Bank stock returns and endogenous money supply in the wake of financial deregulation and crisis: Evidence from

United States

Zatul Effawaty Badaruddin Monash University

Mohamed Ariff Bond University

Contact details: Building H, Monash University, Caulfield Campus, 900 Dandenong Road, Caulfield East, VIC 3145, Australia Phone: +61 3 9903 4019 E-mail: effa.badaruddin@buseco.monash.edu.au

Bank stock returns and endogenous money supply in the wake of financial deregulation and crisis: Evidence from United States

Abstract This study is about the relationship between money supply and bank industry stock returns in United States over thirty years taking into account the endogeneity of money under Post-Keynesian theory. A three-stage least square estimation is used to determine the relationship between money supply and bank industry returns. Bank market structure is also taken into account in this study applying the Herfindahl-Hirschman Index to determine the market structure of the banking market. It is found that there is a positive relationship between money supply and bank industry stock returns consistent with a competitive bank market structure. Episodes of financial deregulation and financial crisis are also included into the model and the results are consistent throughout the sample.

Keywords

Money supply; Three-stage least squares; Bank stock returns E51; G21

JEL Classification

1. Background and motivation Banks are important in a financial system, indeed in an economy, as they are the transmitter of monetary policy changes, for example using bank reserves as the principal channel, from the central bank to the economy. They possess an optimising behaviour in determining money supply, in response to changes in the publics portfolio decisions and loan demand, given the money market conditions set by the central bank (Holtemller, 2003). This behaviour of the public and the commercial banks makes money endogenous (Moore, 1998).

There is a general consensus among the post Keynesian (PK hereafter) theorists that money supply is endogenous, and it is determined by the asset and liability management decisions of the commercial banks, the portfolio decisions of the nonbank public and the demand for bank loans (Palley, 1994). The core of this theory is that causality runs from bank lending to bank deposits, instead of the orthodox view that deposits create loans. The central banks role is to set the level of official shortterm interest rates and thus have no control over total borrowings and money stock 2

other than through open market operations. This notion of endogenous money is not popular among mainstream economists due to its lack of empirical evidence, although the empirical evidence (for example, Arestis (1987), Moore (1989), Arestis and Biefang-Frisancho Mariscal (1995), Foster (1992, 1994), Palley (1994), Howells and Hussein (1998), and Holtemller (2003)) points in the same direction in that loans cause deposits and in turn deposits create money supply supporting the PK theory of money endogeneity.

Although proponents of the PK theory accept the fundamentals of the endogeneity idea, there are disagreements on the approaches taken, especially between the accomodationists and structuralists. Moore (1998) argues that a central bank must always accommodate bank demand for reserves in order to fulfil its responsibility of preserving financial system stability. A central bank has no control over total reserves as this is determined by the quantity demanded by banks to support their lending and deposit-taking activities, but the central bank alters the mix of borrowed and nonborrowed reserves to achieve its target. Thus, under the accomodationists view, money supply is perfectly interest elastic (horizontal).

The structuralist view, on the other hand, argues that money supply is upward sloping as they believe that central banks only partially accommodate the demand for reserves, thus increasing interest rates. Hewitson (1995) asserts that as the banks increase the amount of credit granted, they will face greater risks and demand higher risk premiums. This leads to higher interest rates as the volume of credit increases (Piegay, 1999-2000).

With official short-term interest rates playing the leading role as the instrument of policy, the attention paid to money has declined (King, 2002). However, some central banks1 use money supply growth rates as an information variable; by monitoring its movements as a robustness check to avoid serious monetary policy mistakes. Money growth rates in excess of those needed to sustain economic growth at a noninflationary pace may provide early information on any developing financial instability (European Central Bank, 2004). Previous studies have found that money

For example, Bank of Canada, Bank of England and the European Central Bank.

supply plays an important role in the determination of equity prices such as Keran (1971), Homa and Jaffee (1971) and Hamburger and Kochin (1972); however, there has also been mounting evidence that support Fama (1970) efficient market hypothesis in that stock prices respond only to the unanticipated changes in money supply and that this response is negatively related (for example, Lynge (1981), Cornell (1983), Pearce and Roley (1983, 1985) and Hardouvelis (1987)).

The effects of money supply on stock market returns have been investigated during the monetary targeting regime especially in the United States, but with interest rates being the operating instrument; research has now investigated the impact of interest rates on bank stock returns (for example, Dinenis and Staikouras (1998), Bae (1990), Booth and Officer (1985) and Flannery and James (1984)) or unanticipated inflation on bank stock returns (Lajeri and Dermine (1999). However, these studies have looked at the relationship between money supply or interest rates and stock returns with the efficient market hypothesis in mind. The evolution of the PK theory of endogenous money allows for the relationship between money supply and bank stock returns to be investigated from a different perspective. As proposed by the PK theory of money endogeneity, a change in interest rates will have an affect on the amount of loans and in turn deposits. Empirical evidence shows that changes in loan will affect deposits and in turn changes in deposits will affect money supply. As the banks core (traditional) products are loans and deposits, this will have an impact on its profits and in turn its share prices. However, no study has investigated whether there is a relationship between money supply and bank stock returns taking into account the PK theory of endogenous money.

Even though interest rates have a pass-through effect onto the loan and deposit rates of the commercial banks, thus influencing loan demands; the amount of loans supplied by the bank may be rationed and different depending on whether the bank is in a concentrated or competitive market. Consequently, money supply will change and so will the returns of the bank, depending on the off-balance sheet (OBS) management of the bank. Stiglitz and Weiss (1981) contend that bank will ration credit as taking on loans with high risk will consequently reduce the banks expected return. Early proponents of the PK theory did not take into account credit rationing, which exists when banks quote an interest rate but supply a smaller quantity of loans 4

than what the loan market demands (Dwight and Russell, 1976). If interest rates were set to satisfy all demands for loans, it would increase the probability of default in cases of asymmetric information.

Credit rationing however, depends on whether the banks are in a concentrated or competitive market structure. Petersen and Rajan (1995) provide that banks in concentrated markets use their monopoly power to extract future surpluses from firms and invest in a relationship with them. Alternatively, Cao and Shi (2000) explain that in a competitive market, the number of banks competing for a loan will be smaller, which makes loans less available and the expected loan rate higher than in concentrated markets. On the other hand, Guzman (2000) noted that a competitive banking system will not ration credit as the banks are able to pay higher deposit rates while a monopoly banking system will ration credit as it is more profitable to depress the rate of return on deposits. This is contradictory to the theory presented by Petersen and Rajan (1995). Empirical evidence is mixed, such that Corvoisier and Gropp (2002) found that increased concentration is associated with higher bank margins, while Hou and Robinson (2006) presented evidence that firms in competitive industries earn higher returns.

The effects of changes in money supply on the bank industry and individual bank stock returns may also differ if there is a financial crisis, financial deregulation or policy regime change present. Very few studies have concentrated on financial deregulation or financial crises on its own as most studies examine either the impact of both financial deregulation and financial crises together or both banking and currency crises together in case of financial crises. Lee (1994) reported that there is a long-run equilibrium relationship between stock prices and money supply and concluded that the U.S. market is inefficient due partly to the financial deregulation.

