J. Japanese Int. Economies 30 (2013) 1–18

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Journal of The Japanese andInternational Economies

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How do leverage ratios affect bank shareperformance during financial crises: The Japaneseexperience of the late 1990s

0889-1583/$ - see front matter � 2013 Elsevier Inc. All rights reserved.http://dx.doi.org/10.1016/j.jjie.2013.07.003

⇑ Address: School of Finance, Zhongnan University of Economics and Law, #182 South Nanhu Road, Wuhan CitProvince 430073, PR China. Fax: +86 27 88386612.

E-mail address: cscwin@gmail.com

Sichong Chen ⇑School of Finance, Zhongnan University of Economics and Law, PR ChinaResearch Center for International Finance, Institute of World Economics and Politics, Chinese Academy of Social Sciences, PR China

a r t i c l e i n f o

Article history:Received 15 April 2013Revised 13 June 2013Available online 2 August 2013

JEL classification:G21G28G12G14

Keywords:Leverage ratioBank share performanceFinancial crisisJapanese experience

a b s t r a c t

Chen, Sichong—How do leverage ratios affect bank share perfor-mance during financial crises: The Japanese experience of the late1990s

This study investigates the relationship between leverage ratiosand bank share performance for a sample of Japanese banks duringthe period of financial crisis in the late 1990s. We differentiatebetween two types of leverage ratios: book leverage and marketleverage. We show that market leverage instead of book leverageobserved before the crisis has statistically and economically signif-icant predictive power for the cross-sectional variation in bankperformance during the crisis, even after controlling for a varietyof other indicators reflecting bank’s characteristics and financialconditions. We also find that banks with lower market leverageratios were affected more adversely by the failure announcementsof large financial institutions during the crisis. The results arerobust across alternative model specifications, statistical method-ologies, lengths of sample intervals, and measures of bank shareperformance during the crisis. Our results therefore have impor-tant implications for regulators in identifying distressed banks thatare vulnerable to the deterioration in conditions of the financialsystem. J. Japanese Int. Economies 30 (2013) 1–18. School ofFinance, Zhongnan University of Economics and Law, PR China;Research Center for International Finance, Institute of World

y, Hubei

2 S. Chen / J. Japanese Int. Economies 30 (2013) 1–18

Economics and Politics, Chinese Academy of Social Sciences, PRChina

� 2013 Elsevier Inc. All rights reserved.

1. Introduction

After the 2007–2008 financial crisis, the recent literature gradually recognized the need of findingsensible measures that have significant power of predicting bank performance during bad economictimes. By stressing the importance of identifying distressed banks that are vulnerable to thedeterioration in conditions of the financial system, some researchers have proposed of some newmeasures to help predict bank share performance during the recent sub-prime crisis (e.g., Acharyaet al., 2010; Knaup and Wagner, 2009). Even more studies have been evaluating the relativeimportance of conventional indicators used in the literature, such as individual bank characteristics,various types of leverage ratios, corporate governance and regulatory approaches, by examining howdifferences in those indicators before a financial crisis would affect different aspects of bankperformance during the crisis (e.g., Beltratti and Stulz, 2012; Berger and Bouwman, 2013;Demirgüç-Kunt et al., 2010).

Admittedly, there may be many variables observable for individual banks that would potentiallyhelp us predict which banks are likely to suffer more from a severe shock to the financial system.Among them, leverage ratios have long been regarded as a common measure of financial health by bothbankers and regulators, since leverage ratios are so defined to measure the sensitivity of the value ofequity ownership with respect to changes in the underlying value of the bank. Banks with higherleverage are more vulnerable in the sense that a given percentage change in a bank’s asset value wouldmanifest itself as a higher percentage change in equity value.

Besides, leverage ratios are so important today that need special attention at the prediction exer-cise of bank performance during a crisis at least for the following two reasons. First, although the trig-ger of the current financial crisis was the decline in property prices, the exceptionally high level ofleverage of financial institutions before the crisis was viewed by many economists and policy makersas one of the most important factors that drove such a relatively small amount of initial sub-primeloan loss into the worst financial crisis since the Great Depression. Therefore, our study serves as aninvestigation of the validity of the hypothesis in the recent literature that high leverage of banks couldcontribute to making a financial crisis even worse. Second, leverage ratios are also at the center of theregulatory policy responses to the current financial crisis, as the G-20 and Basel Committee on BankSupervision have proposed of introducing a new leverage ratio binding to supplement the existingBasel II risk-based capital requirements. Using the Japanese experience in the late 1990s instead ofthe recent crisis, our study is also an out-of-sample examination to ensure that the lessons are equallyrelevant for other economies, and thus are more likely to prevail in the future.

Moreover, while much of the current emphasis both in the financial regulators and academicdepartments is placed on the leverage ratio of the financial system as a whole (e.g., Adrian and Shin,2010), the focus of this paper is to look at the cross-section of leverage ratios among financial institu-tions. Although high leverage is a common characteristic shared by many banks in the recent crisis, wecan still observe significant heterogeneity in leverage ratios of banks as well as their performance dur-ing the crisis. If high leverage does contribute to the poor performance of banks during a crisis, wewould expect that banks with more leverage would perform more poorly in a crisis. Specifically, weintend to address the issue that whether the level of leverage ratios before a financial crisis wouldmake a profound difference to bank performance during the financial crisis.

In addition, while much of the attention has been focused on the recent crisis, the empirical exam-ination of the role played by leverage ratios during financial crises should not be confined to this re-cent case. Rather, we need to test our hypothesis using sample beyond the recent crisis to assesswhether the lessons from the recent financial crisis could prevail in the future. The experience ofJapanese financial crisis occurred in the late 1990s therefore offers us a valuable laboratory to evaluate

S. Chen / J. Japanese Int. Economies 30 (2013) 1–18 3

the role of leverage in identifying distressed banks that are vulnerable to the deterioration in condi-tions of the financial system.1

Furthermore, we also differentiate between two types of leverage ratios: book leverage and mar-ket leverage.2 The calculation of book leverage relies on the book value of capital that is an accountingmeasure of the net worth of a bank. However, the balance sheet might provide us with an inaccurateassessment of the true value of a bank’s equity (e.g., D’Hulster, 2009; Berk and DeMarzo, 2011). First,many of the assets listed on the balance sheet are valued based on their historical cost rather thantheir true value today. The true value might however differ substantially from its book value. Second,many factors might not be recorded on the bank’s balance sheet, such as valuable and/or troubled off-balance-sheet assets. As a result, book leverage might not adequately capture the true extent of lever-age mainly because of both its inherent backward-looking characteristic and its inability to reflectchanging environment.

On the other hand, some economists have instead proposed of using market value of equity tomeasure bank’s capitalization, since the market value of equity measures the amount of capital thatinvestors are willing to offer for a bank, thus provides better estimates of the protection afforded bycapital (e.g., Marcus, 1983; Keeley, 1990; Flannery and Rangan, 2008; Chen, 2010). We argue thatmarket leverage can be viewed as a quality adjustment of book leverage through a refinement ofthe numerator (book value of equity) rather than an elaboration on the denominator (book valueof asset) of the book leverage ratio, such as the replacement of risk-weighted assets for total assetsproposed by the Basel Accord. We could then ask the question: what type of leverage ratios is morerelevant to bank share performance during a financial crisis? We address this question by comparingthe effects of book leverage and market leverage before a crisis on bank share performance duringthe crisis.

This work’s contribution is to investigate the relationship between leverage ratios and bank shareperformance for a sample of Japanese banks during the period of financial crisis in the late 1990s.We compare the predictive power of book leverage ratio and market leverage ratio, and find thatthe market leverage ratio observed before the crisis has statistically and economically significantpredictive power for the cross-sectional variation in bank stock market performance during the Jap-anese financial crisis of the late 1990s, even after controlling for a variety of other bank’s character-istics indicators including bank type, size, asset quality, profitability, liquidity and so on. Moreover,we also employ several empirical designs in order to ensure the robustness of the results so thatthey are not likely to be spurious and due to chance. Specifically, our results are robust across alter-native model specifications, statistical methodologies, lengths of sample intervals, measures of bankshare performance during the financial crisis. Our results therefore have important implications forregulators in identifying distressed banks that are vulnerable to the deterioration in conditions ofthe financial system.

