Probability of default and banking efficiency: How does the market respond?

Abstract

The paper attempts to analyze whether shareholders value as intangible assets the management decisions of bank production plan, in terms of cost efficiency, and risk associated to bank portfolio composition, in terms of probability of default (PoD). To test the market response to both management decisions, we employ a regression equation for bank valuation, using the panel regression model estimation procedure with country and year fixed effects, for the listed banks of 15 European countries, during the period 1997–2016. The results show that shareholders value both the efficiency of the production plan and the default risk. In particular, shareholders positively value banks’ cost efficiency and negatively value those banks with high PoD. These findings have important policy implications and show that the market value performance allows for the provision of more insights than book value into potential drivers of banks’ system stability and potential mechanisms for regulators and supervisors to maintain and control bank stability.