Other studies found evidence that financial crises occurs following financial liberalization such as Demirg-Kunt and Detragiache (1998b) and Mehrez and Kaufmann (1999) and that financial liberalization precedes banking crises and this in turn precedes currency crises Kaminsky and Reinhart (1999). However, there is a lack of evidence mounting to the relationship between stock prices and money supply over

a long-horizon taking into account events such as financial deregulation and financial crises.

This paper is organized as follows: section 2 discusses the research problem and development of the hypotheses. Section 3 lists the contributions of the study to the existing literature. Section 4 describes the data used while section 5 explains the methodology used in the paper. Empirical results are discussed in Section 6, followed by a section on the implications of the study. Finally, section 8 summarises the study.

2. Research problem In light of the above motivations, this paper aims to answer the following questions: 1. Depending on the bank market structure, do changes in money supply affect bank stock returns in aggregate? 2. Are these changes dramatically affected in the presence of a financial crisis or financial deregulation?

A number of hypotheses can be tested from the literature review following the above research problems:

Firstly, if the case is that money supply is endogenous through the behaviour of commercial banks and the public, and that the central bank only determines the level of interest rates; then in aggregate if changes in interest rates are made both exogenously by the central bank and endogenously through market pressures following the structuralists approach, this will have an effect both simultaneously on money supply and also the bank stock returns. It will have an effect on bank stock returns through the profit (interest and non-interest) margins made by the banks.

However, not all changes of interest rates are fully accommodated as banks are able to ration credit where as explained by Stiglitz and Weiss (1981), a bank may refuse to give a loan to a borrower that offers to pay a higher rate than the equilibrium interest rate, as this may be a risky or bad borrower, which ultimately may reduce the banks expected return. The rationing of credit though, depends on the bank market structure that the banks are in. As noted by Petersen and Rajan (1995), banks in concentrated markets invest in a relationship and use their monopoly power at the beginning of the 6

relationship in order to receive profits in the future (as compensation for the lower rate at the start), and in turn increasing their returns. On a different aspect, Cao and Shi (2000), argue that in a competitive market, the number of competitors for a loan can be smaller and thus making loans less available and the expected loan rate higher than in a concentrated market. Thus, suggesting that: Under a concentrated banking system, there is a positive relationship between changes in endogenous money supply and the banking industry stock returns.

However, Guzman (2000) explains that a monopoly bank will offer a lower deposit rate and higher loan rate and will ration credit as it is profitable to depress the deposit rate but a competitive market will not ration credit as they are able to pay a sufficiently high deposit rate, thus increasing the amount of loans and also the banks profits. As concentrated banks are able to ration credit, the amount of credit will be lower; however, with the higher profit margins (higher interest rate and lower deposit rate), the bank stock returns will be higher. This results in the negative relationship between money supply and bank stock returns in a concentrated market. The above arguments thus test the hypothesis that there is a positive relationship between changes in money supply and the bank industry returns especially if the banking system is competitive according to the Herfindahl-Hirschman Index. In light of the above arguments, the hypothesis: Under a competitive banking system, there is a positive relationship between changes in endogenous money supply and the banking industry returns is tested.

Secondly, previous literature investigated on whether the efficient market hypothesis especially with respect to the relationship between money supply and stock returns is supported. One of the conditions for an efficient market is that stock prices follow a random walk; hence stock price changes are unpredictable. Balvers, Cosimano and McDonald (1990) insist that even though stock markets2 may be efficient, stock prices may not follow a random walk, thus: Bank stock returns in the U.S. are efficient but do not follow a random walk
2

It should be noted that Balvers, Cosimano and McDonald (1990) tested stock markets and not the

market for bank stocks.

As the sample period used for this paper is long, events that have occurred may have shifted the amount of loans or deposits and subsequently the money supply. In such cases, the bank stock returns would also change in line with these events. Deregulation of the financial system allows banks greater opportunities to take on risk and also financial innovations. This suggests that with greater financial innovations, there are ways of increasing profits, hence: The relationship between money supply and banking industry stock returns will be positive during financial deregulation, under a competitive banking system.

Financial crises are detrimental to an economy as it disrupts the flow of credit to households and small firms, reduce investment and consumption and may force viable firms into bankruptcy. In the sample period used in this paper, a crisis has occurred that may have interrupted or changed the deposits as investors doubt the strength of banks throughout the crisis: There is a positive relationship between money supply and banking industry stock returns during a financial crisis but there will be changes through deposits, under a competitive banking system.

3. Contributions This study adds to the existing literature in several ways: firstly, the study of money supply and bank stock returns in light of the post-Keynesian theory of endogenous money has not been done before. Most studies relating to the post-Keynesian theory of endogenous money centres around the direction of causality, whereas this study will extend this to include relationship between money supply and bank stock returns. Secondly, literature on efficient market hypothesis is abundant. Since the existence of the well-known theory, the literature on money supply and bank stock returns have subsided. This study will look at this relationship again but through a long period of time. Thirdly, literature on bank market structure is increasing but evidence on the relationship between the bank market structure and returns are mixed. This study will shed light on the relationship between bank stock returns and money supply in light of the bank market structure. Finally, with a sample period of thirty years, a number of events such as financial deregulation and crises have occurred in United States. This

study will investigate the relationship between money supply and bank stock returns taking into account these events which have not been done before.

4. Data All variables are downloaded from Datastream database and the macroeconomic variables are checked against International Monetary Funds (IMF) International Financial Statistics (IFS) database to ensure that there are no errors. The empirical analysis is conducted on quarterly data and the sample periods are dictated by the availability of the data, thus the sample period used is from 1975:3 to 2005:3

The Nasdaq Financial Index is used to represent the bank stock returns in aggregate as it has 519 banks included in it. Data for money supply is the broad form of money supply; M2 and M3. Deposits are the sum of demand and non-demand deposits of the banking institutions, while loans are the domestic credit in United States. The local bill rate and foreign bill rate are the domestic treasury-bill rate and the United Kingdom Treasury bill rate respectively. Currency in circulation is obtained to calculate the ratio cash-to-deposits. Bank lending rate and gross domestic product are also obtained for use in the empirical models.

Equity is private investment excluding housebuilding. Property prices are the housing prices, and where available, the house price index is obtained; otherwise, the consumer price index for housing is used. Private consumption is used as a proxy for general prices. All variables are seasonally adjusted where available. Descriptive statistics of the variables used for empirical analyses are given in Table 1.

As the sample periods used is long, a number of significant events may have occurred that may distress the structural stability of the model. Thus, a number of dummy variables are constructed for use in the empirical analyses. These dummy variables are summarised in Table 2. The period length for the savings and loans crisis included the October 1987 stock market crash, thus, there is no specific dummy variable constructed for the October 1987 stock market crash.

The dummy variable codes are designed as the event followed by the year that the event started, for example, the start of the interest rate deregulation in 1980 is represented by DER80. Thus, the following are the codes for the events: DER for both deregulation of interest rates and deposits, and FINCRIS for financial crisis In the equations, the dummy variables are coded as DERXX and FINCRISXX. As there are different years to different events, the generic code for the years is XX in this case.

Data to calculate the concentration ratios and Herfindahl-Hirschman Index are sourced from Fitch-IBCA Ltd Bankscope database. Only commercial, savings and cooperative banks are included. This is so that the results are limited to only banks and not include non-bank financial institutions. The average number of banks used to calculate the Herfindahl-Hirschman Index is 5235 and the years that data was available in Bankscope was between 1993 and 2005. Bankscope comes with a concentration ratio function, therefore the 3-bank and 5-bank concentration ratios used in this thesis are directly calculated by Bankscope.

