Jrurnal
of Financial
Economics
35 (1994) 99- 122. North-Holland
An examination of voluntary versus
involuntary security issuances by
commercial banks
The impact of capital regulations on
common stock returns*
Marcia Millon Cornett
Southern Illinois Vnilvrsity.
Curhondale.
IL 62901.
USA
Hassan Tehranian
Boston College, C’hesmut Hill.
Received April
MA 02167. VSA
1992. final version received March
1993
Thrs paper examines differences in stock price reactions following voluntary capital injections by
commercial banks and involuntary capital injections required to meet regulatory capital requirements. Empirical tests document that stock price declines associated with voluntary common stock
issues are significantly greater than those associated with involuntary common stock injections,
consistent with Ross (1977). Empirical tests also confirm that for both voluntary and involuntary
stock issuances, the abnormal stock price reaction is negatively related to the relative size of the
offering and positively related to managerial ownership prior to the security issue, although these
relationships are stronger for voluntary issues.
Kep words: Banking; Regulation;
JEL classijicarion: G21
Equity
1. Introduction
Recent empirical studies in corporate finance examine stock price reactions to
announcements
of capital structure changes [see, for example, Asquith and
Corresportduncc IO: Hassan Tehranian,
Chestnut Hill, MA 02167. USA.
Wallace E. Carroll
Schoo! of Managrm?nt.
Boston College.
*The authors are grateful for comments from James Booth, Peter Elmer, Clifford Holderness,
George Kanatas. Alan Marcus. Elizabeth Strock, Robert Taggart, :eminar participants at Indiana
University, and an anonymous referee. An earlier version of the paper was presented al the 1991
Financial Management Association Meetings. The assistance of Pauletta Masterson and Dixie Ober
in the preparation of this manuscript is greatly appreciated.
03134-405X,94/$07.00
cj 1994
Elsevier Science BV. All rights reserved
100
M.M.
Cornert
aud H. Tehranian.
Price reactions
to voluntaryfinvoluntary
security
issues
Mullins ( 1986), Eckbo (1986), Masulis and Korwar (1986), and Mikkelson and
Partch (1986)]. Common stock and convertible debt offerings have generally
been found to produce negative and statistically significant stock price reactions,
while preferred stock and straight debt offerings have generally been found to
produce no statistically significant stock price reactions. The theoretical literature in this area concludes that the documented stock price reactions reflect
more than just the direct effects of capital structure changes on the firms’ cash
flows. Rather, the security offerings are viewed as conveying information to
market participants [see Ross (1977); Myers and Majluf (1.984) also use this
information asymmetry approach to explain stock price :e:actions]. Assuming
that managers possess inside information about the value of t e firm, capital
structure changes are valid signals that allow this information to be conveyed to
investors. As Ross points out, firms issue equity when they have oor prospects,
and they issue debt when prospects are good. Stated simply, a firm with poor
prospects will want to share its downside with new claimants, and thus prefers
the issuance of stock, while a firm with good prospects will not want to share its
upside with new claimants, and thus prefers the issuance of debt.
Previous studies (both empirical and theoretical) consider only voluntary
issuances of securities by sample firms. Capital regulations in the banking
industry, however, may result in involuntary issuances of securities to satisfy
capital standards; these involuntary issues would not be expected to signal
prospects (good or poor) for the firm from Ross’ view.’ We specifically examine
stock price reactions associated with security issuances by commercial banks,
classifying the security issues as involuntary (i.e., mandated to meet regulatory
capital standards) or voluntary. Following Ross (1977), stock price reac.ions
associated with voluntary stock issuances are expected to be negative, since they
signal poor prospects for the bank. For banks which involuntarily issue stock,
however, the stock price decline should be significantly less negative than for the
voluntary issuers.
Other factors have also been found to affect post-issue returns. Asquith and
Mullins (1986), Masulis and Korwar (1986), and Mikkelson and Partch (1986)
argue that the relative size of the issue has a negative effect on the abnormal
returns to the issuing firm’s stockholders. Furthermore, Jensen and Meckling’s
(1976) agency theory and Leland and Pyle’s (1977) signaling theory predict
that an increase in managerial stockholdings has a positive effect on returns.
[Besanko and Kanatas (1991) have developed a theoretical model which explains how these relations apply to voluntary versus involuntary security issuances by banks.] Thus, the stock price reactions associated with voluntary issues
should also be negatively related to the relative size of the offering (measured as
the value of the offering divided by the total assets of the bank) and positively
‘We are grateful to an anonymous
referee for identifying
this distinction.
