Implications of Lotteryness and Implicit Bailout Protection on Bank Valuation: Evidence from Europe

No Thumbnail Available
Journal Title
Journal ISSN
Volume Title
School of Business | Master's thesis
Ask about the availability of the thesis by sending email to the Aalto University Learning Centre
Degree programme
The purpose of this thesis is to study the impact of investors’ preference for lottery-like payoffs among European bank stocks. I will identify four avenues through which such preferences may manifest themselves: (i) Lottery premium, which refers to lottery-type banks yielding lower risk-adjusted returns vis-à-vis non-lottery-type banks. (ii) Changes in bank default probability, stemming jointly from the varying degree of bank lotteryness and government bailout guarantees. (iii) Implicit insurance fee, pertaining to investors accepting lower risk-adjusted returns for large banks in stable economic periods, which is counterbalanced by the performance benefits and downside risk protection enjoyed by such significant financial institution during bank crises. (iv) Levels of bank relative valuation, emanating from lotteryness on the back of the behavioral preference for lottery-type investments and more prudent investors’ predilection to select safeguarded assets akin to put options into their portfolios. The interdependence between lotteryness and bank relative valuation is unique to this paper highlighting its significance. I test these conjectures in a sample of publicly listed banking institutions, commercial banks, and bank holding companies from 28 European countries during the twenty-year period between January 1997 and December 2016. I define lotteryness via a series of alternative lottery variables prevalent in earlier research (e.g. idiosyncratic volatility and idiosyncratic skewness) as well as the MAX/MIN measure following Del Viva et al. (2017a). The paper reports the results from a battery of Fama and MacBeth (1973) regression analyses and multiple time-series asset pricing model specifications. Moreover, the paper introduces a novel evolution to the standard P/BV-ROE model by Wilcox (1984) via the inclusion of lotteryness statistics that may be of value to the practitioners. The main results of this thesis are as follows: Firstly, European banks seem to be affected by lottery premium as high lotteryness tends to lead to lower risk-adjusted returns. Moreover, the overpricing of lottery-type banks is more prominent in a subsample excluding the largest 10% of European banks with lottery premium amounting to up to -10% per annum. Secondly, I find evidence to suggest that higher bank lotteryness could be analogous to risky bank activities. Notwithstanding, the MAX/MIN measure does not seem to imply higher bank default probability, possibly due to the implicit bailout protection embedded in the measure. Thirdly, the large European banks seem to earn between 6% and 7% lower risk-adjusted annual returns during normal (non-crisis) periods. Reciprocally, they have managed to yield almost 8% higher risk-adjusted annual returns vis-à-vis smaller banks in the systematic phase of the European bank crisis. Fourthly, I find that lotteryness can help explain the relative valuations of European banks as investors seem to award higher multiples to lottery-type banks that contemporaneously enjoy implicit bailout protection.
Thesis advisor
Torstila, Sami
lotteryness, lottery premium, regulatory bailout, bank crisis, risk-taking, bank stocks, idiosyncratic volatility, idiosyncratic skewness
Other note