Table 1: Descriptive Statistics

Mean Median 0.0384 0.0020 0.0157 0.0026 0.0182 Maximum 0.2003 0.0851 0.0752 0.0280 0.0363 Minimum -0.2779 -0.0791 -0.0220 -0.0083 -0.0036 Standard Deviation 0.0889 0.0202 0.0131 0.0083 0.0085

Rt
d ln(C / D) t

d ln Dt

0.0308 0.0023 0.0170 0.0047 0.0182

d ln Eqt
d ln Lt d ln MS t

0.0159 0.0039 0.0079 -0.0168 -0.0074 0.0570 0.0243

0.0158 0.0051 0.0080 0.0000 0.0000 -0.0058 0.0500

0.0551 0.0421 0.0387 4.4700 5.1200 7.8677 5.3300

-0.0035 -0.0310 -0.0204 -3.4100 -4.7100 -0.0429 -4.2700

0.0091 0.0116 0.0077 0.8621 1.0030 0.7161 1.2352

d ln( Pp / Pg )t d l n(Y )t d ( Rb )t d ( RL )t
ln( Yt 1 / MSt 1 )

d ( Rb R f )t

Note: Sample size = 121 observations.

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Table 2: Dummy variables created Panel A: Deregulation of loan rates Dummy variable code Event DER80 Interest rate deregulation - DIDMCA introduced (Wells, 2004) DER87 Regulation Q and interest rate ceilings were to be phased out (Wells, 2004) DER94 Geographic deregulation - Riegle-Neal Interstate Banking and Branching Efficeincy Act (Wells, 2004) DER99 Financial modernization - Gramm-Leach-Bliley Act 1999 (Wells, 2004) Panel B: Deregulation of deposits Dummy variable code Event DER83 All controls on time deposits with an original maturity of at least 32 days were lifted (Kaminsky and Schmukler, 2003) Panel C: Financial Crisis Dummy variable code Event FINCRIS86 Savings and Loans Crisis (Curry and Shibut (2000) Asian Financial Crisis (Lindgren, Balio, Enoch, FINCRIS97 Gulde, Quintyn and Teo (1999))

Start date

End date

1980:1 1987:1

2005:3 2005:3

1994:3 1999:4

2005:3 2005:3

Start date

End date

1983:4

2005:3

Start End date date 1986:1 1995:2

1997:2

1999:2

5. Methodology

A fundamental relationship between bank stock returns and money supply is first investigated by testing whether the two variables are cointegrated. The first step to this is to test for unit roots in the variables. An economic series that follows a random walk process is called non-stationary over time and a variable may reach stationarity by differencing it t times. The variable is then referred to as integrated of order t or I(t). In order to test for unit roots, the Augmented Dickey-Fuller (ADF) (Dickey and Fuller 1979, 1981) test is applied. The ADF test can control the higher-order serial correlation when higher-order lags are used. All variables subsequently used in the aggregate model are first tested for unit roots (see Table 3).

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After both variables are determined as being integrated of the same order, a cointegration test may be performed. The multivariate cointegration test proposed by Johansen (1988) is used here as it is more robust than the Engle and Granger (1987) test. The Johansens multivariate test is essentially a likelihood ratio test based on a vector autoregressive (VAR) model which allows for possible dynamic interactions among variables.

5.1 Results of unit root and cointegration tests

The unit root tests indicate that the null hypothesis of all series at level is not stationary (I(0)) cannot be rejected at the 1 percent, 5 percent and 10 percent significance levels as shown in Table 3. Besides log M3, the null hypothesis that the log of money supply in level is not stationary also cannot be rejected. The evolutionary corrector ( ln(Yt 1 / MSt 1) ) is found to be stationary at I(0) at level. Thus, no difference form is required for this. The same series are then tested for first order integration. The results are also presented in Table 3. The t-statistics show that all the series is I(1). The money supply series (M3) is found to be non-stationary at level form; therefore these series cannot be co-integrated with the banking industry returns. Hence, the money supply to be used in this paper will be M2.

From the results, of particular interest is that the unit root tests of the bank stock prices indicate that the null hypothesis that the stock prices at level is not stationary should not be rejected. Also, the unit roots of the bank stock prices in the first difference (the bank stock returns) is found to be stationary, thus rejecting the null hypothesis that it is not stationary at the 1 percent significance level. This suggests that the bank stock returns are efficient in the weak form. These results also support the findings of Chan, Gup and Pan (1997), who found the stock market returns in the U.S. of weak form efficient using the same methodology.

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Table 3 : Unit root tests

Variables SBC Lags 0 0 1 1 2 1 5 6 0 4 3 2 1 a -4.036 -3.447 -3.149 At levels -2.271a, -1.286c, -2.141b, -3.074a, -2.427a, -2.564a, -3.215a,* -0.896c, -2.365a, -2.899a, -0.791a, -2.895a, -83.093a,*** b -3.486 -2.886 -2.580 SBC Lags 0 0 0 0 1 0 4 6 0 1 2 0 c -2.584 -1.943 -1.615 First differences -10.037b,*** -12.113c,*** -8.401b,*** -2.155c,** -3.145b,** -6.274a,*** -0.8c, -4.662c,*** -9.785c,*** -8.552c,*** -2.076c,** -8.089b,***

ln( Pt )
ln(C / D) t

ln Dt

ln Eqt
ln Lt

ln(MS t ) (M2) ln(MS t ) (M3) ( Rb )t ( RL )t ( Rb R f )t

ln( Pp / Pg )t l n(Y )t
ln( Yt 1 / MSt 1)
Critical values 1% level 5% level 10% level

Note: ***, ** and * indicates significance at 1%, 5% and 10% level respectively. a, b and c denotes the test includes a trend and intercept; only an intercept and without trend; and no intercept or trend. SBC is Schwarz (1978) Bayesian Information Criteria.

Table 4 presents the results of the Johansen co-integration tests. The results show the null hypothesis of no cointegrating vectors ( r = 0 ) can be rejected at the 1 percent, 5 percent or 10 percent level of significance. The results show that there is cointegration (at least one cointegrating relation) between bank stock returns and money supply in United States. Overall, the results of the cointegration tests indicate that there is a long-run equilibrium between bank stock returns and money supply, that is, theses two series do not deviate significantly from each other. Instead, the relationship is stable. This result is consistent with Lee (1994) who found the same relationship for the United States.