The rest of the paper would proceed as follows. The next section briefly reviews the literature mostrelated to our work. Section 3 provides a description of the data. Section 4 presents the main results ofour analysis. We show how pre-crisis leverage ratios relate to the cross-sectional variation in bank’sbuy-and-hold stock returns during the crisis and bank’s share price reaction to systemic failures. Thefinal section concludes.

1 There is an emerging literature evaluating the policies adopted by the U.S. during the recent crisis by using the Japaneseexperience of the late 1990s. For example, two recent studies of Hoshi and Kashyap (2010) and Onji et al. (2012) examined how thethe Japanese experience of bank capital injection is related to the U.S. bank recapitalization or even a broader concern on bankingindustry.

2 The book leverage is defined as the amount of book value of capital divided by the bank’s total assets, while the marketleverage is a bank’s market value of equity divided by the bank’s total assets. The market value of equity is equal to the marketprice per share times the number of shares outstanding. Our measures of book leverage and market leverage are defined the sameway as Fama and French (1992), who studied the role of book leverage and market leverage in the cross-section of average stockreturns for U.S. non-financial corporations. However, the market leverage and book leverage defined by Fama and French (1992)are in fact leverage multiples and simply the inverse of our leverage ratios. Note also that the definition of leverage ratios issometimes called capital-to-asset ratio in the banking literature, and is in contrast to the usual sense of ‘‘leverage’’ that higherleverage ratios mean lower ‘‘leverage’’ in the sense of debt-to-equity ratio.

4 S. Chen / J. Japanese Int. Economies 30 (2013) 1–18

2. Related literature

Our work is most related to three literatures. The first one is the literature examining the link be-tween bank performance and leverage ratios measured in different forms. For example, Eetrella et al.(2000) compare the ability of a book leverage ratio and risk-based capital ratio in predicting bank fail-ures using US data in the early 1990s. They find that the book leverage ratio can predict bank failureabout as well as the more complex risk-based capital ratio. Wheelock and Wilson (2000) also find thatthe probability of failure or acquisition are higher for banks with lower book leverage ratios using callreports data of US commercial banks from 1984 to 1993. While early works study the link betweenleverage ratios and bank performance without taking into account the macroeconomic environmentin which the prediction exercise were conducted, similar to the recent literature that recognizedthe potential differences between normal times and crises, we focus on the role of leverage ratiosin a crisis context.

Recently, Berger and Bouwman (2013) examines the effect of pre-crisis leverage ratios on bank per-formance during crises and normal times using US data from 1984 to 2010. They find that banks withhigher leverage ratios performed better during banking crises either measured in their survival ormarket share. Another two recent works of Beltratti and Stulz (2012) and Demirgüç-Kunt et al.(2010), on the other hand, examine the relationship between bank stock returns during the sub-primecrisis and leverage ratios using multi-country data. Their results show that better performing banksdid have less leverage before the recent crisis.

Our work differs from the above works in three ways. The first difference concerns the two differ-ent types of leverage ratios (i.e. book leverage and market leverage) that we explore the potentiallydifferent effects of alternative leverage ratios on bank share performance during a crisis. Second, inaddition to the stock market performance measured in buy-and-hold returns during the crisis, we alsoexamine how the market reaction associated with the failure announcements of large financial insti-tutions is related to pre-crisis leverage ratios using event study methodology. Finally, we examine theJapanese experience in the late 1990s instead of the recent crisis, since any lessons obtained from thecurrent crisis need to be examined out-of-sample to ensure that the lessons are equally relevant forother economies, and thus are more likely to prevail in the future.

Second, our work is also related to the exploration of the effect of leverage ratios on stock prices.Early work of Fama and French (1992) find that higher market leverage is associated with lower aver-age returns, while book leverage has a positive impact on stock returns on average. However, Famaand French (1992) exclude all financial firms from their analysis because of the low leverage ratioscompared to other non-financial corporations. Moreover, in contrast to Fama and French (1992),who are interested in analyzing the impact of leverage on stock returns on average, we are more inter-ested in the effect of leverage ratios on bank stock returns during a financial crisis. A recent work ofMehran and Thakor (2011) focus their attention to the banking industry, and also find that book lever-age ratios and bank stock market value are positively correlated in the cross-section. While Mehranand Thakor (2011) examine the role of book leverage on bank stock market value in the context ofacquisitions, we explore the impact of both market leverage and book leverage on their stock marketvalue in a crisis context.

A third related literature studies the appropriateness or importance of incorporating stock marketinformation to assess Japanese bank performance (e.g., Bremer and Pettway, 2002; Harada and Ito,2011). While there is a large literature documenting convincing evidence that US stock prices quicklyand accurately incorporate information to assess bank conditions, the literature often questions theability of Japanese stock market in differentiating weak banks from others.3 However, Bremer and Pett-way (2002), for example, present evidence to show that stock prices in Japan have indeed provided suf-ficient information to discriminate bank even with its limited and poor disclosure. Bremer and Pettway(2002) and Harada and Ito (2011) focused their attention on stock price information of Japanese banksbefore or after the crisis. On the contrary, we shed light on whether information embedded in the

3 For example, Flannery (1998) provide a review of the US empirical evidence showing that market assessments of banks aregenerally rational, and timely comparing with supervisory assessments. He suggests that bank supervisors could improve theiroversight of banks by incorporating more market-based information into their analysis and actions.

S. Chen / J. Japanese Int. Economies 30 (2013) 1–18 5

leverage ratio have predictive power over the stock market performance of Japanese banks during thecrisis. In this sense, our study is more related to the work of Brewer et al. (2003) and Yamori(1999a,b). They provide evidence that stock prices of Japanese banks respond unfavorably to the failuresof large financial institutions, and the magnitude of responses in stock returns is related to their financialcharacteristics and regulatory status. Unlike Brewer et al. (2003) and Yamori (1999a,b), however, our fo-cus is how the pre-crisis leverage ratios would affect the cross-sectional variation in bank share perfor-mance either measured in buy-and-hold returns during the crisis or abnormal returns associated withthe failure announcements of large financial institutions. Moreover, we also compare the ability of mar-ket leverage (market-based indicator) and book leverage (accounting-based indicator) in explaining thecross-sectional variation in bank share performance during the crisis.

3. Data

3.1. Sample selection

We study the role of leverage ratios in the cross-section of bank performance during the period ofJapanese financial crisis from 1997 to 1998. We use the variation in the cross-section of stock returnsduring the crisis and share price responses to the failures of large financial institutions to evaluate theimportance of two types of leverage ratios. Since both the market leverage ratio and bank performancemeasures are based on the market value of banks, sample banks must be listed on a stock exchange tohave stock price data available. There were 103 banks listed on the Tokyo Stock Exchange (TSE) avail-able during that period. To minimize the impact of infrequent trading on our measures of bank shareperformance, we exclude banks whose stocks are not traded for more than 75 days on the TSE duringthat period. Six regional banks are then dropped from our sample by this criterion. In addition to stockmarket data, we also require each bank in our sample to have accounting data available at the end offiscal year 1996.

As a result, our sample consists of a total of 97 banks that have common stocks traded publicly onthe TSE between 1997 and 1998 with non-trading days no exceeding 75 days. Among them are 13large city and long-term credit banks, 7 trust banks, and 77 regional banks. Our data source comesfrom the intersection of two database included in NEEDS-FinancialQUEST: one is the Corporate Fi-nance Database, and the other is the Stock Database. We obtain daily stock prices from the Stock Data-base, while the accounting data necessary for the following analysis are collected from the CorporateFinance Database.

