#06-10
Visible and Hidden Risk Factors for Banks
Til Schuermann and Kevin J. Stiroh, May 2006
Abstract: This paper examines the common factors that drive the returns of U.S. bank holding companies from
1997 to 2005. We compare a range of market models from a basic one-factor model to a nine-factor
model that includes the standard Fama-French factors and additional factors thought to be particularly
relevant for banks such as interest and credit variables. We show that the market factor clearly
dominates in explaining bank returns, followed by the Fama-French factors. The bank-specific factors
are not informative, particularly for the largest banks, which take advantage of protection in the form
of interest rate and credit derivatives. Even in our broadest model, however, considerable residual
variation remains with the mean pair-wise correlation of residuals for the largest banks near 0.25. This
suggests that important hidden factors remain. A principal component analysis shows that this
residual variance is relatively diffuse,although the largest banks do tend to load in the same direction
on the first component. Relative to large firms in other sectors, bank returns are relatively well
explained with standard risk factors and both the residual correlation and degree of factor loading
agreement are not particularly large. These results have clear implications for public policy in terms
of quantifying the sources of the common exposures across banks necessary for certain types of
systemic risk and for portfolio management in terms of optimal diversification strategies.
Keywords: commercial banks, risk management, portfolio choice, systemic risk.
JEL classifications : G12, G21.
