Essays on the Equity Pricing and Capital Structure of Financial Intermediaries

Lu, Y. (2014). Essays on the Equity Pricing and Capital Structure of Financial Intermediaries. (Unpublished Doctoral thesis, City, University of London)

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Abstract

The thesis investigates the risk-related behaviours of financial institutions across the global financial markets and provides reasonable explanations for the empirical results. The thesis has a few conclusions and contributions to the existing literature. It investigates various risks to which financial institutions are exposed, particularly capital risk, real estate risk and
valuation risk. The importance of capital adequacy had drawn public and regulators attention in the recent financial turmoil, especially when financial institutions face unexpected credit and liquidity shocks in the financial markets. The thesis shows that banking organizations show little pecking order behaviour in capital structure. Banks are different in terms of leverage relative to non-banks, as taxpayers deposit subsidized debt relative to equity in banking. Therefore, the debt structure in banking is different from nonfinancial firms. For the same level of financial deficit, a bank may have higher debt level than non-financial firms. However, this is not due to pecking order but because the taxpayers funds deposit in the bank. The thesis also finds that despite of the regulatory minimum capital requirement, the banking organizations target capital level is linearly and collectively influenced by bank-specific, macroeconomic and country-specific variables.

In addition, the thesis adopts bivariate GARCH framework and finds significant evidences that with the development of mortgage loans issuance and related derivatives, financial institutions are increasingly exposed to real estate markets, and there is a significant and positive cross-volatility spillover from real estate sector to banks, and the co-movement is in the same direction. It is also crucial that financial institutions and fund managers can predict the expected portfolio returns more accurately.

The thesis also finds that zero-beta CAPM significantly improve the expected returns, represented as average predicted returns in the month ahead when comparing with threefactor model, which has difficulty explaining small and growth portfolios returns. We show
that market risk is composed of two components, average market returns and cross-sectional market volatility.

The findings of the thesis not only contribute and extend the existing literature, but also have important implication for regulators, risk and asset managers as well as investors at both company and public policy levels. The regulators and financial institution managers
can monitor banks targeted capital structure more closely based on the bank-specific, macroeconomic and country-specific variables discussed in the thesis. When there is any changes in these determinant variables, institution managers should make relevant adjustments in the targeted capital structure.

Moveover, regulators should be aware the influence of real estate market over financial institutions, especially any significant volatility changes in real estate as it can spillover into financial institutions. As financial institutions are increasingly exposed to real estate market, any significant changes in real estate market can also have influential impact on the capital adequacy in bank organisations. Therefore, it is suggested institutional managers need to control the real estate exposure in their financial assets and include real estate factor in the stress testing.

Furthermore, it is also important that financial institution and fund managers can estimate the expected returns more accurately, so that they can make correct collection of assets for required risk and return. In the thesis we find that the zero-beta CAPM outperforms the
traditional asset pricing model, particularly three-factor model, by providing better prediction on portfolio expected returns. Therefore, the fund managers can adopt the zero- beta ZCAPM framework along with other asset pricing framework when predicting portfolio returns. As high returns often come with high risk, predicting returns more accurately means we can predict and monitor risk more precisely. The financial institution managers can also apply zero-beta CAPM on their institutional asset holdings to monitor whether the institutions are exposed to higher risk assets. The regulators can use the
framework to control the financial intermediaries risk and return behaviour to maintain the financial market stability. By identifying and quantifying the risk and return behaviours of financial intermediaries, stakeholders can assess and improve their management and
investment performances. The empirical findings also help the regulatory bodies to make effective and suitable policies for financial sectors to ensure a stable, prosperity and sustainable growth of financial market.

Item Type: Thesis (Doctoral)
Subjects: H Social Sciences > HG Finance
Divisions: Cass Business School
URI: http://openaccess.city.ac.uk/id/eprint/18253

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