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Table 4 : Johansen cointegration tests results

Tests for cointegration between: ln( Pt ) - ln(MS t )
ln(MS t ) - ln Dt , ln( Yt 1 / MSt 1)

r
r=0 r 1 r=0 r 1 r2 r=0 r 1 r2 r3 r4 r=0 r 1 r2 r3 r4

Trace test 18.03038 1.366011

**

Max. eigenvalue test 16.66437** 1.366011 28.25494*** 10.69155 1.721733 40.52373*** 21.23604 11.65533 4.308727 3.324084

40.66822*** 12.41328 1.721733 81.04791*** 40.52418 19.28814 7.632811 3.324084

ln Dt - ln Lt , ( Rb R f )t , ln(C / D) t , ( Rb )t

62.22751*** 124.2517*** *** 32.07923** 62.02417 ** 18.24603 29.94494 11.69891 10.13362 1.565292 1.565292 Note: ***, ** and * indicates significance at 1, 5 and 10 percent level respectively. r is number of p cointegrating vectors under the null hypothesis. Johansen Cointegration test: Trace Test = T ln 1 ,
* / 1 Maximal Eigenvalue Test = T ln 1 i i
i =1 r

ln Lt - ln Eqt , ln( Pp / Pg )t , l n(Y )t , ( RL )t

{(

)(

)}

i = r +1

5.2 Empirical model for the aggregate bank industry

As the relationship between money supply and bank stock returns has now been established and is found to be stable, a robust and stable model for the determination of money supply, and one which responds to changes in monetary controls, is developed.

An aggregated model of both the U.K. and Australian credit processes has been developed by Foster (1992, 1994). Foster (1992, 1994) uses his model (see equation 1) to test for the endogeneity of money supply using ordinary least squares and two stage least squares (with property being endogenous):
+ + + dM 3 = f d ( Pp / Pg ), dY , dRL , dRb , d (C / D), d ( Rb / R f ), (Yt 1 / M 3t 1 )

(1)

This model includes variables which attempt to reflect the two major credit rationing criteria of (1) the primary method of repayment - the ability of the borrower to repay, represented by regular income (Y), and (2) the secondary method of repayment largely property as security, represented by property prices deflated by general prices (Pp/Pg).

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Borrowers may be sensitive to the loan rate ( RL ), however banks will not be willing to lend more at a higher R L as this will jeopardize their lending criteria.

Banks adjust their portfolios to ensure that total assets equal total liabilities and that there is a target ratio between their holdings of monetary base and deposits. Any deviation of this ratio from the target may be due to changes in cash/deposit preferences of the public, budgetary or balance of payments imbalance. In such a case, the bank will correct the ratio by influencing the bill and marketable financial asset stock. However, an excess demand for bills (a rise in deposits) will decrease the bill rate ( Rb ). Rb can also be shifted by the authorities in an exogenous manner.

Two other developments that affect the credit growth (and hence deposits) are the rising provision of credit through non-bank financial institutions (NBFIs) and bank holdings of assets and liabilities denominated in other currencies. The increasing provision of credit through NBFIs is associated with a decrease in the cash/deposit ratio ( C / D ) due to the increase use of non-bank deposits by NBFIs. The growth of bank holdings of assets and liabilities denominated in other currencies means that an increase in the domestic to foreign short-term interest rate differential ( Rb / R f ) will move more deposits in the domestic currency as it is more attractive, thus, deposits will also increase. On top of this, the model includes an evolutionary corrector (Yt 1 / MSt 1 ) which captures the population level evolutionary shifts, which shows how quickly banks can diversify into new assets to offset the aggregate tendency for non-bank lending to grow more quickly.

This paper extends this further by investigating the relationship between money supply and bank stock returns. Thus, three equations (2, 3 and 4) are derived. The equations have the same foundations as Foster (1992, 1994). However, the model is tested using Zellner and Theil (1962) three-stage least squares (3SLS) method. The 3SLS is a complete system method, which is consistent and asymptotically efficient as it allows heteroskedasticity and contemporaneous correlation to exist between the disturbance terms of the complete model.

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Hence, Equation (2) hypothesise that the bank industry stock returns ( Rt ) is determined by money supply ( MS ), which is endogenous. Equation (3) goes to the endogeneity of money where MS is caused by deposits ( D ) and its lagged variable and an evolutionary corrector (Yt 1 / MSt 1 ) which is expected to be negative if banks do not quickly diversify into new assets to offset the aggregate tendency for non-bank lending to grow more quickly. Finally, equation (4) suggests that D is endogenous itself and explained by loans ( L ), the domestic and foreign interest rate differential ( Rb / R f ) , cash/deposit ratio (C / D ) and the domestic bill rate ( Rb ), where L is

endogenously determined by equity ( Eq ) and property prices ( Pp / Pg ) as a proxy for wealth, income ( Y ), and bank lending rate ( RL ). (C / D) is expected to be negative as it is associated with increase use of non-bank deposits and thus credit (Foster, 1992). Equity ( Eq ) is added into the equation as it was suggested in Foster (1992) that it can also be included as a proxy for wealth. Rt = 1 + 2 d ln MS t + t d ln MSt = 3 + 4 d ln Dt + 5 d ln Dt 1 + 6 ln(Yt 1 / MSt 1 ) + t (2) (3)

d ln Dt = 7 + 8 d ln Lt + 9d ( Rb R f )t + 10d l n(C / D)t + 11d ( Rb )t + t (4)

Instrument s : Eq , Pp / Pg , Y , RL , Yt 1 / MS t 1 , Rb R f , C / D, Rb
Pt where: Rt is ln P where Pt is the banking industry price index calculated by t 1

Datastream, d is the first difference, ln is natural logarithm, and t is time.

The Wald coefficient tests are then utilized to test the hypothesis,
H 0 : 2 = 4 = 5 = 6 = 8 = 9 = 10 = 11 = 0 for the system of equations. Thus,

in reduced form, equations (2a), (3a) and (4a) under the null hypothesis now becomes:
Rt = 1 + t d ln MS t = 3 + t d ln Dt = 7 + t

(2a) (3a) (4a)

Thus, if the null hypothesis is true, then the system of equations will reduce to become equation (2a) as (3a) and (4a) will cease to exist. This implies that bank stock

16

returns in U.S. follow a random walk or a random walk with a drift if the intercept in equation (2a) is found to be significant.

5.3 Chow breakpoint test and results

As the sample period used is long, there are a number of significant events that have occurred throughout the period, as suggested in Table 2. Dummy variables have been constructed for these events and the Chow test can be used to test the structural stability of a model taking these events into consideration.

The Chow test is performed to see whether a model has changed after a certain event. The events listed in Table 2 are tested using simple linear regression model that are taken from the three-stage least squares model in the previous section.

Table 5 summarizes the results of the Chow breakpoint tests. The results indicate that most of the events have an impact on the sample period except for DER80 and FINCRIS97.