3.2. Descriptive statistics

Table 1 shows the descriptive statistics of key variables for our sample banks at the end of fiscalyear 1996.4 Since our focus in this paper is how the cross-sectional variation in leverage ratios wouldaffect bank performance during the crisis, we first have a close look at leverage ratios prior to the crisisin order to better understand the role of leverages on bank share performance. We differentiate betweentwo types of leverage ratios: book leverage ratio (BLR) and market leverage ratio (MLR). The book lever-age is defined as the amount of book value of capital divided by the bank’s total assets, while the marketleverage is a bank’s market value of equity divided by the bank’s total assets. The market value of equityis equal to the market price per share times the number of shares outstanding. While their denominatorshows the amount of value that a bank has deployed its capital it raised through a variety of sources, thenumerator part (either book or market value of equity) provides a measure about the value that would beleft to shareholders after its assets were sold and liabilities are paid. Both leverage ratios are so defined tomeasure the sensitivity of the value of the equity ownership with respect to changes in the underlyingvalue of the bank.

It is clear from the table that the market leverage ratio is higher than book leverage ratio on averageat the end of fiscal year 1996. The market leverage ratio is also highly volatile, ranging from 1.43% to

4 All variable definitions are in Appendix A.

Table 1Descriptive statistics.

Number of observations Mean Standard deviation Minimum Lower quartile Median Upper quartile Maximum

BLR 97 3.85 1.04 0.68 3.29 3.72 4.27 8.56MLR 97 6.12 2.72 1.43 4.54 5.81 6.79 17.03NPL 97 4.00 4.86 0.31 1.28 2.36 4.67 33.76REL 97 10.46 4.45 4.15 6.98 9.55 13.29 27.85RLR 97 51.47 5.56 39.14 47.55 51.04 55.20 65.78ROA 97 0.09 0.44 �1.95 0.06 0.10 0.22 2.67LIQ 97 19.35 4.54 11.12 15.53 19.52 22.56 33.19LTD 97 97.13 53.28 55.29 76.86 83.27 92.70 431.72TA 97 8385.00 14697.20 668.50 1740.30 2727.10 6244.80 77882.30

Note: This table reports descritpve statistics for key variables of our sample banks at the end of fiscal year 1996. Key variablesinclude total assets (TA), book leverage ratio (BLR), market leverage ratio (MLR), non-performing loan ratio (NPL), real estateloan’s exposure (REL), risky loan’s exposure (RLR), return on assets (ROA), liquidity measure (LIQ), deposit-to-loan ratio (DLR).Our sample includes all banks that have common stocks traded publicly on the TSE between 1997 and 1998 with non-tradingdays no exceeding 75 days. Book leverage ratio (BLR) is defined as the amount of book value of capital divided by the bank’stotal assets. Total assets are measured in billion yen, while all the other variables are measured in percentage.

6 S. Chen / J. Japanese Int. Economies 30 (2013) 1–18

17.03%. In contrast, the book leverage ratio is not as variable as market leverage ratio. For example, theHokkaido Takushoku Bank, which failed at November 1997, had a market leverage ratio of 1.61%. Bycontrast, the Bank of Tokyo-Mitsubishi, which was regarded by many as financially healthy, had amarket leverage ratio of 13.78, several times that of the Hokkaido Takushoku Bank. It might reflectthe fact that the bank’s payoffs are expected to be extremely low relative to peer others, or that inves-tors discount expected future payoffs of the bank at a much higher rate than peer others. In fact, theHokkaido Takushoku Bank finally went out of business on November 17, 1997. On the other hand,while the Hokkaido Takushoku Bank had a book leverage ratio of 3.13%, the Bank of Tokyo-Mitsubishienjoyed a slightly higher book leverage ratio of 3.59%. These two numbers, however, does not seem topresent that much difference between them.

In addition to leverage ratios, we include a variety of controlling variables indicating bank’s assetquality, profitability, liquidity, size and so on. Table 1 shows that our sample covers a wide variety ofdifferent sized banks, including both very large banks based on financial centers and medium andsmall sized local banks. Among them, the Bank of Tokyo-Mitsubishi was also the largest bank inthe world at that time, as measured by total assets. The median total asset (TA) is 8385 billion yen,while the mean total asset is 2727 billion yen. It is important to note that there is substantial variationin the non-performing loan ratio (NPL) across banks. We can also observe significant cross-sectionalvariation in bank’s exposure to real-estate related lending (REL). All the banks have also provided alarge share of their total lending to the ‘‘troubled’’ industries (RLR)5. Our table shows that Japanesebanks suffered from low levels of profitability, with the average (median) return on assets (ROA) of0.09% (0.10%). Some banks even present negative net income in 1996. We also report a measures ofliquidity: the ratio of liquidity assets to total assets (LIQ). We confirm that Japanese banks generally havea certain fraction of liquidity assets available at hand to meet adverse shocks. Finally, we include a loan-to-deposit ratio (LTD) as a measure of stable funding. We find that most of the Japanese banks main-tained a high fraction of stable funding with loan-to-deposit ratio no exceeding one.6

We then analyze how a bank’s leverage ratio is related to other measures of bank’s characteristicsand financial conditions before the financial crisis. Table 2 reports the correlations between thesemeasures and leverage ratios. First of all, we can observe that the book leverage and market leverageare positively related with a coefficient of correlation of 0.41. Both the book leverage and market

5 We follow Watanabe (2007) to define ‘‘troubled’’ industries as real estate, construction, wholesale and retail, and serviceindustries.

6 Japanese banks differ in how they fund their assets. City banks and regional banks fund a greater fraction of their assets withdeposits than long-term credit banks and trust banks do. On the other hand, long-term credit banks and trust banks rely much oftheir funding on corporate bonds or fiduciary assets.

Table 2Correlation matrix.

MLR BLR NPL REL RLR ROA LIQ LTD TA

MLR 1.00 0.41 0.06 0.08 �0.43 0.47 0.15 0.16 0.49BLR 0.41 1.00 �0.24 �0.35 0.02 0.74 0.15 �0.22 �0.28NPL 0.06 �0.24 1.00 0.55 �0.12 �0.04 �0.09 0.45 0.31REL 0.08 �0.35 0.55 1.00 �0.05 �0.25 �0.09 0.62 0.38RLR �0.43 0.02 �0.12 �0.05 1.00 �0.05 �0.26 �0.16 �0.39ROA 0.47 0.74 �0.04 �0.25 �0.05 1.00 0.17 �0.17 �0.12LIQ 0.15 0.15 �0.09 �0.09 �0.26 0.17 1.00 �0.02 �0.10LTD 0.16 �0.22 0.45 0.62 �0.16 �0.17 �0.02 1.00 0.40TA 0.49 �0.28 0.31 0.38 �0.39 �0.12 �0.10 0.40 1.00

Note: This table reports the correlations of market leverage ratio (MLR) and book leverage ratio (BLR), together with other bankcharacteristics reflecting their financial condition, profitability, liquidity and size. For each bank, MLR is the ratio of marketvalues of equity (number of shares outstanding multiplied by the daily closing price) at the end of June in 1997 to total assetsfor the last fiscal year ending in March of 1997, BLR is the ratio of book values of equity to total assets recorded for the fiscal yearending in March of 1997, Non-performing loan ratio (NPL) is the ratio of non-performing loans to total loans, Real-estate loanratio (REL) is the ratio of loans to firms in the real estate industry to total loans, Risky loan ratio (RLR) is the ratio of presumablyrisky loans to ‘‘troubled’’ industries ( that include the construction, whole sale and retail, service, and real estate industries) tototal loans, Return on assets (ROA) is the ratio of net income to total assets, liquidity ratio (LIQ) is the ratio of liquidity assets(sum of cash and securities) to total assets, Loan-to-deposit ratio (LTD) is the ratio of the amount of a bank’s total loans to theirtotal deposits, Total assets (TA) is defined as the natural logarithms of total assets. All the financial characteristics variablesdefined above are measure at the end of fiscal year ending in March of 1997. Our sample includes all banks that have commonstocks traded publicly on the TSE between 1997 and 1998 with non-trading days no exceeding 75 days.