M. M. Comett and H. Tehranian.
Price reactiom
to toluntary/incoluntary
security issues
101
related to the fractional ownership of the bank’s insiders. Stock price reactions
associated with involuntary stock issuances, and their relation with relative size
of the issue and fractional ownership, are expected to be less severe than for
voluntary stock issuances because involuntary rssuances do not conform to the
conditions in Ross (1977). Our empirical work tests these hypotheses.
Wansley and Dhillon (1989) and Polonchek, Slovin, and Sushka (1989)
examine stock price reactions to issuances of securities by commercial bank
holding companies without distinguishing between voluntary and involuntary
issuances. Both studies find that the announcements of common stock issuances
are associated with significant negative stock price reactions, but the reactions
are smaller than those found for industrial firms. Keeley (1989) examines 24
capital issues by banks during the period 19751986, and finds that involuntary
stock issues produce a significantly more negative return than voluntary issues,
contrary to the predictions drawn from Ross (1977). Keeley offers three explanations for this finding. First, banks which are forced to issue equity in an effort to
diminish the risk exposure of the deposit insurance fund would experience larger
negative returns than banks that are not forced to issue equity, because the
issuance would diminish the value of the deposit insurance guarantee. Second,
regulatory-induced increases in capital could result in larger negative announcement effects because distortions such as taxes or agency costs could force
a change in capital structure away from the bank’s optimum. Finally, a security
issuance by a bank known by the market to be under regulatory pressure to
increase its capital level might convey regulatory inside information about the
firm’s future prospects.
Our results indicate that involuntary common stock issuances undertaken to
satisfy regulated capital ,-dequacy levels produce abnormal stock price returns
which are significantly less negative than voluntary common stock issuances.
Furthermore, the stock price reactions to both voluntary and involuntary
issuances of common stock are negatively related to the relative size of the issue
and positively related to the managerial ownership in the bank prior to issuance,
although the relationships are not as strong for involuntary stock issuances. Our
results imply that the voluntary issuance of equity and the corresponding signal
of poor expected performance [in the context of Ross (1977)-Jcause the market
to drive stock prices down significantly. The issuance of equity required to
maintain capital standards, however, is not associated with any signal of future
prospects for the firm. Thus, the market does not react as unfavorably to an
involuntary stock issue. While our results are contrary to Keeley’s the variation
in the way capital standards were imposed during the sample periods studied in
the respective papers allows both to be consistent with Ross’ capital structure
signaling model. During Keeley’s sample period, capital injections required to
alleviate capital deficiencies were discretionary on the part of bank regulators
and, therefore, conveyed information to the market regarding the bank’s
expected performance. Capital injections during our sample period were a
102
M.M. Cornett and H. Tehrarrian, Price reactions to roltmtar~/involuntarv security issues
function of stated capital ratios and thus did not convey information. Our
results may also differ from Keeley’s because of differences in sample sizes.
The remainder of the paper is organized as follows. Section 2 recaps the
regulation of capital standards over the last 40 years. Section 3 describes the
data, methodology, and hypotheses employed in the empirical tests, while
section 4 presents the results. Finally, section 5 concludes the paper.
2. Capital regulation of commercial banks
The arguments in favor of capital regulation have been well documented in
the finance literature. Virtually all of these papers [for example, Koehn and
Santomero ( i980), Grouchy and Galai (1986), and Kim and Santomero (198811
recognize t h: regulators are concerned about the safety and soundness of
individual banks as well as the banking system as a whole. Since regulators are
responsible for ensuring public confidence in the banking system, they want to
ensure that bank managers are given incentives to maintain the institution’s
financial soundness. Capital standards are one way of providing these incentives. Also, as pointed out in several papers [for example, Buser, Chen, and Kane
(1981) and Dietrich and James (1983)-J,capital reduces the risk to the insurers
(government) when bank deposits are virtually fully insured by government
agencies at a flat rate premium. From the bank’s point of view, equity represents
funds available for investment purposes, and also acts as a buffer against
unanticipated earnings losses [see Taggart and Greenbaum ( 1978)].2
The regulation of capital standards for U.S. banks has been implemented in
various forms over the last 40 years. In the 195Os,the Federal Reserve mandated
the level of capital according to the analysis of bank capital (ABC) system.
This method employed a precise formula applying a certain percentage of
capital to be held against different asset categories. By the mid-1970s, this
formula had become sufficiently complex and difficult to administer that it was
dropped a the method of determining capital levels for banks. [See Moulton
(1987) for a more detailed discussion of the history of capital regulation
guidelines.]
In place of the ABC system, federal and state regulatory agencies used
a subjective approach based on peer group comparisons to decide if a bank had
sufficient capital. During the 1970s this method essentially involved regulators
persuading
banks to increase capital when needed and, in extreme cases,
requiring a bank to formulate a plan to raise capital.