Table 5 : Chow breakpoint test results

F-statistic Deregulation of loan rates DER80 = 1 for 1980:2 2005:3 and 0 otherwise DER87 = 1 for 1987:1 2005:3 and 0 otherwise DER94 = 1 for 1994:4 2005:3 and 0 otherwise DER99 = 1 for 1999:4 2005:3 and 0 otherwise Deregulation of deposits DER83 = 1 for 1983:4 2005:3 and 0 otherwise Financial crisis FINCRIS86 = 1 if 1986:1 1995:4 and 0 otherwise FINCRIS97 = 1 if 1997:2 1999:2 and 0 otherwise
Equations used:
Rt = 1 + 2 d ln MS t + t d ln MSt = 3 + 4 d ln Dt + 5 d ln Dt 1 + 6 ln(Yt 1 / MSt 1 ) + t
d ln Dt = 7 + 8 d ln Lt + 9d ( Rb R f )t + 10d l n(C / D )t + 11d ( Rb )t + t
Instrument s : Eq , Pp / Pg , Y , RL , Yt 1 / MS t 1 , Rb R f , C / D , Rb

Log likelihood ratio

0.656582 6.603002*** 8.464779*** 9.025482***

3.526775 31.50688*** 39.08572*** 41.27822***

7.838381*** 29.63018*** 5.47152*** 0.906811

(2) (3) (4)

40.84958*** 7.796495

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For further testing in the following empirical models, additive and interactive dummy variables were included back in the equations as in equations (2), (3) and (4) and the regressions were performed:
Rt = 1 + 2 d ln MS t + 12 d ln MS t DV + 13 DV + t
d ln MSt = 3 + 4 d ln Dt + 5 d ln Dt 1 + 6 d ln(Yt 1 / MSt 1 ) + 14 d ln Dt DV + 15 d ln Dt 1 DV + 16 d ln(Yt 1 / MSt 1 ) DV + 17 DV + t

(5) (6)

d ln Dt = 7 + 8 d ln Lt + 9d ( Rb R f )t + 10 d l n(C / D)t + 11d ( Rb )t +

18 d ln Lt DV + 19 d ( Rb R f )t DV + 20 d l n(C / D)t DV + 21d ( Rb )t DV + 22 DV + t

(7)

where DV = the relevant dummy variable, for example, DERXX or FINCRISXX.

Only those additive or multiplicative dummy variables that are significant either at the 1 percent, 5 percent or 10 percent confidence intervals are included in the empirical models. Table 6 summarises the dummy variables that are included in the equations.

18

Table 6 : Chow breakpoint test results

Equation (6a)
d ln MS t = 3 + 4 d ln D t + 5 d ln D t 1 + 6 d ln(Yt 1 / MS t 1 ) + t

d ln Dt = 7 + 8 d ln Lt + 9d ( Rb R f )t + 10d l n(C / D)t + 11d ( Rb )t + t

Equation (7a)

+ 14d ln Dt DERXX

+ 15d ln Dt 1 DERXX

+ 16 d ln(Yt 1 / MSt 1 ) DERXX

+ 17 DERXX

+ 18 d ln Lt DERXX

+ 19d ( Rb R f )t DERXX

+ 20d l n(C / D)t DERXX

+ 21d ( Rb )t DERXX

+ 22 DERXX

Loan rate deregulation DER87 DER94 DER99 Deposit rate deregulation DER83
Rt = 1 + 2 d ln MSt + t
+ 12 d ln MS t FINCRISXX

Equation (5b)
+ 13 FINCRISXX
+ 14 d ln Dt FINCRISXX + 15d ln Dt 1 FINCRISXX

Equation (6b)
d ln MS t = 3 + 4 d ln D t + 5 d ln D t 1 + 6 d ln(Yt 1 / MS t 1 ) + t

+ 16 d ln(Yt 1 / MSt 1 ) FINCRISXX

+ 17 FINCRISXX

FINCRIS86

19

5.4 Aggregate model with dummy variables

The results of the Chow breakpoint tests confirm that the model is not stable due to the presence of structural breaks caused by the occurrence of a number of events. These are considered into the aggregate model, which then modifies equations (3) and (4) to include the existence of the events through dummy variables.

5.4.1 Financial deregulation

The model is modified such that relevant dummy variables are included into equation (3) and (4):
Rt = 1 + 2 d ln MS t + t d ln MS t = 3 + 4 d ln Dt + 5 d ln Dt 1 + 6 ln(Yt 1 / MS t 1 ) +

(2) (6a)

14 d ln Dt DERXX + 15 d ln Dt 1 DERXX + 16 ln(Yt 1 / MS t 1 ) DERXX + 17 DERXX + t

d ln Dt = 7 + 8 d ln Lt + 9d ( Rb R f )t + 10d l n(C / D)t + 11d ( Rb )t +

18 d ln Lt DERXX + 19d ( Rb R f )t DERXX + 20d l n(C / D)t DERXX + 21d ( Rb )t DERXX + 22 DERXX + t Instrument s : Eq , Pp / Pg , Y , RL , Yt 1 / MS t 1 , Rb R f , C / D, Rb

(7a)

It should be noted, however, that not all the interactive dummy variables are included when the model is tested.

5.4.2 Financial crisis

For the financial crisis period, equations (2) and (3) in the basic model now become:
Rt = 1 + 2 d ln MS t + 12 d ln MS t + t d ln MS t = 3 + 4 d ln Dt + 5 d ln Dt 1 + 6 ln(Yt 1 / MS t 1 ) +

(5b) (6b)

16 ln(Yt 1 / MS t 1 ) FINCRISXX + 17 FINCRISXX + t

Instrument s : Eq , Pp / Pg , Y , RL , Yt 1 / MS t 1 , Rb R f , C / D, Rb

d ln Dt = 7 + 8 d ln Lt + 9d ( Rb R f )t + 10d l n(C / D)t + 11d ( Rb )t + t (4)

5.5 Bank market structure

Concentration ratios and the Herfindahl-Hirschmann Index (HHI) are used to assess the market structure of the banks in United States. As data to calculate the HHI is

20

taken from 1993 due to availability of data, the 3SLS basic model is re-estimated from 1993 to test for Hypothesis 1. It is cautioned that the HHI is used to give an understanding of the market structure of the countries banking and therefore is not included in the 3SLS model

The k-concentration ratio is used to measure the market share in an industry. Thus, in banking, it sums only the market share of the k largest banks, and is indicated as:
CRk = i =1 s i
k

(8)

Where si is the market share of the ith bank when ranked in descending order. In this paper, k used is 3 and 5 following Cetorelli and Gambera (2001). Thus, the 3-bank and 5-bank concentration ratios of the largest banks will be determined for each country. As a general rule, if the 3-bank and 5-bank concentration ratio is above about 30 and 50 respectively, then it indicates that the three and five largest banks hold more than 30% and 50% market share indicating a more concentrated market. On the other hand, if the ratio is less than about 30 and 50, then it shows that the markets are competitive.

The Herfindahl-Hirschman Index (HHI) is defined as the sum of the squares of the market shares of each individual firm, such that:
HHI = i =1 si2
k

(9)

where si is the market share of firm i in the market, and k is the number of firms. The index ranges from 0 to 10,000 with an index close to zero indicates a competitive industry with no dominant players, while an index close to 10,000 represents a concentrated industry.
5.5.1 Results of the concentration ratios and Herfindahl-Hirschman Index

Table 7 summarises the results of the 3-bank and 5-bank concentration ratios and the Herfindahl-Hirschman Indices (HHI) based on total assets. the 3-bank and 5-bank concentration ratio was found to be less than 30 and 50 respectively for the United States indicating that it is a competitive market and the HHI is less than 1000 for all years, confirming the presence of a competitive market.