S. Chen / J. Japanese Int. Economies 30 (2013) 1–18 7

leverage are highly correlated with a profitability measure of return on assets. The correlation be-tween book leverage and return on assets is particularly high at a level of 0.74. Both the book leverageand market leverage are also moderately correlated with bank liquidity measured as the ratio ofliquidity asset dividing total assets. The two leverage ratios are also related to other measures of bankcharacteristics, but with opposite signs. For example, larger banks tend to have lower book leveragethan smaller banks but enjoy higher levels of market leverage. The book leverage is also negativelyrelated to bank’s non-performing loan ratios and bank’s exposure to real-estate related lending, butnot closely associated with bank’s lending activity in the ‘‘troubled’’ industries. On the other hand,banks that invested heavily on the ‘‘troubled’’ industries seem to suffer from lower market leverageratios.

4. Results

To investigate the role of leverage ratios in identifying distressed banks that are vulnerable to thedeterioration in conditions of the financial system, we study, in a cross-sectional setting, whether thebank share performance of our sample banks during the financial crisis in the late 1990s is associatedwith leverage ratios before the crisis. Note however that our study is not about the causes of financialcrises, but an investigation of the validity of the hypothesis in the recent literature that high leveragecould contribute to the poor performance of banks during financial crises. Both academics and policymakers have argued that high leverage is responsible to the poor performance of banks during the cri-sis, thus making the crisis even worse. We therefore hypothesize that a bank’s share performance dur-ing a financial crisis is positively associated with its leverage ratios prior to the crisis.

4.1. Bank leverage and buy-and-hold stock returns during the crisis

First, we have to decide how to measure bank performance during the financial crisis. The mainmeasure we adopt in this paper to assess bank performance is buy-and-hold returns during the crisis.While the finance literature might suggest different methods for measuring bank performance in dif-ferent contexts, the buy-and-hold returns is widely regarded as a better measure when our focus is onthe cross-sectional variation in bank share performance (e.g., Fahlenbrach et al., 2011; Beltratti and

8 S. Chen / J. Japanese Int. Economies 30 (2013) 1–18

Stulz, 2012). In addition, we also need to decide for which period of time the buy-and-hold returns forour sample of banks correspond to their stock market performance during the crisis. We regard theone-year buy-and-hold stock return over the period of time from the beginning of July 1997 to theend of June 1998 as our benchmark measure of bank share performance during the financial crisis.We also examine alternative lengths of sample intervals for the robustness of our results.

We would examine the relation between leverage ratios before the crisis and bank’s buy-and-holdstock returns during the crisis using both structured and non-structured methods. The non-structureapproach (categorical analysis) would help us grasp the underlying relationship without imposingfunctional structure. On the other hand, the structure approach (regression analysis) could enableus drawing formal inferences about the relationship between leverage ratios and bank share perfor-mance during the crisis by imposing a functional form (e.g. a linear relation) between them. Thesetwo approaches could provide a cross-check for each other to see if we can yield consistent and robustconclusions.

4.1.1. Categorical analysisFirst, we present the results of categorical analysis by assigning banks into groups based on their

share performance during the crisis. Specifically, we consider the effect of bank leverage by comparingbanks that failed in the following financial turmoil to a comparable sample of banks that performedrelatively well during the financial crisis. In other words, we examine the role of leverage ratios ob-served before the crisis on the stock return performance during the crisis by making a comparisonof the leverage ratios of failed banks and a comparable sample of ‘‘good’’ surviving banks. The resultsare reported in Table 3.

We identified five banks that get into ‘‘troubled’’ (failed, nationalized, or experienced bank run)during the financial crisis from 1997 to 1998: Hokkaido Takushoku Bank, Long-Term Credit Bank ofJapan, Nippon Credit Bank, Ashikaga Bank, and Tokuyo City Bank. Among them are three large cityand long-term credit banks based on money center, and two small regional banks based on local busi-ness operations. We then screen five ‘‘good’’ banks out based on bank type and stock market perfor-mance during the crisis in order to make a comparison with those five ‘‘troubled’’ banks: The Bank of

Table 3A comparison of the ‘‘troubled’’ banks and a comparable sample of ‘‘good’’ banks.

Bank Type MLR BLR Performance

Panel A: ‘‘Troubled’’ banksHokkaido Takushoku Bank City 1.61 3.13 Failed

(November 17, 1997)Long-term Credit Bank of Japan City 4.06 3.26 Nationalized

(October 19, 1998)Nippon Credit Bank City 3.24 0.68 Nationalized

(December 14, 1998)Ashikaga Bank Regional 4.18 2.77 Bank-Run

(November 18, 1997)Tokuyo City Bank Regional 1.43 1.59 Failed

(November 26, 1997)Average 2.90 2.29

Panel B: ‘‘Good’’ banksBank of Tokyo-Mitusbishi City 13.78 3.59 16.31Industrial Bank of Japan City 10.40 3.29 1.32Sumitomo Bank City 10.33 3.13 24.25Shizuoka Bank Regional 13.41 5.94 29.11Hachijuni Bank Regional 12.03 4.79 14.34Average 11.99 4.15 17.07

Note: This table compares the leverage ratios of a set of ‘‘troubled’’ banks (failed, nationalized, or experienced bank run) and acomparable sample of ‘‘good’’ surviving banks that are selected based on bank type and stock market performance during thatcrisis. For each bank, market leverage (MLR) is the ratio of market values of equity (number of shares outstanding multiplied bythe daily closing price) at the end of June in 1997 to total assets for the last fiscal year ending in March of 1997, while bookleverage (BLR) is the ratio of book values of equity to total assets recorded for the fiscal year ending in March of 1997.

S. Chen / J. Japanese Int. Economies 30 (2013) 1–18 9

Tokyo-Mitsubishi, Industrial Bank of Japan, Sumitomo Bank, Shizuoka Bank, and Hachijuni Bank.While the book leverage ratio of five ‘‘troubled’’ banks is 2.29% on average, the average book leverageratio of the five ‘‘good’’ banks is 4.15%, nearly twice that of ‘‘troubled’’ banks. The five ‘‘troubled’’ banksalso hold a similarly low level of market leverage ratio on average (2.9%) compared with their averagebook leverage. On the other hand, the five ‘‘good’’ banks enjoyed a high level of market leverage onaverage (about 12%) compared to their average book leverage. In other words, we can observe an evenlarger spread in market leverage than book leverage between the group of ‘‘troubled’’ banks and thegroup of five ‘‘good’’ banks. Overall, we find that bank share performance during the crisis is positivelyrelated to leverage ratios prior to the crisis, regardless of whether the leverage ratio is measured inmarket leverage or book leverage.

In order to provide you an overall picture of how the leverage ratios prior to the crisis are related totheir stock market performance, Fig. 1 shows the scatter plot of buy-and-hold stock returns during thefinancial crisis on the vertical axis against bank leverages on the horizontal axis (BLR in Panel (a) andMLR in Panel (b)). We can again confirm that banks with lower ratios of market leverage and bookleverage tend to be affected more adversely to present worse performance than those with higher ra-tios of market leverage and book leverage during the financial crisis.