‘Other papers have argued that capital standards can be ineffective [see Koehn and Santomero
(1980)] or redundant [see Grouchy and Galai (1986)] in controlling bank risk. It is not our inteniA:l
to argue for or against capital regulation as a means of controlling bank risk. but rather to look ;I!
the impact of capital requirements on bank value.
M. M. Cornet1 arid W. Tehanian,
Price reactions IO colrc~~tar~linooluntar), security issues
103
The imposition of minimum levels of capital for commercial banks was
reinstated in 1981, although regulators differed at first in setting minimum
requirements. The Federal Deposit Insurance Corporation (FDIC) adopted
a minimum primary capital-to-asset ratio of 5%, while the Federal Reserve
System (Fed) and the Office of the Comptroller of Currency (OCC) set the
minimum primary capital standard at 6% for bank holding companies with
assets of $1 billion or less and 5% for banks over $1 billion. The capital ratios for
the 17 largest banks were initially considered on an individual basis, although
minimum capital ratios were established for these 17 largest banking organizations in June 1983, in accordance with the International Lending and
Supervision Act of 1983 [see Moulton (1987)]. This law also required that by
1985 all banks, regardless of their international or local market situation,
maintain minimum capital standards. Acccfdingly, in 1985, federal banking
regulators called for a minimum ratio of primary capital to total assets of 5.5%
and total capital to total assets of 6%. Banks which fel! below these minimums
were required to submit plans to regulators describing how they would forthwith remedy the shortfall.
In July 1988, the United States and eleven other leading industrialized
countries announced preliminary agreements on capital standards to be
universally applied to all internationally-active banking institutions in their
respective jurisdictions. In addition to the establishment of minimum acceptable
levels of capital, the Fed set up ‘zones’ of adequacy based on total capital to
assets ratios. For regional banks, the zone minimums set in 1981 were: i) zone 1,
acceptable (6.5% or more of total capital), ii) zone 2, possibly undercapitalized
(5.5% to 6.5% total capital), and iii) zone 3, undercapitalized (less than 5.5% of
total capital). Banks in zone 1 are subject to minimal regulatory supervision,
while banks in zone 2 are subject to greater regulatory supervision and banks in
zone 3 receive continuous supervision. Levels associated with all three zones
were increased by 0.5% as a result of the International Lending and Supervision
Act of 1983. Thus, the 6.5% cutoff for acceptable capital was increased to 7% in
June 1983.
The OCC and Fed classify a bank’s capital as either primary capital, consisting of common stock, perpetual preferred stock, surplus, undivided profits,
capital reserves, mandatory convertible debt, loan and lease loss reserves, and
minority interest in consolidated subsidiaries less intangible assets, or as secondary capital, consisting of limited-life preferred stock, subordinated notes and
debentures (straight or convertible), and mandatory convertible debt instruments not eligible to be counted as primary capital. (The FDIC’s definition of
primary capital differs somewhat from the OCC and Fed definition.)
Ir appears that capital regulation is coming full circle, with the Fee’ recently
enacting new guidelines which attempt to explicitly factor the quality of the
bank‘s assets, as well as off-balance-sheet risk exposure, into the detcrminatbn
of ;I bank’s minimum capital requirement. Thus, similar to the ABC system of
104
M.M. Cortrcrt and H. Tehranian. Price reactions to voluntnry/involuntary security issues
the 1950s and 196Os,a bank’s required capital is related to its risk profile in such
a way that higher-risk activities require that relatively more bank capital be
held. The new capital standards were phased in such that a minimum capital
level of 7.25% was required as of December 31, 1991, with an increase to 8% as
of December 31, 1992.
3. Data and methodology
3.1. Data
This study examines announcements of all security offerings (except initial
public offerings by banks that were previously privately-owned) by publiclytraded commercial banks in the United States during the period June 1983,
when the seventeen largest banks were first required to comply to the new
capital standards, through December 1989. After June 1983, all banks operated
with the same capital requirements. While the legal capital requirements were
increased in 1985, the zones of classification remained the same over the entire
sample period. Our sample of banks contains both bank holding companies and
independent banks. The initial sample of bank security issuances was collected
from the investment Dealer’s Digest (IDD). We searched the Wall Street Journal
( WSJ) Index for announcements tif security offerings and used the dates of
these announcements as the initial announcement date. If no mention of the
security offering was found in the WSJ Index, we used the date that the offering
was registered with the Securities and Exchange Commission (SEC) as the
initial announcement date. (If the WSJ announcement occurred after the
offering was registered with the SEC, we used the registration date as the
initial announcement date.) Registration dates are listed in the IDD. We
included only those security offerings which contributed to the bank’s primary
or secondary capital (i.e., common stock, preferred stock, and subordinated
debt) as defined by the various regulatory agencies. For shelf registrations we
include only the announcement of the shelf registration itself; we did not
evaluate the stock price reaction of the subsequent security offerings from
a pu.rticular shelf registration. The final sample includes 49 1 security offerings by
176 different banks.