21

Table 7 : 3-bank, 5-bank concentration ratios and the Herfindahl-Hirschman Index for each country based on total assets
Year CR3 CR5 HHI 16.04 20.9 147.15 1993 17.2 21.9 159.61 1994 16.89 22.13 156.05 1995 18.99 24.24 180.78 1996 17.15 24.41 178.56 1997 18.75 26.91 201.45 1998 21.77 28.78 240.7 1999 21.46 28.14 233.8 2000 23.16 29.76 254.07 2001 23.49 31.23 269.7 2002 23.32 31.1 269.73 2003 27.95 36.64 351.22 2004 30.66 40.24 416.05 2005 Note: CR3, CR5 and HHI denotes 3-bank concentration ratio, 5-bank concentration ratio and Herfindahl-Hirschman Index respectively

6. Results 6.1 Three-stage least squares (3SLS) estimation: 1975-2005

The basic model suggests that money supply is positively related to bank stock returns in United States. Table 8 shows the results of the basic model. Consistent with the bank structure effects, an increase in money supply increases bank stock returns by 6.01 percent in the U.S. This would be consistent with Guzman (2000) in that banks in competitive markets do not ration credit as they are able to pay a sufficiently high deposit rate, thus increasing the amount of loans (which in turn will increase money supply through the PK theory of endogenous money) and also the banks profits; thus money supply and bank stock returns have a positive relationship in a competitive market.

It follows that money is endogenous in all the countries as suggested by most previous evidence by the PK theorists, where an increase in loans increases deposits and in turn an increase in deposits increases money supply. An increase in deposits increases money supply by 36.35 percent. Also, an increase in the lag of deposits increased money supply by 14.38 percent. The evolutionary corrector ( ln(Yt 1 / MSt 1) ) was found to have a positive relationship with money supply where an increase in the evolutionary corrector increases money supply by 1.06 percent. This indicates that the banks in U.S. quickly diversify into new assets to offset the quick growth of non-bank

22

lending. An increase in loans raises deposits by 33.32 percent and the foreign-todomestic interest rate differential variable was insignificant. The cash-to-deposit ratio was negatively related to deposits where an increase in the ratio would decrease deposits by 34.71 percent. An increase in the short-term bill rate decreases deposits by 0.40 percent. The R2 show that the model is able to explain 47.71 percent of the variations in the values of the bank stock returns. The Wald test indicates that all variables are significant in explaining the banking industry stock returns and that this suggests the bank returns in all the countries do not follow a random walk in the long run.

6.2 Basic model 1993-2005

The basic model is re-estimated between the years 1993 and 2005 to understand the relationship between money supply and bank industry stock returns taking into account the bank market structure in United States. The results of the three-stage least squares estimated between 1993 and 2005 are included in Table 8.

The results indicate that the relationship between money supply and banking industry stock returns is positive, similar to the 1973-2005 basic model. In U.S., an increase in money supply increases bank stock returns by 19.63 percent. Again, this could be due to the bank market structure of U.S. being a competitive market as indicated by the Herfindahl-Hirschman Index in section 5.5.1. An increase in deposits increases money supply by 42.29 percent. Also, an increase in the lagged deposits has significant positive effects on money supply in U.S. An increase in the lag of deposits increases money supply by 23.94 percent in U.S. The evolutionary corrector is insignificant. Loans have a significant positive effect on deposits where an increase in loans increases deposits by 74.2 percent. The foreign-to-domestic interest rate differential is found to be insignificant; while an increase in the ratio cash-to-deposits decreases deposits by 14.38 percent, which means there is a lower provision of credit through non-bank financial institutions. The domestic short-term bill rate is found to be significant where an increase in the short-term bill rate reduces deposits by 1.31 percent.

23

The R2 show that the model is able to explain 46.07 percent of the variation in the values of the bank stock returns. The Wald test indicates that all variables are significant in explaining the banking industry stock returns and that this suggests the bank returns in all the countries do not follow a random walk.

Table 8: Results for the basic model (model without dummy variables) Variables 1975-2005 1993-2005

1
d ln MS t

0.0297 (0.0086)

***

0.0413*** (0.013) 0.1963** (0.0876) -0.097 (0.0854) 0.4229*** (0.0856) 0.2394*** (0.0876) 0.0132 (0.0111) 0.0016 (0.0054) 0.742** (0.3204) 0.0027 (0.0025) -0.1438** (0.0574) -0.0131*** (0.0036) 0.4607 Reject at 1% p=0.0000

3
d ln Dt

0.0601* (0.0363) -0.0754*** (0.0174) 0.3635*** (0.0415) 0.1438*** (0.0412) 0.0106*** (0.0022) 0.0117*** (0.0036) 0.3332* (0.187) 0.0008 (0.0009) -0.3471*** (0.0508) -0.0041*** (0.0014) 0.4771 Reject at 1% p=0.0000

d ln Dt 1
d ln( Yt 1 / MSt 1)

7
d ln Lt

d ( Rb R f )t
d ln(C / D) t d ( Rb )t

R2 Wald test

Note: *** and * denotes significance at 1% and 10% level respectively. Numbers in parentheses are standard errors and p = probability. Wald test: H 0 : 2 = 4 = 5 = 6 = 8 = 9 = 10 = 11 = 0 . 3SLS
equations:

Rt = 1 + 2 d ln MSt + t d ln MSt = 3 + 4 d ln Dt + 5 d ln Dt 1 + 6 ln(Yt 1 / MSt 1 ) + t

(2) (3); (4);

d ln Dt = 7 + 8 d ln Lt + 9d ( Rb R f )t + 10d l n(C / D )t + 11d ( Rb )t + t

Instrument s : Eq , Pp / Pg , Y , RL , Yt 1 / MS t 1 , Rb R f , C / D , Rb

24

6.3 Models with financial deregulation and crisis dummy variables.

Three loan rate deregulation periods were tested in the United States: (1) DER87 indicates the end of the interest rate deregulation where Regulation Q and the interest rate ceilings were phased out; (2) DER94 denotes geographic deregulation in the U.S.; and (3) DER99 stands for the introduction of financial modernization in the U.S. Another deregulation period that was tested is DER83 which denotes the lifting of all controls on time deposits in the United States. As with the basic model, it was found the money supply is positively related to bank stock returns. Table 9 summarises the results. Table 10 summarises the results of the financial crisis model.

6.3.1 DER87: regulation Q phased out

An increase in money supply increases bank stock returns by 10.12 percent. During DER87, an increase in deposits and its lag increased money supply by 36.94 percent and 15.33 percent respectively. An increase in the evolutionary corrector increased money supply by 0.95 percent. The Chow breakpoint test indicates that there are no structural breaks in equation (6a), thus no dummy variables are included. The results also indicate that an increase in loans increases deposits by 18.03 percent. During deregulation an increase in the cash-to-deposit ratio would decrease deposits by 25.52 percent compared to 66.75 percent before the interest rates ceilings and Regulation Q was phased out. During the deregulation, the short term bill rate was found to be negatively related to deposits indicating there is an excess demand for bills. An increase in the short term bill rate during deregulation decrease deposits by 0.62 percent. The foreign to interest rate differential and short term bill rate before the deregulation period were found to be insignificant.

6.3.2 DER94: geographic deregulation

An increase in money supply increases bank stock returns by 15.19 percent. The results indicate that an increase in deposits increases money supply by 38.97 percent. During deregulation, an increase in the lag of deposits increases money supply by 36.95 percent compared to before deregulation where the increase in just 7.65 percent. An increase in the evolutionary corrector increases money supply by 1.87 percent. Loans and deposits were found to be positively related where an increase in loans increases deposits by 18.03 percent. An increase in the ratio cash-to-

25

deposits decreases deposits by 17.02 percent during deregulation as opposed to 69.34 percent before deregulation. An increase in the short term bill rate during deregulation decrease deposits by 0.81 percent. It was also found that all other things equal, geographic deregulation increased deposits by 1.27 percent compared to 1.8 percent before the deregulation. Again, the foreign to interest rate differential and short term bill rate before the deregulation period were found to be insignificant.

