
^
TB
-0.0430** -0.0287** -0.161 **
(0.0124) (0.0087) (0.0575)
DD
-0.0054
-0.0228
-0.104
(0.0244) (0.0171) (0.113)
SA
-0.0051
0.0074
-0.0278
(0.0177) (0.0124) (0.0815)
TD
-0.0082
-0.0037
-0.0292
(0.0159) (0.0111) (0.0730)
CASH
0.0088
0.0283
0.0893
(0.0367) (0.0255) (0.1675)
Constant
R2
0.171
0.0864
0.946*
(0.0872) (0.0608) (0.4008)
0.314
F-statistic
0.293
5.21**
Number
observations
of
0.272
4.71**
63
4.26**
63
63
NOTES: Standard errors are sn parentheses. Independent variables are deflated by book value of equlty
*Signlflcant at the 5 percent level.
**Signlficant at the I percent level.
the uncertain asset and liability items singly and in combination have effective
maturities equal to SHORT. The following hypotheses are tested.
H1: DD has the same effective maturity as SHORT (Ct2 =
-Ctl).
H2: CASH has the same effective maturity as SHORT (Ct5
= Ctl).
H3: SA has the same effective maturity as SHORT (Ct3 = H4: TD has the same effective maturity as SHORT (Ct4 =
-R 1)-
a I) -
Results
The results of estimating (2) for each of the three interest rate factors (RGNMA, RG7,
RTB) are presented in Table 2.1l As expected, SHORT carries a significant negative
sign for each interest sensitivity measure, though all the other balance sheet coefficients are indistinguishable from zero. This result is consistent with the hypothesis
that the uncertain items' effective maturities are not equal to SHORTVS. We tested
hypotheses H 1 through H4 to determine if the uncertain items had effective matu-
rities similar to SHORT. These results are shown in Table 3. The data quite strongly
reject the hypotheses that the three liabilities (DD, SA, TD) have effective maturities
equal to SHORTVS. 12 For CASH, the evidence is less conclusive. CASH is composed
"Table 2 shows sixty-three observations (instead of sixty-seven) because four sample banks turned out
to be too small to file the Large Bank Supplement to the Report of Condition.
'2Assuming that TD had a uniform maturity composition over this period is probably incorrect because
six-month money market CD's (MMCD) were first introduced on June 1, 1978. Until March 1979,
however, thrift institutions attracted the great majority of these accounts. By December 31, 1981, MMCD
accounted for 61.1 percent of all retail TD, potentially lowering the average TD maturity below its
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MARK J. FLANNERY AND CHRISTOPHER M. JAMES : 443
TABLE 3
HYPOTHESIS TESTS ON THE UNCERTAIN BALANCE SHEET ITEMS EFFECTIVE MATURITIES
p
CNMA
p
c7
H1: Fl s7 4.02* 10.13**
H2:
Fl
s7
2.10
5.34*
H3:
FX
S7
6.71*
2.69
p
TB
6.02*
2.32
4.58*
H4: FX S7 7.79** 6.63* 5.88*
HS: F4 57 6.49** 5.86** 5.24**
H6:
F4
s7
0.182
0.477
0.345
NOTES:
H 1. DD has the same effective maturlty as SHORT (a2 = -a 1).
H2: CASH has the same effectlve maturity as SHORT (ot5 = otl).
H3: SA has the same effective maturity as SHORT (0t3 = -otl).
H4: TD has the same effective maturity as SHORT (0t4 = -ot l).
H5. All four uncertaln stems have the same effective matunty as SHORT (-a1 = a2 = a3 = a4 = -as)H6 All four uncertaln stems have the same effectlve maturlty as the omitted assets and llabllltles (a2 = a3 = a4 = as = 0).
*NUII hypothesls rejected at 5 percent confldence level.
**NUII hypothesls rejected at I percent confidence level.
Of three separate types of assets. The first, reserves and vault cash, should manifest
a long effective maturity because its own rate is permanently fixed at zero. The
second component, due from balances, is more likely to generate implicit earnings
that fluctuate promptly with market rate changes. The third component, cash items
in the process of collection, does not represent resources currently available to the
bank and would therefore have no prominent effect on its market value. The results
for H2 provide ambiguous evidence about whether CASH, on average, is equivalent
to SHORT or not.
The restrictions in H 1 through H4 can also be imposed simultaneously.
H5: All four uncertain items have the same effective maturity as SHORT
(-at I = 0t2 = 0t3 = 0t4 = at5).
Table 3 indicates that H 5 is easily rejected for
joint hypothesis
H6: All four uncertain items have the same effective maturity as the omitted
assets and liabilities (at2 = 0t3 = 0t4 = 0t5 = 0)
further confirms the evidence in Table 2 that the four uncertain items' coefficients
are jointly zero. 13 In sum, the market appears to value the uncertain balance sheet
items as if their effective maturities exceed SHORT's.
Another perspective on the effective maturity of these four items is contained in
Table 4, which reports regressions of the form
pre-MMCD level. However, the data indicate that MMCD have not shortened retail time deposits to the
point where they are equivalent to SHORT: we reestimated the market model (1) for two subperiods
(before and after January 1, 1979). H4 was rejected at the 5 percent level in each subperiod.