4.1.2. Regression analysisSecond, under the assumption that the relation between bank leverage and share performance dur-

ing the crisis is linear, we can estimate the cross-sectional relation between leverage ratios and bankshare performance during the crisis by imposing an assumption that the relation is linear. This allowsus to draw statistical inferences about the relationship between leverage ratios and bank share perfor-mance during the crisis. We also compare the estimated difference in share performance of failedbanks relative to surviving banks at different levels of leverage, in order to gauge the economic signif-icance of leverage ratios in affecting the bank share performance during the crisis. In particular, wespecify the cross-sectional regression as follows:

Ri ¼ aþ b � Xi þ c � Controli þ d � Typei þ �i; ð1Þ

where Ri is the buy-and-hold stock return for bank i during the financial crisis from 1997 to 1998; Xi

denotes either book leverage or market leverage for bank i observed at the end of fiscal year 1996; Con-

troli is a set of control variables for each bank that are likely to contain information affecting bank’sstock market performance during the financial crisis; Typei is dummy variables indicating the typeof bank i; �i is an error term. We should observe a positive coefficient (b > 0) if the results are consis-tent with our hypothesis.

We first consider the effect of leverage ratios without controlling other variables reflecting bank’sfinancial health and risk characteristics. The results are reported in Table 4. Our univariate analysisshows that a bank’s market leverage prior to the crisis is significantly and positively associated withits stock market performance during the crisis. This cross-sectional test confirms our impression fromthe intuitive comparisons between the ‘‘troubled’’ banks and a comparable sample of ‘‘good’’ banksthat banks with lower market leverage tend to be affected more unfavorably to present worse stockmarket performance than those with higher market leverage during the financial crisis. It thereforesuggests that the market leverage ratio may contain useful information of how a bank would performduring the financial crisis. On the other hand, although the coefficient estimates of book leverage isalso positive, they are not statistically significant at the conventional levels. A natural question thenis whether the market leverage has economic relevance when the effects of book leverage are properlycontrolled. Our results show that the market leverage indeed has incremental significance even whenbook leverage is controlled for. Our findings are robust to alternative lengths of sample intervals.

Note that a new leverage ratio binding is proposed after the global financial crisis, in order to sup-plement the existing Basel capital requirements. Thus, it is interesting to compare the predictivepower of Basel capital adequacy ratio with book leverage ratio and market leverage ratio using the Jap-anese experience, although this exercise would reduce our sample size significantly. When consideredalone, the predictive coefficients of Basel capital adequacy ratio over alternative sample intervals arenot only positive (in a range from 3.2 to 3.7), but also statistically significant at the conventional levels.However, both the economic and statistical significance of Basel capital adequacy ratio decrease when

86420

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Book Leverage (%)

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’s S

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City and Long−Term Credit BankRegional BankTrust Bank

Hokkaido Takushoku BankTokuyo City Bank

Long−Term Credit Bank of Japan

The Nippon Credit Bank

ASHIKAGA BANK

Tokyo Sowa Bank

Kanto Bank

Shizuoka Bank

Hokkoku BankKeiyo Bank

Nippon Trust Bank

(a) Book leverage and stock returns

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Tokuyo City Bank

Long−Term Credit Bank of Japan

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ASHIKAGA BANK

Hokkaido Bank

Kanto Bank

Shizuoka Bank

Hachijuni Bank

Bank of Tokyo−MitusbishiNippon Trust Bank

Mitsubishi Trust Bank

(b) Market leverage and stock returns

Fig. 1. Bank leverage and bank share performance during the financial crisis from 1997 to 1998. Note: The horizontal axis iseither book leverage ratio (BLR, in Panel (a)) or market leverage ratio (MLR, in Panel (b)) recorded at the end of fiscal year 1996,while the vertical axis is the bank’s share performance during the financial crisis measured as stock returns from the end of June1997 through the end of June 1998. Source: Author’s calculations using the NEEDS-FinancialQUEST database.

10 S. Chen / J. Japanese Int. Economies 30 (2013) 1–18

the book leverage ratio is added into the model. Furthermore, the Basel capital ratio would even haveno economic relevance when the effects of market leverage ratios are properly controlled for. There-fore, our results can hold even when the Basel-type capital adequacy ratio is used.7

7 To conserve space, these results are not reported here but are available upon request.

Table 4Market leverage vs. book leverage.

A: December 1997 B: June 1998 C: December 1998

(1) (2) (3) (1) (2) (3) (1) (2) (3)

Intercept �35.86⁄⁄ �32.98⁄⁄ �32.36⁄⁄ �32.07⁄⁄ �29.73⁄⁄ �29.08⁄⁄ �33.82⁄⁄ �35.31⁄⁄ �34.92⁄⁄

(5.43) (10.54) (10.12) (5.58) (11.00) (10.86) (5.85) (10.58) (10.44)MLR 2.85⁄⁄ 3.15⁄⁄ 3.02⁄⁄ 3.27⁄⁄ 2.07⁄ 1.98⁄

(0.81) (0.83) (0.83) (0.79) (0.88) (0.90)BLR 3.23 �1.29 3.60 �1.10 3.25 0.41

(2.45) (2.53) (2.53) (2.58) (2.42) (2.48)CITY �35.38⁄⁄ �26.07⁄⁄ �37.40⁄⁄ �43.19⁄⁄ �33.15⁄⁄ �44.91⁄⁄ �50.70⁄⁄ �42.96⁄⁄ �50.06⁄⁄

(4.74) (6.92) (6.46) (4.90) (7.12) (6.60) (4.83) (6.49) (6.46)TRUST �41.00⁄⁄ �28.89⁄⁄ �42.18⁄⁄ �43.44⁄⁄ �30.65⁄⁄ �44.45⁄⁄ �52.43⁄⁄ �43.72⁄⁄ �52.06⁄⁄

(6.23) (7.50) (6.28) (6.60) (5.71) (7.01) (8.84) (6.08) (9.23)Obs 97 97 97 97 97 97 97 97 97

Note: This table shows the estimation results of OLS regressions of a bank’s share performance during the financial crisismeasured as the stock return over alternative lengths of sample intervals (A is from the end of June 1997 to the end of December1997, B is from the end of June 1997 to the end of June 1998, C is from the end of June 1997 to the end of December 1998) on itsmarket leverage and book leverage prior to the crisis at the end of fiscal year 1996 without controlling other variables reflectingbank’s financial health and risk characteristics. The market leverage ratio (MLR) is the ratio of market values of equity (numberof shares outstanding multiplied by the daily closing price) at the end of June in 1997 to total assets for the last fiscal yearending in March of 1997. The book leverage ratio (BLR) is the ratio of book values of equity to total assets recorded for the fiscalyear ending in March of 1997. We also include dummy variables indicating the institutional categories of banks in allregressions, CITY for city and long-term credit banks, TRUST for trust banks, while regional banks are treated as the base type. Inparentheses are heteroscedasticity-robust standard errors. Our sample includes all banks that have common stocks tradedpublicly on the TSE between 1997 and 1998 with non-trading days no exceeding 75 days.⁄ Significance at the 5% level.⁄⁄ Significance at the 1% level.

S. Chen / J. Japanese Int. Economies 30 (2013) 1–18 11

However, can we use the market leverage ratio to incrementally improve the predictive power forbank’s performance during the crisis even after controlling for a variety of other traditional risk mea-sures? To answer this question, we regress a bank’s share performance during the financial crisis on itsmarket leverage ratio together with other controlling variables reflecting bank’s financial strength andrisk characteristics observed before the financial crisis. The results are reported in Table 5. We firstbegin with regressions by adding different set of control variables separately. Column (1) shows theresult by including a traditional bank risk measure of non-performing loan ratio (NPL). In Columns(2), we examine whether the relationship between market leverage and bank performance duringthe financial crisis is robust when controlling for proxies of asset quality measured as exposures toreal-estate lending (REL) and ‘‘troubled’’ industries related lending (RLR). Column (3) controls for abank’s profitability measure (ROA). In Column (4), we account for the effect of including additionalmeasures of liquidity risk tolerance (LIQ) and stable funding (LTD). Finally, we investigate the relationbetween market leverage and bank’s share performance during the financial crisis by including the fulllist of control variables. The result is reported in Column (5).

