Risk-return Portfolio Level Trade-off for Czech Banks (2024)

Prague Economic Papers 2024, 33(2):187-219|DOI:10.18267/j.pep.859

Risk-return Portfolio Level Trade-off for Czech Banks

Pavel Jankulár

Faculty of Finance and Accounting, Department of Monetary Theory and Policy, Prague University of Economics and Business, Prague, Czech Republic

This paper examines the validity of the risk-return trade-off for a sample of Czech banks over the period 2002-2022 by analysing the relationship between the bank risk and risk-adjusted returns. I find evidence of a significant negative association between the regulatory risk measure and risk-adjusted returns, indicating that the risk-return trade-off does not hold. Specifically, a 100 bps increase in the risk is associated with about a 7 bps decrease in the return on risk-adjusted assets (RORWA) and an 11 bps decrease in the risk-adjusted net interest margin (rNIM) in the short run. The long-run effect is about double for RORWA and almost triple for rNIM. I also find evidence that during the period of low interest rates, the effect for RORWA was about a half smaller, albeit still negative. On the contrary, when non-regulatory measures of risk or risk-adjusted profitability are used, the risk-return trade-off seems to hold.

Keywords: bank profitability, bank risk, risk-return trade-off, RORWA, RAROC, dynamic panel regression,

JEL classification: C33, D01, G11, G14, G21

Received: November 26, 2023; Revised: January 16, 2024; Accepted: January 21, 2024; Published: May 3, 2024 Show citation

