# risks for jordanian banks

### Abstract

Geographically diversified BHCs can achieve a lower cost of funds by enlarging their deposit bases, increase their revenues through new investment opportunities and synergy gains, improve managerial efficiency by spreading their managerial expertise over a larger scale of operation, and see greater productive efficiency due to enhanced takeover threats. Moreover, portfolio theory suggests that geographically diversified BHCs can reduce earning volatility through the "coinsurance effect" documented in Lowellen (1971) and Boot and Schmeits (2000). Some empirical studies support the above arguments. For example, Akhigbe and Whyte (2003) and Hughes et al. (1999) find that interstate banking leads to a higher level of profitability and a lower level of earning volatility, insolvency risk, and market risk. On the other hand, geographic diversification may be associated with value loss, due to the lack of managerial skills or lack of information when entering new markets, and a more complex organization and product structure and, hence, intensified agency problems (Acharya, Hasan, and Saunders 2006, Baele, Jonghe, and Vennet 2007). These circumstances may reduce profitability, increase risk and reduce firm value. Demsetz and Strahan (1997) and Chong (1991) find that bank diversification does not necessarily result in lower risk because diversified banks may raise their leverage and may pursue riskier activities, such as risky lucrative loans or speculative derivatives positions, due to competitive pressures. DeLong (2001) also demonstrates that activity-diversified and/or geographically diversified mergers destroy firm value. In the end, how geographic diversification is associated with firm value and risk becomes an empirical question.

Based on the above discussion, we propose the following hypothesis:

This paper aims to assess the level of risk in 13 Jordanian commercial banks over the period 1995 to 2008. To measure risk level, we apply risk index developed by Hannan and Hanweck (1988). Risk index provides comprehensive measures that capture any risk that could affect earning of banks. High risk index reflects strong financial strength while low risk index reflects financial weakness. Our findings reveal that the average risk index of banks is 17.5 units compared to the mean industry index of 27.93 units. The lower value for risk index for the banks in the sample compared to the industry mean reflects the higher risk borne by some of the banks in the sample due to poor performance. In terms of the banks, the highest index is 33.3 units of Arab Jordan Investment bank and the lowest index of 6.8 units of Jordan Investment and Finance Bank. For the Jordanian banking industry, the highest value for the risk index is 38 units (in 2008) while the year 1997 has the lowest of 11 units. Our finding provides evidence that a bank with a higher risk index level indicates that the bank has strong capital and profit relative to their risk as measured by the volatility of their returns.

### 1. Introduction

There is extensive empirical evidence that the increase of the size of the risks inherent in the work of banks is one of the main reasons behind their failure (Demirg-Kunt & Detragiache, 1998). Especially in developing countries, banking crises lead to negative effects such as slowdown of economic growth, loss of confidence in local banking institutions and investors turning their capital to more stability places. These effects deepened when monetary authorities were unable to emerge from the crisis and address the problems (Dell'Ariccia, Detragiache, & Rajan, 2008). Therefore, an assessment of the level of risk for banks will help or alert the authorities to reduce any possible future banking crises. In other words, assessment of the present level of risks for banks is a proactive step which will help banks to avoid any future crises.

Many studies have done to evaluate risk of banks around the world (Blasko & Sinkey, 2006; Garcia-Marco & Robles-Fernandez, 2008; Konishi & Yasuda, 2004; Nash & Sinkey Jr., 1997), but none has done for Jordanian banks. In addition, Jordanian banks had never ranked according to their risk exposure. Hence, the objective of this paper is to answer the following question: what is the level of risk for Jordanian banks based on their risk index?

### 2. Assessing level of risks for Jordanian banks

We used risk index to assess risk exposure for Jordanian commercial banks. Risk index was developed and used by (Hannan & Hanweck, 1988), and also implemented by (Blasko & Sinkey, 2006; Eisenbeis & Kwast, 1991; Garcia-Marco & Robles-Fernandez, 2008; Konishi & Yasuda, 2004; Nash & Sinkey Jr., 1997; Sinkey Jr. & Nash, 1993). Risk index is defined as the sum of the mean net return on assets plus the mean ratio of equity to total assets divided by the standard deviation of the return on assets.