The main message from the regression results in Table 5 is that the coefficient of market leverageratio is robust to the inclusion of a variety of other traditional risk measures, and is positive in a rel-atively narrow range from 2.48 to 3.30 and always statistically significant at the 1% level. Moreover,given the wide range of market leverage ratios across banks, the estimated coefficients of marketleverage are economically significant. For example, it implies a difference in the expected share priceperformance of (11.99 � 2.90) � 2.64 = 24% between our group of ‘‘troubled’’ banks and the group offive comparably ‘‘good’’ banks, in the case of controlling for all the other variables considered in ourregressions (a coefficient of 2.64). It suggests that banks with lower market leverage ratio are likelyto be influenced much more than banks with higher market leverage ratios during the financial crisis.It is also worth noting that the traditional measures of bank risk, such as non-performing loan ratiosand exposure to real estate related lending, are not significant at all. Our findings are again robust toalternative lengths of sample intervals.

Table 5The predictive power of market leverage ratio during the financial crisis of 1997–1998.

A: December 1997 B: June 1998 C: December 1998

(1) (2) (3) (4) (5) (1) (2) (3) (4) (5) (1) (2) (3) (4) (5)

Intercept �28.02 ⁄⁄⁄ �10.86 �36.51⁄⁄⁄ �41.41⁄⁄⁄ �9.71 �26.39⁄⁄⁄ �15.45 �33.32⁄⁄⁄ �39.77⁄⁄⁄ �26.55 �28.69⁄⁄⁄ �18.87 �32.49⁄⁄⁄ �24.18⁄⁄ �3.66(5.79) (16.89) (5.47) (11.32) (19.38) (6.01) (16.31) (5.24) (11.87) (18.69) (6.23) (18.86) (5.67) (11.73) (20.34)

MLR 2.11⁄⁄⁄ 2.31⁄⁄⁄ 3.00⁄⁄⁄ 2.74⁄⁄⁄ 1.97⁄⁄⁄ 2.48⁄⁄⁄ 2.68⁄⁄⁄ 3.30⁄⁄⁄ 2.83⁄⁄⁄ 2.64⁄⁄⁄ 1.59⁄ 1.63⁄ 1.78⁄⁄ 1.78⁄⁄ 1.91⁄⁄

(0.73) (0.72) (0.84) (0.80) (0.72) (0.78) (0.73) (0.79) (0.80) (0.74) (0.87) (0.83) (0.89) (0.87) (0.96)NPL �1.46 �1.34 �1.05 �0.88 �0.95 �0.86

(0.90) (0.87) (0.94) (0.90) (0.83) (0.69)REL �0.80 �0.68 �0.46 �0.24 �0.87 �0.29

(0.55) (0.56) (0.57) (0.56) (0.58) (0.64)RLR �0.28 �0.21 �0.2 �0.06 �0.09 �0.16

(0.33) (0.32) (0.3) (0.3) (0.34) (0.34)ROA �1.73 �2.57 �3.36 �4.15 3.54 1.45

(3.53) (3.5) (4.02) (4.8) (4.66) (4.95)LIQ 0.40 �0.05 0.60 0.36 0.02 �0.25

(0.39) (0.35) (0.38) (0.34) (0.44) (0.42)LTD �0.02 0.01 �0.04 �0.03 �0.1⁄⁄⁄ �0.08⁄⁄

(0.03) (0.04) (0.04) (0.04) (0.02) (0.04)CITY �25.76⁄⁄⁄ �30.85⁄⁄⁄ �36.05⁄⁄⁄ �32.05⁄⁄⁄ �24.46⁄⁄⁄ �36.23⁄⁄⁄ �40.65⁄⁄⁄ �44.5⁄⁄⁄ �37.68⁄⁄⁄ �33.73⁄⁄⁄ �44.4⁄⁄⁄ �45.42⁄⁄⁄ �49.32⁄⁄⁄ �41.8⁄⁄⁄ �36.65⁄⁄⁄

(5.66) (6.9) (5.22) (6.71) (7.36) (6.21) (6.45) (5.24) (6.38) (7.1) (6.06) (6.19) (5.29) (5.93) (7.14)TRUST �23.93⁄⁄ �33.51⁄⁄⁄ �40.92⁄⁄⁄ �41.26⁄⁄⁄ �19.16⁄ �31.09⁄⁄ �39.31⁄⁄⁄ �43.27⁄⁄⁄ �43.23⁄⁄⁄ �29.81⁄⁄⁄ �41.25⁄⁄⁄ �43.37⁄⁄⁄ �52.61⁄⁄⁄ �42.47⁄⁄⁄ �30.32⁄⁄

(11.33) (9.1) (6.15) (7.39) (11.21) (12.1) (8.86) (6.6) (7.58) (10.96) (13.22) (10.81) (8.74) (8.78) (11.88)adj.R2 0.48 0.43 0.41 0.41 0.46 0.53 0.5 0.5 0.51 0.51 0.57 0.56 0.56 0.58 0.58Obs 97 97 97 97 97 97 97 97 97 97 97 97 97 97 97

Note: This table shows the estimation results of OLS regressions of a bank’s share performance during the financial crisis measured as the stock return over alternative lengths of sampleintervals (A is from the end of June 1997 to the end of December 1997, B is from the end of June 1997 to the end of June 1998, C is from the end of June 1997 to the end of December 1998)on its market leverage ratio prior to the crisis at the end of June 1997 and other controlling variables. Market leverage ratio (MLR) is the ratio of market values of equity (number of sharesoutstanding multiplied by the daily closing price) at the end of June in 1997 to total assets for the last fiscal year ending in March of 1997. For controls, we include the followings variables:Non-performing loan ratio (NPL) is the ratio of non-performing loans to total loans, Real-estate loan ratio (REL) is the ratio of loans to firms in the real estate industry to total loans, Riskyloan ratio (RLR) is the ratio of presumably risky loans to ‘‘troubled’’ industries (that include the construction, whole sale and retail, service, and real estate industries) to total loans, Returnon assets (ROA) is the ratio of net income to total assets, liquidity ratio (LIQ) is the ratio of liquidity assets (sum of cash and securities) to total assets, Loan-to-deposit ratio (LTD) is the ratioof the amount of a bank’s total loans to total deposits. All the financial characteristics variables defined above are measured at the end of fiscal year ending in March of 1997. We alsoinclude dummy variables indicating the institutional categories of banks in all regressions, CITY for city and long-term credit banks, TRUST for trust banks, while regional banks are treatedas the base type. In parentheses are heteroscedasticity-robust standard errors. Our sample includes all banks that have common stocks traded publicly on the TSE between 1997 and 1998with non-trading days no exceeding 75 days.⁄ Significance at the 10% level.⁄⁄ Significance at the 5% level.⁄⁄⁄ Significance at the 1% level.

12S.Chen

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1990 1995 2000 2005

−10

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5

Year

Estim

ated

Slo

pe C

oeffi

cien

ts

MLRBLR

Fig. 2. The dynamics of the cross-sectional relationship between leverage ratios and bank stock returns over the sample periodfrom 1988 to 2008. Note: The blue line with triangles plots the changing slope coefficients on book leverage, while the red linewith circles gives the changing slope coefficients on market leverage.

S. Chen / J. Japanese Int. Economies 30 (2013) 1–18 13

4.1.3. The dynamics of the relationship between bank leverage and stock returnsIn order to emphasize the importance of taking into account the macroeconomic environment in

which the prediction ability of leverage ratios were analyzed, we would like to take a close look athow the relationship between leverage rations and bank share performance have changed over time.We conduct a cross-sectional regression of individual bank’s annual stock returns against their lever-age ratios at each year over the sample period from 1988 to 2008, in order to examine the relationshipbetween leverage ratios and bank stock market performance over the subsequent one-year period. Wethen plot the changing estimated slope coefficients over the sample period in Fig. 2.