'3Some evidence on the power of these tests was obtained by estimating a regression like (2) with
known LONG net assets (investments and fixed rate loans in excess of one year, long-term debentures,
etc.) in place of SHORT. (In order to obtain information beyond that provided by regression (2), LONG
included only a subset of the assets and liabilities excluded from the SHORT regressions.) These
regressions did not reject the joint hypothesis that all four uncertain items had coefficients equal to the
one on LONG. By contrast, the constraint that all four uncertain coefficients were zero (implying an
effective maturity equal to SHORT) was strongly rejected.
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444 : MONEY, CREDIT, AND BANKING
TABLE 4
RESULTS FROM REGRESSION (3)
A
p
A
CNMA
p
A
C7
p
TB
Constant 0.138** 0.145* 0.054** 0.034 0.544** 0.649*
(0.0177) (0.0697) (0.0126) (0.0482) (0.0816) (0.3090)
SHORT, - 0.049** - 0.032** - 0.199**
(0.0095) (0.0068) (0.0436)
SHORTz
R2
0
305
0.003
0.002
(0.0103) (0.0069)
0.001
0.269
0.001
0.023
(0.0463)
0.254
0.004
F-statistic 26.75** 0.060 22.43** 0.080 20.80** 0.250
Number
of
63
63
63
63
63
63
observations
NOTE: Standard elTors are in parentheses.
*SIgnlficant at the S percent confidence level.
**SIgnificant at the 1 percent confidence level.
A -SHORTt
,(3
IJ
=aO+al
_
J
EQ
+
UJ
(3)
where SHORTi is alternatively equal to SHORT (when i = 1) or to (SHORT +
CASH - DD - TD-SA) (when i = 2). Recalling that a short asset should carry
a negative sign in (3), Table 4 clearly indicates that SHORT2 does not behave as a
proper short-term asset. SHORT2 is perversely signed within regression relations that
are statistically insignificant at conventional levels. These results are uniform across
the three interest rate measures. By contrast, SHORT1 always carries a significant
negative coefficient and its regressions explain a surprisingly high proportion of the
cross-sectional variation in ,B,>. Once again, the data strongly reject the hypothesis
that investors have considered these four uncertain balance sheet items equivalent to
known short-term bank assets and liabilities.
3. CONCLUSION
Given the conceptual difficulty of inferring bank interest rate risk
accounting data, we have utilized bank stock prices to infer the effective maturities
of four prominent balance sheet items. The evidence indicates that demand, savings,
and small time deposit balances do not affect bank interest rate sensitivity in the
same way as SHORT. Because these items comprise such a large proportion of bank
resources, their effective maturities have a prominent influence on any bank's
estimated gap position. The empirical evidence suggests that demand, savings, and
retail time deposit balances are "sticky" or imperfectly responsive to changes in
market rates. When market interest rates rise (fall), the bank's effective cost of these
liabilities changes by a smaller amount, raising (lowering) bank income, ceteris
paribus. Higher portfolio shares of these deposits accordingly reduce the interest rate
elasticity of bank equity. The evidence for CASH, which comprises 12.1 percent of
our average bank's assets (211 percent of equity), is less strong.
The practical significance of our results can be demonstrated by examining the
implied gap measures. Assuming that the four uncertain items are subject to repric-
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MARK J. FLANNERY AND CHRISTOPHER M. JAMES : 445
ing within one year yields an estimated gap-short-term liabilities less sh
assets-equal to 37.3 percent of assets or 655 percent of equity at our average
sample bank. Such a bank would suffer significant income fluctuations when market
rates change and might easily fail in the face of a large enough unanticipated rate
increase. Properly recognizing these items' longer effective maturity, however,
reduces the average short-term gap (liabilities less assets) to -2. 84 percent of assets
or -22.3 percent of equity. The implied exposure to interest rate risk now appears
much less serious. (Flannery (1981) comes to a similar conclusion after analyzing
bank accounting data.)
An operational method for measuring bank interest rate risk exposure will require
substantially more research. For example, we must determine if the deposit supply
inelasticities implied by our data have been seriously altered by the introduction of
newer retail deposit accounts paying market rates. At a minimum, however, our
results demonstrate the importance of distinguishing between stated and effective
maturities in banking.
LITERATURE
CITED
Dimson, Elroy. "Risk Measurement when Shares Are Subject to Infrequent Trading." Journal
of Financial Economics 7 (June 1979), 197-226 .
Flannery, Mark J. "Market Interest Rates and Commercial Bank Profitability: An Empirical
Investigation." Journal of Finance 36 (December 1981), 1085-101.
. "Retail Bank Deposits as Quasi-Fixed Factors of Production." American Economic
Review 72 (June 1982), 527-36.
Flannery, Mark J., and Christopher James. "The Effect of Interest Rate Changes on the
Common Stock Returns of Financial Institutions." Journal of Finance (1984), in press.
Grove, M. A. "On 'Duration' and Optimal Maturity Structure of the Balance Sheet." The Bell
Journal of Economics and Management Science S (Fall 1974), 696-709.
Hester, Donald D., and James L. Pierce. Bank Management and Portfolio Behavior. New
Haven, Conn.: Yale University Press, 1975.
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