It is expressed as:

RI= (ROA+CAP)\ SDROA ............. (1)

Where:

ROA: return on assets, measured by net income to total assets.

CAP: capital ratio, measured by total capital to total assets.

SDROA: standard deviation of return on assets.

Equation (1) shows risk index measurement. The numerator is consisting from two ratios. First: return on assets which measure the ability of management to use the real and financial resources of the bank to generate return. It is most famously accepted accounting evaluate of overall bank performance. Second: bank's ratio of equity capital to total assets which is standard measure of soundness and safety of banks. It measures capital adequacy which provides a cushion against failure. The denominator includes standard deviation of return on assets which is a good measure for the variability of return on assets. Risk index provides comprehensive measure that captures risks such as credit risk, liquidity risk, operational risk, interest rate risk and any risk that could affect bank's earning (Sinkey, 1998). Thus, Bank risk index is useful because they collapse several pieces of information into a signal number.

The result of risk index is a measure, expressed in units of standard deviations of ROA, of how much a bank's accounting earnings can decline until it has a negative book value. In other words, risk index measure the thickness of the book value that a bank has to absorb accounting losses. Hence, a lower risk index implies a riskier bank and a high index implies a safer bank (Blasko & Sinkey, 2006).

We followed (Nash & Sinkey Jr., 1997) approach to measure risk index. First: we measured the standard deviation of ROA on bank by bank basis over years, we got a risk index for each bank for a given year. In this way, the risks associated with banks' work are reflected in the standard deviation of ROA over time for a given bank. Second: we measured risk index of all banks by using average of return on assets, average capital ratio and slandered deviation of ROA for all banks in a given year, we got risk index of the industry of all banks in a given year. This way assumes that the risks are reflected in the standard deviation of return on assets across the sample of banks in a given year.

### 3. Results and discussion

Table 5.1 shows ranking of banks based on their risk index. We found that the average risk index of banks is 17.5 points, meaning that banks on average have 17.5 unit standard deviations of ROA that can decline until they have negative book value. Among the banks, the average of risk index of Arab Jordan Investment bank is the highest followed by Arab bank. The averages of their risk index measure over test period are 33.3 points and 30.3 points respectively. Among banks, they have lowest value standard deviation of ROA. Thus, Arab Jordan Investment bank and Arab bank are the safer banks between banks in the study. In contrast, with an average of 6.8 points, Jordan Investment and Finance bank has the lowest risk index between banks. This was attributed to highest value of standard deviation of ROA between banks.

4. Conclusion

In this paper, we apply the risk index to measure the risk exposure of banks. Risk Index has not been widely used as a tool to indicate banking risk. It is the first time finding to document the risk index value for Jordanian banks as Bank Risk Index, whereas in most cases, the only index available is the stock market index. The documentation of the risk index for banks could provide a significant indicator for risk for both the practitioners, regulators and the bank customers themselves as to which bank should be on the watchlist.

### References

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Dell'Ariccia, G., Detragiache, E., & Rajan, R. (2008). The real effect of banking crises. Journal of Financial Intermediation, 17(1), 89-112.

Demirg-Kunt, A., & Detragiache, E. (1998). The Determinants of Banking Crises in Developing and Developed Countries. IMF Staff Papers, 45(1), 81-109.

Eisenbeis, R. A., & Kwast, M. L. (1991). Are Real Estate Specializing Depositories Viable? Evidence from Commercial Banks. Journal of Financial Services Research, 5(1), 5-24.

Garcia-Marco, T., & Robles-Fernandez, M. D. (2008). Risk-taking behavior and ownership in the banking industry: The Spanish evidence. Journal of Economics & Business, 60(4), 332-354.

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Sinkey, J. F. (1998). Commercial bank financial management in the financial-services industry (Fifth ed.): A Simton & Schuster Company.

Sinkey Jr., J. F., & Nash, R. C. (1993). Assessing the Riskiness and Profitability of Credit-Card Banks. Journal of Financial Services Research, 7(2), 127-150.