To determine whether the issuance of the security was voluntary or involuntary, we use the Federal Reserve Board’s definition of ‘zones’ for classifying
banks with respect to supervisory action. As described in section 2, throughout
our sample period banks with total capital ratios in excess of 7% were deemed
by regulators to have ‘adequate’ capital, and their security issues are therefore
classified in our paper as voluntary. Banks with total capital ratios below 7%
were considered to be ‘undercapitalized’, and these security issues fall into our
involuntary issue subsample.
M.M.
Cornett and H. Tehranim.
Price reactioru tti rokntary/im
dmtary .wcurity issups
105
We choose the 7% minimum zone 1 total capital ratio rather than the fiGjo
minimum required total capital ratio to distinguish between voluntary and
involuntary security issuances for three reasons. First, the 7% minimum zone
1 ratio was in effect for the entire sample period (June 1983 to December 1989).
In comparison, the required total capital ratio was 5.5% from June 1983 to
December 1985, while the 6% legal minimum capital ratio was in effect from
1986 to 1989. Second, fewer than 10% of the capital issuances occurred when the
bark‘s total capital ratio was below 4%; using the zone classifications thus
ensures a sufficient sample size for involuntary capital injections. Finally, once
a bank goes below the 7% level of capital (and thus becomes classified as less
than ‘acceptably’ capitalized), regulatory involvement or intervention becomes
relatively pronounced for that bank, so that few banks actually operated near
this level. To avoid regulatory scrutiny, capital injections generally occurred
when the bank’s capital fell below the 7?/0 !evel.
Financial statement information needed to calculate the capital ratios is
obtained from the FDIC Report of Income and Report of Condition data tapes.
The FDIC data tapes r-eport information by bank. For the bank holding
companies in the sample, data for the individual banks in the holding company
were cumulated to obtain t5e overall holding company figures. Using a 7% total
capital ratio as of the end of ihe year pri:br to the security issue as the cutoff level,
the full sample of 491 offerings is divided into 238 voluntary issues of capital and
253 involuntary issues of capital.
Table 1 lists characteristics of the sample, including the year the security
offering was announced, the type of security issued, and Moody’s rating on debt
issues. Table 1 reports only 22 voluntary issues in the last seven months of 1983
and all of 1984, compared to 105 involuntary issues. The relatively high incidence of involuntary issues is most likely due to the fact that the new capital
standards had recently been imposed. It was during the first years after the rule
change that banks built up their ratios above the 7% level deemed by regulators
to separate adequately and inadequately capitalized banks. More surprising is
the fxt that the large majority of capital issues by banks from 1987 through
1989 were voluntary. During this period there was a sharp increase in bank
failures, particularly in the southwest pprt of the U.S. Yet our data sample
implies that undercapitalized banks did not issue new capital in an attempt to
salvage themselves, possibly because market participants were able to distinguish betwec;n adequatelv and inadequately capitalized banks and would not
invest in new issues by the high-risk banks. The low number of involuntary
issues would then be due not to !ack of desire by the undercapitalized banks to
build up their capital position, but rather to the inability to raise capital at an
acceptable price. Another interesting fact reported in table 1 is that over half of
the securities issued by both groups (voluntary and involuntary) involved
straight debt. One explanation for this is that the bank managers want to
maintain ownership control of the bank. The issuance of straight debt allows
106
M.M.
Cornett and H. Tehranian,
Price reactions
to voluntary/involuntary
security
issues
Table 1
Characteristics
of 491 security offerings by commercial banks between June 1983 and December
1989.
Voluntary issuesa
(n = 238)
Number
Year of announcement
1983
1984
1985
1986
1987
1988
1989
Type of security issued
Common stock
Preferred stock
Convertible debt
Straight debt
Common stock and convertible debt
Common stock and straight debt
Preferred stock and straight debt
Common stock and preferred stock
Rating on debt issues
> A3
< BAA1
Not rated
Percent
of total (%)
Involuntary issues
(n = 253)
Number
Percent
of total (%)
4
18
42
49
53
30
42
1.7
7.6
17.6
20.6
22.3
12.6
17.6
34
71
62
48
28
6
4
13.4
28.0
24.5
19.0
11.1
2.4
1.6
61
23
17
132
1
0
4
0
25.6
9.7
7.1
55.5
0.4
0.0
1.7
0.0
59
24
20
146
23.3
9.5
7.9
57.7
1
2
1
0.4
0.8
0.4
100
31
23
64.9
20.1
15.0
147
9
13
87.0
5.3
7.7
“An issue is classified as voluntary if the bank’s total capital ratio is above 7% prior to the issue
and involuntary if the total capital ratio is below 7% prior to the issue. These groupings are based on
the Fed’s classifications for adequately and inadequately capitahed banks.