It is clear that the book leverage appears to be positively related to bank stock returns on average,while the market leverage seems on average to have a negative impact on bank stock returns. Thisfinding is consistent with Fama and French (1992)’s exploration of non-financial corporations thatthe two leverage ratios are related to stock returns on average, but with opposite signs.

Moreover, it is interesting to observe that although the estimated slopes of market leverage arenegative or slightly positive most of the time, it is highly positive in 1997 when the most severe finan-cial crisis in Japan’s post-war history occurred. It confirms our conjecture that the prediction exerciseduring times of crises could potentially be different from those of normal times. We also argue thatthis patten of changes in slope coefficients on market leverage over time is consistent with rationalasset pricing story. Asset pricing models suggest that banks with lower market leverage ratios wouldearn higher returns on average, precisely because they are expected to do badly in bad times such aswhen the banking system as a whole is in trouble.

4.2. Bank leverage and its share price reaction to systemic failures

So far, we have used bank’s buy-and-hold stock returns to measure bank share performance duringthe financial crisis. We now consider another approach of using bank’s stock price movements in re-sponse to the failures of large financial institutions (abnormal returns in the event window) in the fallof 1997 as an alternative measure of bank share performance during the financial crisis. The systemicfailures during the financial crisis of late 1990s were large shocks to Japan’s financial system thatcould reasonably be expected to worsen the macroeconomic environment in which the survivingbanks operate. Since the failures indicate further deterioration in conditions of the financial systemduring the crisis, bank’s share price reactions to those systemic failures can therefore serve as anappropriate measure of bank share performance during the intensified stage of the financial crisis.We then evaluate the differences in the magnitude of abnormal returns of individual banks associated

14 S. Chen / J. Japanese Int. Economies 30 (2013) 1–18

with the failure announcements of large financial institutions using event study methodology. In otherwords, we study how differences in leverage ratios before a crisis would impact bank share perfor-mance during the crisis by examining whether banks with lower leverage ratios were affected moreadversely by the failure of large financial institutions.

Moreover, this experiment has an advantage compared to the above analysis based on buy-and-hold stock returns. One may argue that our results above are driven by omitted variables correlatedwith both leverages and buy-and-hold stock returns, although we control extensively for variablespotentially affecting stock market performance during the crisis. Since this analysis takes the formof an event study, the results are less likely to be affected by mis-specifications of the model of ex-pected stock returns. In what follows, we therefore examine the market reaction to the failureannouncements of large financial institutions conditional on leverage ratios.

4.2.1. Empirical designFirst, we employ a market model used in the standard event study literature to generate abnormal

returns associated with the failure announcements. We would use a one-year common estimationperiod around our event dates. As a result, our estimation period including event window consistsof a total of 245 days, stretching from 206 days before the first event to 25 days after the last event.Following Binder and Norton (1999) and Brewer et al. (2003), we also permit a shift both in interceptsand market beta coefficients after the first systemic failure, since the three systemic failures of largefinancial institutions in the fall of 1997 are close to each other. Our specific estimation model is asfollows:

8 Wereporte

Rfi;tg ¼ ai þ ai � SHIFTþ bi � Rfm;tg þ bi � SHIFT � Rfm;tg þX

e

XT

w¼0

kfi;w;eg � Dfw;eg þ �fi;tg; ð2Þ

where R{i,t} is the stock return on bank i for day t; ai is the intercept coefficient for bank i; SHIFT is abinary variable that equals one after the first event day (i.e. the failure of Sanyo Securities); R{m,t} is thereturn on the value-weighted market portfolio for day t; bi is the market beta coefficient for bank i;k{i,w,e} is the event coefficient for bank i; e is the number of events (e = 3); D{w,e} is a binary variablethat equals one if day t is within the event window w (w 2 [0,T]), zero otherwise; �{i,t} is a disturbanceterm. Therefore, the estimated parameter k{i,w,e} represents an estimate of abnormal return for bank ion wth day within the eth event window. Eq. (2) is then estimated for each bank separately using or-dinary least squares.8

If there is no new information conveyed to the market by the failure announcements occurred in1997, we could observe no significant market response associated with the failure events. Brewer et al.(2003) provided evidence to reject the irrelevance hypothesis that the failure of large financial insti-tutions did reveal new information to have a significantly negative impact on the valuation of surviv-ing banks. Spiegel and Yamori (2004) and Yamori (1999a,b) also rejected the pure contagionhypothesis by demonstrating that the contagion effects are primarily confined to banks with similarcharacteristics such as financial condition, and regulatory status. Our focus in this paper, however,is to test the role of leverage ratios in explaining the differential responses of the bank to systemic fail-ures. In other words, we explore the question of whether there is a cross-sectional variation in the re-sponse of surviving banks to large bank failures in a way systematically related to their leverage ratiosbefore the crisis.

Since banks with lower leverage ratios have more sensitivity of equity value with respect to under-lying asset changes, we should observe a negative relationship between leverage ratios and abnormalreturns even if all the banks are perceived to suffer from the same amount of loss, regulatory costs, orrevaluation of their assets value by the newly revealed information. We therefore hypothesize that thehigher a bank’s leverage ratio, the less it would be affected by the failure announcements.

replicated the regressions using generalized least squares, but the results did not change materially from the resultsd herein.

Table 6Regression results of how the leverage ratios are related to a bank’s share price reaction to systemic failures in the fall of 1997.

A: Sanyo Securities Failure (November 4, 1997) B: Hokkaido Takushoku Bank Failure (November 17, 1997) C: Yamaichi Securities Failure (November 25, 1997)

(1) (2) (3) (4) (1) (2) (3) (4) (1) (2) (3) (4)

Intercept �4.43⁄⁄⁄ �4.9⁄⁄⁄ �4.91⁄⁄⁄ 0.42 �11.02⁄⁄⁄ �13.31⁄⁄ �13.33⁄⁄ �0.03 �15.53⁄⁄⁄ �11.11⁄ �11.13⁄ �33.22⁄⁄

(1.15) (1.53) (1.46) (4.28) (3.27) (5.85) (5.87) (8.3) (3.29) (6.16) (5.71) (15.23)MLR 0.61⁄⁄⁄ 0.57⁄⁄⁄ 0.48⁄⁄⁄ 1.28⁄⁄⁄ 1.08⁄⁄ 0.92⁄⁄ 1.96⁄⁄⁄ 2.34⁄⁄⁄ 1.92⁄⁄⁄

(0.17) (0.21) (0.17) (0.41) (0.43) (0.4) (0.52) (0.76) (0.64)BLR 0.98⁄⁄⁄ 0.18 2.36⁄ 0.84 1.67 �1.61

(0.35) (0.40) (1.21) (1.33) (1.45) (1.9)NPL �0.23⁄⁄⁄ �0.60 �0.84⁄

(0.08) (0.63) (0.46)REL �0.12 �0.44 �0.44

(0.16) (0.42) (0.47)RLR 0.01 0.03 0.48⁄⁄

(0.07) (0.17) (0.21)ROA �0.35 �0.56 �3.64

(0.94) (2.22) (3.72)LIQ �0.11 �0.23 0.03

(0.09) (0.19) (0.29)LTD �0.01 0 �0.02

(0.01) (0.02) (0.03)CITY �3.59⁄⁄⁄ �0.99 �3.28⁄⁄ �1.2 �2.89 2.92 �1.41 3.04 �10.1⁄⁄ �3.52 �12.91⁄⁄ �0.55

(1.33) (1.6) (1.59) (1.56) (2.66) (3.74) (4.05) (3.97) (4.4) (5.47) (6.12) (6.23)TRUST �6.15⁄⁄⁄ �3.6⁄⁄ �5.98⁄⁄⁄ �0.74 �1.09 4.21 �0.27 12.42⁄⁄ �24.33⁄⁄⁄ �16.17⁄⁄ �25.89⁄⁄⁄ �5.62