Open full article

1. Albertazzi, U., Gambacorta, L. (2009). Bank Profitability and the Business Cycle. Journal of Financial Stability, 5, 393-409. https://doi.org/10.1016/j.jfs.2008.10.002 Go to original source...
2. Altavilla, C., Boucinha, M., Peydró, J.-L. (2018). Monetary Policy and Bank Profitability in a Low Interest Rate Environment. Economic Policy, 33(96). https://doi.org/10.1093/epolic/eiy013 Go to original source...
3. Altunbas, Y., Gambacorta, L., Marquez-Ibanes, D. (2010). Bank Risk and Monetary Policy. Journal of Financial Stability, 6(3), 121-129. https://doi.org/10.1016/j.jfs.2009.07.001 Go to original source...
4. Arellano, M., Bond, S. (1991). Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations. The Review of Economic Studies, 58(2), 277-297. https://doi.org/10.2307/2297968 Go to original source...
5. Arellano, M., Bover, O. (1995). Another Look at the Instrumental-variable Estimation of Error Components Models. Journal of Econometrics, 68, 29-52. https://doi.org/10.1016/0304-4076(94)01642-D Go to original source...
6. Arseneau, D. M. (2020). How Would US Banks Fare in a Negative Interest Rate Environment? International Journal of Central Banking, 16(5), 269-308. Go to original source...
7. Athanasoglou, P. P., Brissimis, S. N., Delis, M. D. (2008). Bank-specific, Industry-specific and Macroeconomic Determinants of Bank Profitability. Journal of International Financial Markets, Institutions and Money, 18, 121-136. https://doi.org/10.1016/j.intfin.2006.07.001 Go to original source...
8. Ayuso, J., Perez, D., Saurina, J. (2004). Are Capital Buffers Pro-cyclical? Evidence from Spanish Panel Data. Journal of Financial Intermediation, 13(2), 249-264. https://doi.org/10.1016/S1042-9573(03)00044-5 Go to original source...
9. Baum, Ch. F. (2013). Dynamic Panel Data Estimators. EC823: Applied Econometrics, Boston College.
10. Bikker, J., Vervliet T. (2017). Bank Profitability and Risk-taking Under Low Interest Rates. International Journal of Finance and Economics, 23(1), 3-18. https://doi.org/10.1002/ijfe.1595 Go to original source...
11. Borio, C., Zhu, H. (2012). Capital Regulation, Risk-taking and Monetary Policy: A Missing Link in the Transmission Mechanism? Journal of Financial Stability, 8(4), 236-251. https://doi.org/10.1016/j.jfs.2011.12.003 Go to original source...
12. Borio, C., Gambacorta, L., Hofmann, B. (2017). The Influence of Monetary Policy on Bank Profitability. International Finance, 20(1), 48-63. https://doi.org/10.1111/infi.12104 Go to original source...
13. Bourke, P. (1989). Concentration and Other Determinants of Bank Profitability in Europe, North America and Australia. Journal of Banking and Finance, 13, 65-79. https://doi.org/10.1016/0378-4266(89)90020-4 Go to original source...
14. Brei, M., Gambacorta, L. (2016). Are Bank Capital Ratios Pro-cyclical? New Evidence and Perspectives. Economic Policy, 31(86), 357-403. https://doi.org/10.1093/epolic/eiw001 Go to original source...
15. Bun, M., Carree, M. (2005). Bias-corrected Estimation in Dynamic Panel Data Models. Journal of Business & Economic Statistics, 23, 200-210. Go to original source...
16. Cannata, F., Casellina, S., Quagliariello M. (2011). The Myths and Truths about Basel II Cyclicality. Risk, 24, 65-69.
17. Cihak, M., Hesse, H. (2008). Islamic Banks and Financial Stability: An Empirical Analysis. Journal of Financial Service Research, 38(2), 95-113. https://doi.org/10.1007/s10693-010-0089-0 Go to original source...
18. Claessens, S., Coleman, N., Donelly, M. (2018). "Low-for-long" Interest Rates and Banks' Interest Margins and Profitability: Cross-country Evidence. Journal of Financial Intermediation, 35, 1-16. https://doi.org/10.1016/j.jfi.2017.05.004 Go to original source...
19. Claeys, S., Vennet, R. V. (2008). Determinants of Bank Interest Margins in Central and Eastern Europe: A Comparison with the West. Economic Systems, 32, 197-216. https://doi.org/10.1016/j.ecosys.2007.04.001 Go to original source...
20. Cruz-Garcia, P., de Guevara, J. F. (2019). Determinants of Net Interest Margin: The Effect of Capital Requirements and Deposit Insurance Scheme. The European Journal of Finance, 1102-1123. https://doi.org/10.1080/1351847X.2019.1700149. Go to original source...
21. Czech Banking Association. (2022). Report on Czech Banking Association activities in 2021. CBA.