them to maintain control while at the same time build up the bank’s capita1
position [see Stulz (198811.Table 1 also reports that only 23 of the 238 voluntary
and 24 of the 253 involuntary issues involved preferred stock. As pointed out by
Palonchek, Sloven, and Sushka (1989), there is a long-standing tradition in the
banking industry that the issuance of preferred stock is taken as a signal of
financial distress. This argument has its basis in the fact that preferred stock
issuances were originally accepted as part of a bank’s capital as a means of
providing banks in extreme difficulty with emergency capital.
Table 2 lists some summary statistics of the sample, including the book value
of assets of the issuing bank at year-end prior to the security issue, the relative
size of the issue (the dollar value of the issue divided by the book value of assets
of the issuing bank prior to the issue), the issuing bank’s primary and total
capital ratio at year-end prior to the issue, and managerial ownership in the
Issuing bank prior to the securitlr offering. All accounting data used to tabulate
M. M. Cornett
and H. Tehranian,
Price reactions
to t~ohultar,,linrolurttar~
security
issues
107
Table 2
Summary statistics of 491 security offerings by 176 commercial banks between June 1983 and
December 1989.
Voluntary issues” (n = 233)
Minimum
Mean
Book value
%38,289.6
$124.7
Relative
1.36%
Maximum
qf issuing
bank’s assets prior
%181,192.4
21.98%
0.02%
bank’s primary
1.oo%
0.99%
Minimum
to security
offering
$29,809.6
capital’
7.81%
prior
5.88%
to assets ratio
prior
6.21%
6.69%
qf issuing
3.98%
to security
0.50%
0.66%
offering
6.98%
to security
$12,235.2
bank’s assets)
52.74%
to security
Median
of .S)
$131,432.8
3.98%
in issuing bunk prior
2.00%
(in millions
0.02%
to assets ratio
7.26%
Maximum
$172.5
1.17%
capitalb
ownership
66.15%
Mean
size divided by book va!ue
14.66%
7.00%
Managerial
6.14%
$16.48855
11.37%
4.45%
Issuing bank’s total
8.16%
Median
size of issue (offering
issuing
7.51%
Involuntary issues (n = 253)
5.99%
o&ring
7.iN%
6.35%
o&ring
62.40%
1.93%
“An issue is classified as voluntary if the bank’s total capita1 ratio is above 7% prior to the issue
and involuntary if the total capital ratio is below 7% prior to the issue. These groupings are based on
the Fed’s 1983 classifications for adequately and inadequately capitalized banks.
bPrimary capital consists of book values of common stock, perpetual preferred stock, surplus,
undivided profits, capita1 reserves, mandatory convertible debt, loan and lease loss reserves, and
minority interest in consolidated subsidiaries less intangible assets.
‘Total capital consists of primary capital plus limited life preferred stock, subordinated notes and
debentures (straight and convertible), and mandatory convertible debt instruments not eligible to be
counted as primary capital.
information in table 2 were obtamed from the FDIC Report of Income and
Report of Condition data tapes. Managerial ownership (actual and beneficial
ownership of the board of directors) was obtained from proxy statements prior
to the security offering.
3.2. Methodology
The hypotheses examined in this study are tested by applying standard
event-study methodology and by estimating cross-sectional regressions. Stock
data are obtained from the Centerjbr Research in Security Price (CRSP) data
tapes. The abnormal return (AR) for security i on event day t is calculated as
follows:
(1)
108
M. M. Cornett and H. Thanian,
Price reactions lo volunrar~~linvoluntary security issues
where Ri, and Rmit +j ij = - 2, . . . ,2) are the rate of return on security i and the
rate of return
on the CRSP equally-weighted index on event day t +j. The
coefficients cii and gij are ordinary least squares estimates of the intercept and
slope of the market mode1 regression. The models used in previous studies are
slightly different from eq. (1). We employ the market return at several leads and
lags as explanatory variables to overcome the possibility of nonsynchr+ .:.3;s
trading in our sample, especially for the smaller banks [see Scholes and Wil:~..~rs
(197711.Because stock issuances frequently follow a period of superica ,P:+;L. i
performance [see Asquith and Mullins (1986)], the estimation peric+ ff~n ?c
market mode1 comes from the period t = + 20 through t = + 120.