6.3.3 DER99: financial modernisation

The results show that an increase in money supply increases bank stock returns by 13.06 percent. An increase in deposits and its lag increases money supply by 36.11 and 14.61 percent respectively. An increase in the evolutionary corrector before the deregulation period increases money supply by 1.59 percent compared to 5.11 percent during deregulation. All things being equal, deregulation decreases money supply by 37.80 percent compared to 11.76 percent before the deregulation. An increase in loans increases deposits by 11.51 percent. An increase in the cash-todeposit ratio decreases deposits by 11.24 percent during the deregulation compared to 64.93 percent before the event. An increase in the short term bill rate during deregulation decrease deposits by 0.87 percent. Again, the foreign to interest rate differential and short term bill rate before the deregulation period were found to be insignificant.

6.3.4 DER83: lifting of all controls on time deposits

The results for the United States show that an increase in money supply increases bank stock returns by 4.25 percent. An increase in deposits and its lag increases money supply by 37.24 percent and 12.45 percent respectively. During deregulation, an increase in the lag of deposits increases money supply by 30.47 percent. An increase in the evolutionary corrector increases deposits by 1.52 percent indicating that banks diversify into new assets to offset the quick growth of non-bank lending during this period. In addition, an increase in loans increases deposits by 20.29 percent, an increase in the ratio cash-to-deposits decreases deposits by 66.23 percent before deregulation and 26.05 during deregulation, showing a provision for credit through NBFIs. During deregulation, an increase in the short term bill rate

26

decreases deposits by 0.53 percent. Again the foreign-to-domestic interest rate differential was found to be insignificant.

The positive relationship between deposits and loans and subsequently loans and money supply indicates the money is endogenous in U.S. The amount of loans affected the ratio cash-to-deposits more than loans indicating that there is provision of credit through non-bank financial institutions (lesser during deregulation than before). Before deregulation, banks experience a rise in NBFI deposits and associated borrowing. The deposit rate deregulation affected the cash-to-deposit ratio in the U.S. the same way as it did during loan rate deregulation. Due to the nature of the financial system in the U.S. (where there is a large number of non-bank financial institutions), the deregulation of deposit (and loan) rates seem to have a major effect in the U.S. The R2 indicates that the model is able to explain most of the variation (between 55 and 84 percent) in the value of the bank stock returns. The Wald test shows that all variables are significant in explaining the model at the 1 percent significance level, which also suggests that the bank stock returns do not follow a random walk.

6.3.5 FINCRIS86: Savings and loans crisis

Table 10 summarises the results of the domestic financial crisis. An increase in money supply increases bank stock returns by only 14.25 percent. An increase in deposits and its lag increase money supply by 31.7 and 11.63 percent respectively. During the savings and loan crisis, an increase in the evolutionary corrector increases money supply by 8.99 percent compared to 0.98 percent before and after the crisis. This indicates that banks do not diversify quickly enough to compensate for the aggregate tendency of the faster growth of non-bank lending. The savings and loans crisis impacted money supply to where all other things being equal, the crisis decreased money supply by 68.87 percent compared to only 0.66 percent during a non-crisis period. An increase in loans increase deposits by 39.01 percent, which is higher than the basic model; and an increase in the ratio cash-to-deposits decreases deposits by 35.08 percent. In addition, an increase in the short-term bill rate decreases deposits by 0.42 percent and the foreign-to-domestic interest rate differential was found to be insignificant.

27

As there is a positive relationship between loans and deposits and deposits and money supply, money supply can be said to be endogenous even during a financial crisis. However, in the U.S., the crisis itself had an impact on money supply by decreasing it. It was also found that during a crisis, the evolutionary corrector increased dramatically indicating that banks quickly diversify into new assets to offset the increase in non-bank lending. This could also be a precautionary behaviour by the public as an increase in income (Y), does not filter through to money supply. Thus, other alternative assets besides bank deposits are more attractive during a financial crisis where the banks are vulnerable. This is true in the case of U.S. where the short term bill rate was found to be significant as there is an excess demand for bills causing the authorities to reduce the bill rate. The R2 for the models indicate that the models can explain most of the variation in the value of the bank stock returns. The
Wald test again shows that all variables are significant in explaining the model at the

1 percent significance level, which also suggests that the bank stock returns do not follow a random walk.

28

Table 9 : Models with interest rate deregulation dummy variables

Variables
1

d ln MSt

3
d ln Dt
d ln D t 1

ln(Yt 1 / MSt 1 )
d ln Dt 1 DERXX ln(Yt 1 / MS t 1 ) DERXX

DER87 0.0292*** (0.0081) 0.1012** (0.0498) -0.0678*** (0.0178) 0.3694*** (0.0413) 0.1533*** (0.0408) 0.0095*** (0.0023)

DER94 0.0281*** (0.0095) 0.1519** (0.0627) -0.1392*** (0.0186) 0.3897*** (0.0385) 0.0765* (0.0412) 0.0187*** (0.0024) 0.293*** (0.0645)

DER99 0.0285*** (0.0093) 0.1306** (0.0628) -0.1176*** (0.0196) 0.3611*** (0.0399) 0.1461*** (0.0394) 0.0159*** (0.0025)

DER83 0.0302*** (0.0087) 0.0425* (0.0258) -0.1127*** (0.0205) 0.3724*** (0.0402) 0.1245*** (0.0408) 0.0152*** (0.0026) 0.1802** (0.0719)

DERXX

7
d ln Lt

d ( Rb R f )t
d ln(C / D) t

d ( Rb )t
d ln(C / D) t DERXX

d ( Rb )t DERXX
DERXX

0.0138*** (0.0018) 0.1803** (0.079) 0.0005 (0.0008) -0.6675*** (0.0928) -0.0011 (0.0013) 0.4123*** (0.1038) -0.0062** (0.0028)

Wald test R2

p=0.0000 0.5528

0.018*** (0.0018) 0.1178* (0.0664) 0.0008 (0.0007) -0.6934*** (0.0624) -0.0017 (0.0011) 0.5232*** (0.0802) -0.0081** (0.0031) -0.0053*** (0.002) p=0.0000 0.6337

0.0352** (0.0147) -0.2604** (0.1109) 0.0166*** (0.0016) 0.1151* (0.0669) 0.0009 (0.0007) -0.6493*** (0.0562) -0.0017 (0.0011) 0.5369*** (0.0786) -0.0087** (0.0035)

0.0135*** (0.0018) 0.2029** (0.0795) 0.0004 (0.0008) -0.6623*** (0.1014) -0.0009 (0.0013) 0.4018*** (0.1109) -0.0053** (0.0023)

p=0.0000 0.6317

p=0.0000 0.5455

Note: ***, ** and * denotes significance at 1 percent, 5 percent and 10 percent level respectively. Numbers in parentheses are standard errors and p = probability. p=0.0000 denotes rejection of the null hypothesis at the 1 percent level of significance. Wald test: H 0 : 2 = 4 = 5 = 6 = 8 = 9 = 10 = 11 = 14 = 15 = 16 = 17 = 18 = 19 = 20 = 21 = 22 = 0 . Dummy variables include: DER87 = 1 for 1987:1 2005:3 and 0 otherwise, DER94 = 1 for 1994:4 2005:3 and 0 otherwise, DER99 = 1 for 1999:4 2005:3 and 0 otherwise,DER83 = 1 for 1983:4 2005:3 and 0 otherwise. Dummy variables included are following those summarised in Table 6, thus the following is a generic model where not all dummy variables are included: (2) Rt = 1 + 2 d ln MS t + t

d ln MSt = 3 + 4 d ln Dt + 5 d ln Dt 1 + 6 ln(Yt 1 / MSt 1 ) + 14 d ln Dt DERXX +