(1.45) (1.52) (1.51) (2.35) (2.66) (3.54) (3.26) (5.77) (7.07) (7.79) (6.97) (7.71)adj.R2 0.23 0.14 0.22 0.27 0.07 0.03 0.06 0.08 0.25 0.12 0.25 0.33N 88 88 88 88 88 88 88 88 88 88 88 88

Note: This table shows the estimation results of OLS regressions of how the leverage ratios measured before the crisis at the end of fiscal year 1996 are related to a bank’s share pricereaction to three systemic failures of large financial institutions in the fall of 1997. The market leverage ratio (MLR) is the ratio of market values of equity (number of shares outstandingmultiplied by the daily closing price) at the end of June in 1997 to total assets for the last fiscal year ending in March of 1997, while book leverage ratio (BLR) is the ratio of book values ofequity to total assets recorded for the fiscal year ending in March of 1997. For controls, we include the followings variables: Non-performing loan ratio (NPL) is the ratio of non-performingloans to total loans, Real-estate loan ratio (REL) is the ratio of loans to firms in the real estate industry to total loans, Risky loan ratio (RLR) is the ratio of presumably risky loans to‘‘troubled’’ industries (that include the construction, whole sale and retail, service, and real estate industries) to total loans, Return on assets (ROA) is the ratio of net income to total assets,liquidity ratio (LIQ) is the ratio of liquidity assets (sum of cash and securities) to total assets, Loan-to-deposit ratio (LTD) is the ratio of the amount of a bank’s total loans to their totaldeposits. All the financial characteristics variables defined above are measure at the end of fiscal year ending in March of 1997. We also include dummy variables indicating theinstitutional categories of banks in all regressions, CITY for city and long-term credit banks, TRUST for trust banks, while regional banks are treated as the base type. In parentheses areheteroscedasticity-robust standard errors. Our sample includes all banks that have common stocks traded publicly on the TSE between 1997 and 1998, as well as satisfying both of thefollowing two trading conditions: first, they should have non-trading days no exceeding 75 days during the period between 1997 and 1998; second, they should also have trading recordsduring the event window.⁄ Significance at the 10% level.⁄⁄ Significance at the 5% level.⁄⁄⁄ Significance at the 1% level.

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16 S. Chen / J. Japanese Int. Economies 30 (2013) 1–18

To test this proposition, we then regress the individual bank’s abnormal returns obtained from thestandard event-study approach that we postulated above on bank’s leverage ratios before the crisistogether with other controlling variables reflecting bank’s financial strength and risk characteristics.

9 In w

/i ¼ aþ b � Xi þ c � Controli þ d � Typei þ �i; ð3Þ

where /i is the cumulated abnormal returns for bank i over the event window w (w 2 [0,T])9; Xi iseither the book leverage or market leverage for the ith bank before the crisis; Controli is a set of controlvariables for bank i reflecting financial health and risk characteristics measured at the end of fiscal year1996; Typei is dummy variables indicating the type of bank i.

4.2.2. Empirical resultsThe results are reported in Table 6. Our results indicate that Japanese banks taken as a whole are

adversely affected by all the three failure events. This fact is consistent with the previous findings (e.g.,Brewer et al., 2003) that the systemic failures do convey new information about the Japanese bankingsystem. More importantly, both market leverage and book leverage seem to be positively and signif-icantly related to the abnormal returns following the failure announcements. The higher a bank’sleverage ratio before the crisis, the more resistant it is to the bad news brought by the announcementsof systemic failures. In other words, taken separately, either market leverage or book leverage seemsto have predictive power for the cross-sectional variation in bank’s stock responses to the systemicfailures. However, once we put them together, book leverage lose predictive power for all the cases.On the other hand, the market leverage’s predictive power is robust to the inclusions of other controlvariables reflecting individual bank’s financial health and risk characteristics. It confirms our earlierfindings that market leverage instead book leverage observed before the crisis has predictive powerfor the cross-sectional variation in bank share performance during the crisis.

In short, the results suggest that our findings are not only robust to alternative model specifications(the inclusion of alternative set of additional control variables), statistical methodologies and changesin the lengths of sample intervals, but can also survive by using alternative measures of bank shareperformance during the crisis.

5. Conclusion

In this paper, we investigate in a cross-sectional setting the relationship between leverage ratiosand bank share performance for a sample of commercial banks during the period of Japanese financialcrisis in the late 1990s. We differentiate between two types of leverage ratios: book leverage and mar-ket leverage. We show that market leverage instead of book leverage observed before the crisis hasstatistically and economically significant predictive power for the cross-sectional variation in bankperformance measured in buy-and-hold stock returns during the crisis, even after controlling for avariety of other indicators reflecting bank’s characteristics and financial conditions. The results are ro-bust across alternative model specifications, statistical methodologies and lengths of sample intervals.

Moreover, we also employ standard event study methods to examine how the leverage ratios areassociated with the response of bank share prices to the systemic failures of large financial institutionsduring the financial crisis. Although we find that both market leverage and book leverage seem to bepositively and significantly related to the abnormal performance associated with the announcementsof systemic failures, the book leverage would lose its predictive power once we control for marketleverage. On the other hand, the predictive power of market leverage is robust even to the inclusionsof other control variables reflecting individual bank’s financial health and risk characteristics.

Our findings suggest that the market leverage instead book leverage observed before the crisis canmake a difference for the cross-sectional variation in bank share performance during the crisis. Ourresults therefore have important implications for financial regulators that monitoring market leverageratios in addition to book leverage ratios could provide more useful information to help regulators in

hat follows, we will follow Brewer et al. (2003) to report our results based on a two-day event window (w 2 [0,+1]).

Table 7Variable definitions.

Variable Definition

BLR The book leverage ratio, defined as the amount of book value of capital divided by the bank’s total assetsMLR The market leverage ratio, defined as the ratio of market values of equity at the end of June, 1997 divided by

bank’s total assets for the end of last fiscal year. We calculate the market value of equity as the number ofoutstanding shares times the stock price

NPL Non-performing loan ratio, defined as the ratio of non-performing loans to total lending. We calculate non-performing loans as the sum of loans to bankrupt borrowers, past-due loans, loans with debt forgiveness, andloans to specific borrows under support

REL A measure of bank’s exposure to real-estate related lending that is defined as the share of real-estate relatedloans in total lending

RLR A measure of bank’s exposure to ‘‘troubled’’ industries that is defined as the share of loans to ‘‘troubled’’industries in total lending. We follow Watanabe (Watanabe, 2007) to define ‘‘troubled’’ industries as realestate, construction, wholesale and retail, and service industries

ROA A profitability measure of return on assets that is defined as the ratio of business profit before taxes to totalassets

LIQ A liquidity measure that is defined as the ratio of liquidity assets (sum of cash and securities) to total assetsDLR Deposit-to-loan ratio, defined as the ratio of total deposit to total loansTA Total assets measured in billion yen

Note: All the variables defined above are measured at the end of fiscal year ending in March of 1997.

S. Chen / J. Japanese Int. Economies 30 (2013) 1–18 17

identifying distressed banks that are vulnerable to the deterioration in conditions of the financial sys-tem. It makes sense for regulators to enhance market discipline rather than replacing it.

Acknowledgments

I would like to thank comments from participants at the Pacific-Rim Conference of the Associationfor Comparative Economic Studies in Hawaii, 2012. I am especially indebted to the anonymous refereefor constructive suggestions that helped improve the paper greatly. I also acknowledge financial sup-port from the Project Sponsored by the Scientific Research Foundation for the Returned Overseas Chi-nese Scholars, State Education Ministry, the Fundamental Research Funds for the Central Universities(2012022), and the scientific research foundation of Zhongnan University of Economics and Law. Allremaining errors are mine.

Appendix A

Table 7.

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