Risk and Uncertainty in Banking Sector -A study of the Post-Earnings Announcement Drift in European banks - Did the market reflect the banks' exposure to risk before the magnitude of the financial crisis was a fact?

Abstract

Background and Problem When the financial crisis started in 2007, the attention was directed towards the risks that the banking sector was exposed to. The information asymmetry between the banks and the market caused uncertainty for the investors, and this uncertainty had to be taken into consideration for investment decisions and would affect the asset pricing (Bird & Yeung, 2012). Exposure to risks is a natural part of the banking sector, however, the question is to what extent the investors understand these risks, and how much of the uncertainty caused by these risks that they incorporate in their investment decision process. In this research the amount of credit losses and the banks’ liquidity status after the financial crisis is used as a measurement of how well the banks managed the crisis. The level of the banks’ exposure to risks can therefore be measured with these two proxies and the phenomenon Post-Earnings Announcement Drift (PEAD) can be examined to detect the uncertainty that the market perceive. Also, the auditors’ role in limiting the uncertainty for the investors is examined through comparing the market’s reaction after the earnings’ announcement in the unaudited Q1-Q3 reports and the audited Q4 report. The investors’ reaction to earnings’ announcement is investigated to provide insights into whether the uncertainty the investors faced did affect their investment decisions and if they, with the answer in hand, did foresee which banks would manage the crisis and which ones would fail. Purpose The purpose of this research is to investigate if a relationship can be observed between the stock prices and the uncertainty that the market is facing due to potential risks in the banking sector. Method The method used to find answers to the research questions is to analyze the phenomenon Post-Earnings Announcement Drift in listed banks in Europe during the years 2005-2009. The investors’ reaction to earnings’ announcement is investigated to provide insights into whether the uncertainty the investors faced did affect their investment decisions. The PEAD is measured as the relation between the Cumulative Abnormal Return (CAR) and the Standardized Unexpected Earnings (SUE), where the size of the CAR explains to which extent the unexpected earnings cause an effect on the stock prices. Conclusion From this study the authors cannot claim that there is a difference in PEAD for the banks that did not manage the crisis well, compared to the banks that maintained stability through the crisis. Based on this research, the conclusion is that the market did not foresee which banks that would manage the crisis and which ones that would not. However, this study does indicate that some form of investors’ uncertainty has been captured. Significant difference among some of the groups has been observed where the liquidity was testes as a proxy for the risk exposure. Furthermore, from the results the authors cannot claim that the differences in PEAD between the quarters could be derived from the auditors’ role of limiting risk for the investors.