The average abnormal return on event day t for a portfolio of N securiti;s 1s
The test statistic, Z,, for AAR, is based on the standardized abnormal return
SARi,y3 and is calculated as
Zr = 2
SARi,/JN.
(3)
i=l
The Z-statistic has a unit-normal distribution.4
3Where
and Sf is the residual variance for security i from the market model regression, L the number of
observations during the estimation period, R,k the return on the market portfolio for the kth day of
the estimation period, and i?,,, the average return of the market portfolio for the estimation period.
*Standard event-study methodology
was used to obtain cumulative abnormal returns,
CAR
and average standardized cumulative returns.
SCAR
used in the next section.
M.M.
Cornett and H. Tehranian,
Price reactions to ~~olttntar~Jkr’olu~~tar), security issues
109
irkaddition to the event-study tests, we estimate cross-sectional regressions
employing the standardized announcement-period common stock returns as the
dependent variable and various independent variables which have been
documented in the finance literature as influencing announcement-period returns. These include the bank’s total capital ratio prior to the security offering,
the relative size of the security offering, managerial fractional ownership, the
bond rating at the time of issue (if the security involved debt), the cumulative
excess stock return over a period prior to the security offering, and the stock
return variance over a period prior to the security offering. Separate regressions
are run for the subsamples of voluntary and involuntary security offerings.
In the next section we use the data and methodology described above to
empirically test for differences in stock price reactions for voluntary versus
involuntary security issuances. We test three hypotheses: 1) the stock price
reaction associated with the voluntary issue of equity claims by commercial
banks is significantly more negative than that associated with the involuntary
issue of equity; 2) the stock price reaction associated with the issue of equity
claims by commercial banks is negatively related to the size of the injection, i.e.,
the smaller the relative size of the equity injection, the 1~s negative the stock
price reaction; and 3) the stock price reaction associated with the issue of equity
claims by commercial banks is positively related to the insider ownership in the
bank prior to the equity injection, i.e., the larger the initial ownership by the
bank’s insiders the less negative the stock price reaction.
4. Results
4. I.
Portfob
analysis
Table 3 presents the average abnormal portfolio returns around the announcement of a security issue for the samples of voluntary and involuntary
security issues by banks based on the type of security issued. Panel A of table
3 lists the results for the voluntary security issues, while panel B lists the results
for the involuntary security issues. Panel C summarizes the differences in the
abnormal returns between the voluntary and involuntary issues. The cumulative
average abnorrlal returns are reported for the interval beginning 60 days before
and ending two days before the announcement, as well as for the two-day
(t= - 1 and t = 0) announcement period. For each portfolio return reported in
panels A and B of table 3, the corresponding Z-statistic and the percent of
negative abnormal returns is alsn reported.
For the two-day (t = - 1 and 0) announcement period, table 3 shows that the
average abnormal return for the sample of voluntary common stock issuances is
- 1.56% (Z = - 4.53, significant at the 0.01 level), while the involuntary
issuances of common stock produce an average prediction error of - 0.64%
(Z= - 1.45, insignificant). As reported in panel C of table 3, the difference in
110
M.M. Cornerr and H. Tehranian, Price reactions to voluntar~~jinvoluntarysecurity issues
Table 3
Portfolio abnormal returns for subsamples of 238 voluntary and 253 invc:untaty security issues by
176 banks between June 1983 and December 1989, based on the type of security issued.
Type of security issued
Common
stock
Straight
debt
Convertible
debt
Preferred
stock
Combinations
Panel A: Voluntary issue.9
Sample size
61
132
17
23
5
Event period ( - 60, - 2)
Z-statistic
Percent negative
6 640/ob
2:71
26
4 83%b
4102
37
7 830hb
3:14
29
9 32%’
2:21
2.2
31 70%b
3.39
20
0.47%
0.27
30
0.25%
0.12
40
_~__
Event period ( - 1,O)
Z-statistic
Percent negative
0.18%
- 1 560hb
0.17%
0.33
- 4153
0.95
53
79
49
____
Panel B: Involuntary issues
Sample size
59
146
20
24
4
Event period ( - 60, - 2)
Z-statistic
Percent negative
2.04%
1.46
23
2 14%’
2:05
33
8 270hb
3:04
30
2.72%
1.03
21
23 13%’
2.49
25
Event period ( - 1,O)
Z-statistic
Percent negative
- 0.64%
- 1.45
61
0 32*/od
I:86
41
- 0.50%
- 0.93
5,7
- 0.18%
- 0.37
54
0.07 %
0.09
25
Panel C: Diferences in abnormal returns between voluntary and involuntary security issues
Event period ( - 60, - 2)
Differences in abnormal returns
Z-statistic for difference
4.60%
0.86
2.69%
- 092%’
2:14
- 0.15%
0.59
1.50
- 0.44%
0.25
6.60%
0.86
8.57%
0.40
0.68%
0.87
0.65%
0.45
0.18%
0.01
Event period ( - 1,O)
Difference in abnormal returns
Z-statistic for difference
“An issue is classified as voluntary if the bank’s total capital ratio is above 7% prior to the issue
and involuntary if the total capital ratio is below 7% prior to the issue. These groupings are based on
the Fed’s classifications for adequately capitalized banks.