22. Czech Banking Association. (2023). Report on Czech Banking Association activities in 2022. CBA.
23. Czech National Bank. (2023). Financial Stability Report - spring 2023. CNB.
24. Dao, O. L. K., Ho, T. T. N., Le, H. D., Duong, N. Q. (2021). Multimarket Contact and Risk-adjusted Profitability in the Banking Sector: Empirical Evidence from Vietnam. Journal of Asian Finance, Economics and Business, 8(3), 1171-1180.
25. De Vos, I., Everaert, G., Ruyssen, I. (2015). Bootstrap-based Bias Correction and Inference for Dynamic Panels with Fixed Effects. The Stata Journal, 15(4), 986-1018. https://doi.org/10.1177/1536867X1501500404 Go to original source...
26. Demirguc-Kunt, A., Huizinga, H. (2000). Financial Structure and Bank Profitability. World Policy Research Working Paper Series, 2430. Go to original source...
27. Döme, S., Kerbl, S. (2017). Comparability of Basel Risk Weights in the EU Banking Sector. Financial Stability Report, 34, 68-89.
28. Everaert, G., Pozzi, L. (2007). Bootstrap-based Bias Correction for Dynamic Panels. Journal of Economic Dynamics and Control, 3(4), 1160-1184. https://doi.org/10.1016/j.jedc.2006.04.006 Go to original source...
29. Fredriksson, A., Moro, A. (2014). Bank-SMEs Relationship and Banks' Risk-adjusted Profitability. Journal of Banking and Finance, 41, 67-77. https://doi.org/10.1016/j.jbankfin.2013.12.026 Go to original source...
30. Gambacorta, L., Mistrulli, P. E. (2004). Does Bank Capital Affect Lending Behavior? Journal of Financial Intermediation, 13(4), 436-457. https://doi.org/10.1016/j.jfi.2004.06.001 Go to original source...
31. Genay, H., Podjasek, R. (2014). What Is the Impact of a Low Interest Rate Environment on Bank Profitability? Chicago Fed Letter, Number 324. The Federal Reserve Bank of Chicago.
32. Hanzlik, P., Teply, P. (2020). Key Factors of the Net Interest Margin of European and US Banks in a Low Interest Rate Environment. International Journal of Finance & Economics, 27(3), 2795-2818. https://doi.org/10.1002/ijfe.2299 Go to original source...
33. Hull, J. C. (2012). Risk Management and Financial Institutions. 3rd edition. John Wiley and Sons. ISBN-10 1118269039.
34. Choi, I. (2001). Unit Root Tests for Panel Data. Journal of International Money and Finance, 20, 249-272. https://doi.org/10.1016/S0261-5606(00)00048-6 Go to original source...
35. Dickey, D. A., Fuller, W. A. (1981). Likelihood Ratio Statistics for Autoregressive Time Series with a Unit Root. Econometrica, 49, 1057-1072. https://doi.org/10.2307/1912517 Go to original source...
36. Ioannidou, V. P., Ongena, S., Peydro, J.-L. (2015). Monetary Policy, Risk-taking and Pricing: Evidence from Quasi-natural Experiment. Review of Finance, 19(1), 95-144. https://doi.org/10.1093/rof/rfu035 Go to original source...
37. Janda, K., Kravtsov, O. (2020). Banking Supervision and Risk-adjusted Performance in the Host Country Environment. FFA Working Paper 5/2020. Go to original source...
38. Janda, K., Kravtsov, O. (2022). Regulatory Stress Tests and Bank Responses: Heterogeneous Treatment Effect in Dynamic Settings. International Journal of Central Banking, 18(2), 1-49.
39. Jiménez, G. Ongena, S., Peydro, J.-L., Saurina, J. (2014). Hazardous Times for Monetary Policy: What Do Twenty-three Million Bank Loans Say About the Effects of Monetary Policy on Credit Risk-taking? Econometrica, 82(2), 463-505. https://doi.org/10.3982/ECTA10104 Go to original source...
40. Judson, R., Owen, A. (1999). Estimating Dynamic Panel Data Models: A Practical Guide for Macroeconomists. Economics Letters, 65(1), 9-15. https://doi.org/10.1016/S0165-1765(99)00130-5 Go to original source...
41. Kerbl, S., Sigmund, M. (2017). Negative Interest Rates: Forecasting Banks' Profitability in a New Environment. https://doi.org/10.2139/ssrn.2901932 Go to original source...
42. Kiviet, J. F. (1995). On Bias, Inconsistency, and Efficiency of Various Estimators in Dynamic Panel Data Models. Journal of Econometrics, 68(1), 53-78. https://doi.org/10.1016/0304-4076(94)01643-E Go to original source...
43. Kok, Ch., Móré, C., Pancaro, C. (2015). Bank Profitability Challenges in Euro Area Banks: The Role of Cyclical and Structural Factors. ECB Financial Stability Review, May 2015.
44. Kolcunova, D., Malovana, S. (2022). The Effect of Higher Capital Requirements on Bank Lending: The Capital Surplus Matters. Empirica, 49, 793-832. https://doi.org/10.1007/s10663-022-09536-x Go to original source...
