The Stock Market and Bank Risk-Taking

We argue that stock market pressure to generate earnings encourages banks to increase risk. We measure risk using confidential supervisory ratings as well as financial information released in regulatory filings. We document that there is an increase in the risk-taking behavior of banks that become part of publicly traded bank holding companies (BHCs) either through a public listing (IPO) or acquisition by a publicly-traded BHC. This increase in risk is greater than the increase in risk for a control group of banks that intended a private-to-public transition through an IPO or acquisition, but where the deal failed. This finding is robust to instrumenting deal failure with an index of stock returns shortly after deal announcement. There are a number of explanations of this finding, but cross-sectional and time-series evidence points to stock-market earnings pressure. In particular, we find that the relative increase in risk by banks that transition to being publicly held is more pronounced if they have good governance, consistent with the idea that stock-price maximization underlies the incentive to take risk. We also find more pronounced effects in periods when the Fed funds rate and credit spreads are low. This finding is consistent with the idea that when there is downward pressure on bank earnings, publicly-held banks tend to increase risk more than privately-held banks.