bSignificant at better than the 0.01 level.
‘Significant at better than the 0.05 level.
dSignificant at better than the 0.10 level.
atnormal returns between involuntary and voluntary stock issuances, 0.92%, is
significant (Z-statistic for difference in means is 2.14)‘. The percent of negative
abnormal returns for the voluntary and involuntary equity issuances are 79%
and 61%, respectively, both of which are significant at the 0.01 level. The
significant decrease in stock prices associated with voluntary stock issuances,
‘To determine whether the difference is abnormal returns is statistically significant the following
formula is used:
M.M. Cornett and H. Teltranian. Price reacrions to voluntary/involuntary security issues
111
combined with the lack of a significant decline in stock prices for the involuntary
stock issuances, lends support to Ross’ (1977) capital structure signaling model.
That is, the voluntary issuance of equity sends a signal of poor expected
performance to the market, resulting in a drop in stock prices. An involuntary
stock issuance required to meet capital standards is not associated with a signal
of future prospects for the bank and thus does not cause the market to react as
unfavorably.
A key difference between voluntary and involuntary offers is that involuntary
offers are anticipated to a greater degree. Since the classificati\:r) of an involuntary offer is based on the book value of the bank’s capital: the market can
forecast which banks are capital-deficient. Consequently, i; is possible that the
differential announcement-period returns for stock issuances described above
are due not to differential signals, but to the fact that the negative signal was
released and the stock prices reacted during the preannouncement period. From
table 3 it is apparent that the preannouncement period (t = - 60 through
t = - 2) exhibits positive and generally statistically significant average abnormal returns regardless of the type of security issued. For the sample of voluntary
stock issues, the average cumulative abnormal return over this period is 6.64%
(2 = 2.71) while for the sample of involuntary stock issues the average cumulative abnormal return is 2.04% (2 = 1.46). These results do not appear to be
driven by outlier observations, as 26% of the voluntary sample and 23% of the
involuntary sample experience negative abnormal returns over the preannouncement period. Although the preannouncement abnormal returns are larger for the
voluntary issues than for the involuntary issues, the difference, 4.60%, is not
statistically significant (Z = 0.86). Thus, the differential stock price reaction found
at the announcement of voluntary versus involuntary stock issues does indeed
appear to be due to differential signals sent to the market at and/or prior to the
announcement of the issue. While the market can identify capital-deficient banks
prior to the announcement of a stock issue, it does not appear to impound any
significant stock price decline during this period which is not impounded in stock
prices of capital-sufficient banks. Again, it appears that the involuntary issuance
of stock does not send a signal to the market about the bank’s future prospects.
Interestingly, even those banks which were classified by regu!ators as having
inadequate capital experience the stock price increases prior to the issuance of
securities required to build up the capital position. One possible explanation for
this result has to do with the decline in thl::level of interest rates during much of
the period of study. Certainly the whole tnarket reacted favorably to this decline,
Z = (SCAR, - SCARJ
7 --
T2 - Tl + 1 “’
T, -I-1
+
NI
N2
>
’
for a period r = T, to I = T2, IV, and N2 represent the number of observations in the two portfolios.
11.2
M.M.
Cornett
and H. Tehranian,
Price reactions
to voluntar~/involuntary
security
issues
but banks, which were severely crippled by the sharp rise in rates in the late 1970s
and early 198Os,may have experienced larger positive stock price reactions to the
falling rates than did the rest of the market. Another reason for the result is that
just prior to the period of study, two major pieces of legislation concerning bank
regulation were passed (the Depository Institutions Deregulation and Monetary
Control Act and the Garn-St. GL.main Depository Institutions Act). As shown in
Cornett and Tehranian (1989, 1990),banks reacted favorably to these regulations.
It is possible that as banks implemented the changes allowed by these two acts,
they continued to experience positive abnormal returns.