45. Kosmidou, K., Tanna, S., Pasiouras, F. (2008). Determinants of Profitability of Domestic UK Commercial Banks: Panel Evidence from the Period 1995-2002. Economics, Finance and Accounting Applied Research, Working paper, Series No. RP08-4, 1-27. Coventry University.
46. Maddaloni, A., Peydro, J.-L. (2011). Bank Risk-taking, Securitization, Supervision, and Low Interest Rates: Evidence from the Euro-area and the U.S. Lending Standards. Review of Financial Studies, 24(6), 2121-2165. https://doi.org/10.1093/rfs/hhr015 Go to original source...
47. Malovana, S. Bajzik, J. Ehrenbergerova, D., Janku J. (2023). A Prolonged Period of Low Interest Rates: Unintended Consequences. Journal of Economic Survey, 37(2), 526-572. Go to original source...
48. Malovana, S., Kolcunova, D., Broz, V. (2017). Does Monetary Policy Influence Banks' Perception of Risks? CNB Working Paper Series 9/2017.
49. Malovana, S., Kolcunova, D., Broz, V. (2019). Does Monetary Policy Influence Banks' Risk Weights under the Internal Ratings-based Approach? Economic Systems, 43(2). https://doi.org/10.1016/j.ecosys.2018.10.003 Go to original source...
50. Mariathasan, M., Merrouche, O. (2014). The Manipulation of Basel Risk Weights. Journal of Financial Intermediation, 23, 300-321. https://doi.org/10.1016/j.jfi.2014.04.004 Go to original source...
51. Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, 7(1), 77-91. https://doi.org/10.2307/2975974 Go to original source...
52. Modigliani, F., Modigliani, L. (1997). Risk-adjusted Performance. Journal of Portfolio Management, 23, 45-54. https://doi.org/10.3905/jpm.23.2.45 Go to original source...
53. Molyneux, P., Thorton, J. (1992). Determinants of European Bank Profitability: A Note. Journal of Banking and Finance, 16, 1173-1178. https://doi.org/10.1016/0378-4266(92)90065-8 Go to original source...
54. Molyneux, P., Reghezza, A., Xie, R. (2019). Bank Margins and Profits in a World of Negative Rates. Journal of Banking and Finance, 107. https://doi.org/10.1016/j.jbankfin.2019.105613 Go to original source...
55. Nickell, S. (1981). Biases in Dynamic Models with Fixed Effects. Econometrica, 49(6), 1417-1426. https://doi.org/10.2307/1911408 Go to original source...
56. Paltrinieri, A., Dreassi, A., Rossi, S., Khan, A. (2021). Risk-adjusted Profitability and Stability of Islamic and Conventional Banks: Does Revenue Diversification Matter? Global Finance Journal, 50, 100517. https://doi.org/10.1016/j.gfj.2020.100517 Go to original source...
57. Roengpitya, R., Tarshev, N., Tsatsaronis, K. (2014). Bank Business Model. BIS Quarterly Review, December 2014.
58. Roodman, D. (2009). A Note on the Theme of Too Many Instruments. Oxford Bulletin of Economics and Statistics, 71(1), 135-158. https://doi.org/10.1111/j.1468-0084.2008.00542.x Go to original source...
59. Ross, S. A. (1976). The Arbitrage Theory of Capital Asset Pricing. Journal of Economic Theory, 13(3), 341-360. https://doi.org/10.1016/0022-0531(76)90046-6 Go to original source...
60. Saona, P. (2011). Determinants of the Profitability of the US Banking Industry. International Journal of Business and Social Science, 2(22), 254-269.
61. Sharpe, W. F. (1964). Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. The Journal of Finance, 19(3), 425-442. https://doi.org/10.1111/j.1540-6261.1964.tb02865.x Go to original source...
62. Stiglitz, J. E., Weiss, A. (1981). Credit Rationing in Markets with Imperfect Information. The American Economic Review, 71(3), 393-410.
63. Sutorova, B., Teply, P. (2014). EU Banks' Profitability and Risk Adjustment Decisions under Basel III. Ekonomicky casopis, 62(7), 667-691.
64. Tabak, B. M., Fazio, D. M., Paiva, K. C. de O., Cajueiro, D. O. (2016). Financial Stability and Bank Supervision. Finance Research Letters, 18, 322-327. https://doi.org/10.1016/j.frl.2016.05.008 Go to original source...
65. Vallascas, F., Hagendorff, J. (2013). The Risk Sensitivity of Capital Requirements: Evidence from an International Sample of Large Banks. Review of Finance, 17, 1947-1988. https://doi.org/10.1093/rof/rfs042 Go to original source...
66. Wooldridge, J. M. (2012). Introductory Econometrics: A Modern Approach (5th edition). South-Western, Cengage Learning. ISBN-13: 978-1-111-53104-1.
67. World Bank. (2023). World Bank Data Bank, Metadata Glossary.