(6a) (7a)

15d ln Dt 1 DERXX + 16 ln(Yt 1 / MSt 1 ) DERXX + 17 DERXX + t d ln Dt = 7 + 8d ln Lt + 9d ( Rb R f )t + 10d l n(C / D)t + 11d ( Rb )t + 18 d ln Lt DERXX +
19d ( Rb R f )t DERXX + 20d l n(C / D)t DERXX + 21d ( Rb )t DERXX + 22 DERXX + t
Instrument s : Eq , Pp / Pg , Y , RL , Yt 1 / MS t 1 , Rb R f , C / D , Rb

29

Table 10 : Savings and loans crisis

Variables
1
d ln MSt

3
d ln Dt d ln D t 1

ln(Yt 1 / MSt 1)
ln(Yt 1 / MSt 1 ) FINCRISXX
FINCRISXX

7
d ln Lt
d ( Rb R f )t
d ln(C / D) t

d ( Rb )t

Wald test R2

FINCRIS86 0.0283*** (0.0094) 0.1425** (0.0643) -0.066*** (0.0149) 0.317*** (0.0371) 0.1163*** (0.0365) 0.0098*** (0.0019) 0.0801*** (0.021) -0.6227*** (0.1622) 0.0106*** (0.0035) 0.3901** (0.1809) 0.0007 (0.0008) -0.3508*** (0.0496) -0.0042*** (0.0013) p=0.0000 0.4925

Note: ***, ** and * denotes significance at 1 percent, 5 percent and 10 percent level respectively. Numbers in parentheses are standard errors and p = probability. Dummy variables: U.S.: FINCRIS86 = 1 if 1986:1 1995:4 and 0 otherwise. Wald test: H 0 : 2 = 4 = 5 = 6 = 8 = 9 = 10 = 11 = 12 = 13 = 14 = 15 = 16 = 17 = 0 . p=0.0000 denotes rejection of the null hypothesis at the 1 percent level of significance. 3SLS equations include: (2) Rt = 1 + 2 d ln MS t + 12 d ln MS t + t
d ln MSt = 3 + 4 d ln Dt + 5 d ln Dt 1 + 6 ln(Yt 1 / MSt 1 ) + 16 ln(Yt 1 / MSt 1 ) FINCRISXX + 17 FINCRISXX + t d ln Dt = 7 + 8 d ln Lt + 9d ( Rb R f )t + 10 d l n(C / D )t + 11d ( Rb )t + t Instrument s : Eq , Pp / Pg , Y , RL , Yt 1 / MS t 1 , Rb R f , C / D , Rb

(6b) (4)

30

7. Implications

The findings of this study provide several important implications. Firstly, changes in money supply are related to bank stock returns through the PK theory of endogenous money. This study supports and adds to the growing number of literature related to PK theory of endogenous money especially for developed countries, for example, Arestis (1987), Arestis and Biefang-Frisancho Mariscal (1995), Moore (1989), Foster (1992), Palley (1994), Howells and Hussein (1998), Caporale and Howells (2001) and Holtemller (2003).

Secondly, the positive relationship between money supply and bank stock returns considering the competitive bank market structure of United States suggests that banks in concentrated markets ration credit as argued by Guzman (2000) such that banks in concentrated markets are able to lower deposit rates and increase loan rates, thus increasing profit margins, whereas banks in competitive markets do not ration credit, making loans increase along with its profit margins. Thus, these findings add to the understanding of the market structure in the banking industry.

Thirdly, a sufficient condition of the efficient market hypothesis is that stock price changes (thus, stock returns) follow a random walk in the short run. The results of this study consistently found that even though bank stock returns are efficient, they do not follow a random walk over the thirty year sample period. This study sheds light to the efficient market hypothesis in that in the long-run bank stock returns do not follow a random walk.

8. Summary

This study examines the relationship between money supply and bank stock returns in United States in the context of endogenous money. The Post-Keynesian theory of the endogeneity of money indicates that money is caused by deposits which is in turn caused by demand for bank loans, with the central banks role is to set the level of official short-term interest rates. However, even if the nonbank public demands loans, banks are able to ration credit to those that are of high risk. This impact of this credit rationing however, depends on whether the bank market structure is concentrated

31

(monopoly) or competitive. This study uses the three-stage least squares estimation to determine the relationship between money supply and bank industry stock returns from 1975Q3 to 2005Q3 and Herfindahl Hirschman Index to determine the bank market structure in United States. With such a long time period, periods of financial deregulation and financial crises are also included.

The empirical models developed in this study produced a number of results. First, the Engle Granger and Johansen cointegration tests concluded that there is a long-run equilibrium relationship between money supply and bank stock returns in aggregate. This is consistent with Lee (1994) who found the same relationship in the United States. With further investigation using the three-stage least squares model, this study found that there is a relationship between money supply and bank stock returns in aggregate. The results also indicate that money is endogenous supporting the PK theory of endogenous money such that loans and deposits are significantly positive related and deposits and money supply were also significantly positive related. Supporting Foster (1992, 1994), the results consistently indicate that the cash-todeposit ratio was negatively related to bank stock returns indicating that there is an increasing provision of credit through non-bank financial institutions. It was also found that bank stock returns do not follow a random walk thus opposing the efficient market hypotheses and also opposing the findings of Pearce and Roley (1983, 1985). Thus, the results do not support Hypothesis 2 in that bank stock returns in each country follow a random walk with a drift

Events such as financial crises and financial deregulation may disrupt the relationship between money supply and bank stock returns. This study incorporated significant events into the empirical models to test whether there are significant differences between money supply and bank stock returns in the presence of these events. The results show that the relationships between money supply and bank stock returns are still the same as the basic model but the events do disrupt the flow of deposits and loans. Thus, the results support Hypothesis 3 and 4. A possible explanation on why the relationship between money supply and bank stock returns are not disrupted could be due to the long-run equilibrium relationship and the fact that the models are tested over a long sample period. 32

The findings also support Guzman (2000) in that concentrated banking system will ration credit and hence offers a lower deposit rate and higher interest rate than competitive banking systems. As concentrated banks are able to ration credit, the amount of credit will be lower; however, with the higher profit margins (higher interest rate and lower deposit rate), the bank stock returns will be higher. This results in the negative relationship between money supply and bank stock returns. However, the findings contradicts that of Petersen and Rajan (1995) in that banks invest in lending relationships by giving lower rates on loans at the beginning of the relationships in order to extract future surpluses. Thus, the results of the study support the hypothesis that there is a positive (negative) relationship between changes in money supply and the bank industry returns especially if the banking system is concentrated (competitive) according to the Herfindahl-Hirschman Index.

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