In order to help differentiate banking-related effects versus effects specifically
related to the issuance of new securities, we included a banking index in the
market model. The index we constructed was an equally-weighted index of all
banks listed on the CRSP data tapes {n = 260). The resulting cumulative
preannouncement period abno; &nalreturns are 7.15% (Z = 2.92) for voluntary
issues of common stock and 1.92% (Z = 1.21) for involuntary issues. The
difference, 5.23%, is not significant (Z = 1.12). The two-day announcementperiod abnormal return for the voluntary stock issues is - 1.61% (Z = - 4.72),
and for involuntary stock issues it is - 0.58% (Z = - 1.34%). The difference,
4.14%, is significant at better than the 5% level (Z = 2.53). Including a banking
index does not materially affect our earlier findings.
All other types of securities listed in table 3 produce insignificant portfolio
prediction errors, except for involuntary straight-debt issues, which experience an
average prediction error of 0.32% (Z = 1.86, significant at the 0.10 level). Additionally, as reported in panel C, differences in abnormal returns for voluntary
vrersusinvoluntary debt and preferred stock issues are not statistically significant.
One possible explanation is the fact that banks use so little equity and so much
fixed-rate financing. The average primary capital ratios reported in table 2 for our
banks are 7.51% and 5.88% for voluntary and involuntary issues, respectively,
while the average value of the relative size of the issue was 1.36% and 1.17% for
voluntary and involuntary, respectively. A 1% to 1.5% increase in a bank’s equity
ratio from a base of less than 10% is relatively large. A 1% to 1.5% increase in
debt and preferred stock from a base of more than 90% is small. Thus, the ability
to convey information through a debt or preferred stock issue, whether it be
voluntary or involuntary, is limited. Accordingly, we see insignificant returns for
the voluntary and involun:ary issues of debt and preferred stock.
The magnitude of the abnormal announcement-period common stock returns
for the involuntary common stock issues is similar to that documented for
utilities by Asquith and Mullins (1986) and Masulis and Korwar (1986), who
find two-day average abnormal returns of - 0.90% and - 0.68%, respectively.
This similarity is not surprising since both cases involve regulatory intervention
for the issuance of common stock. The regulatory intervention is, of course,
different in the utility industry in that utility regulators do not typically force
a stock issue. Rather, to keep up with demand, utilities issue stock relatively
frequently. Their stock issuances are thus better anticipated by the market and
hence, the stock price reaction is less negative.
The results for the voluntary common stock issuances are about half the
magnitude of those documented for industrials by Mikkelson and Partch (lY86),
Asquith and Mullins (1986), and Masulis and .;orwar (1986), who find two-day
average prediction egrors of - 3.56%, - 2.70%, and - 3.25%, respectively.
Furthermore, the annu.tincement-period returns found here are larger than
those for banks in Polonchek, Slovin, and Sushka (1989) (two-day average
abnormal return = - 1.09% in the post-December 1981 period), but similar to
those in Wansley and Dhillon (1989) (two-day prediction error = - 1.51%).
These results suggest that for the voluntary stock issues the regulatory environment acts to reduce the information asymmetries of Ross (1977).
Our results for convertible debt offerings are contrary to those of industrials
documented by Mikkelson and Partch (1986) and Eckbo (1986) who find
significant negative stock price reactions, but are consistent with the insignificant stock price reactions for banks found by Polonchek, Slovin, and Sushka
(1989). Mikkelson and Partch and Eckbo attribute the negative stock price
reactions co the equity feature of convertible debt. It appears from our results
and those of Polonchek, Slovin, and Sushka that this equity feature is not
significant enough to produce negative stock price reactions for either voluntary
or involuntary convertible debt issues by banks. The results found here for
preferred stock are consistent with earlier findings for industrials [by Mikkelson
and Partch (1986)] and for banks [by Polonchek, Slovin, and Sushka (1989) and
Wansley and Dhillon (1989)]. Similarly, the nonnegative stock price reactions to
straight debt offerings are consistent with the previous literature (for both
industrials and banks). Since the issuance of straight debt, convertible debt,
preferred stock, and the combinations thereof do not impact managerial holdings and since the stock price reactions associated with their issue for voluntary
and involuntary issues produce no significant differences, we group these categories together in conducting the remaining empirical tests.
4.2. Results bused on relatit’e size qf the qfering
Table 4 lists the two-day announcement-period portfolio abnormal returns
for voluntary and involuntary stock issuances grouped according to the relative
size of the offering. Column 1 lists the relative size groupings. Selecting 0.5% and
1.1% as cutoff points to develop our three portfolio groupings allowed.approximately one-third of the full samples to fall into each category. Columns
2 through 5 list results for common stock issuances, including the two-day
(t = - 1, 0) abnormal return, the Z-statistic, the sample size, and the percent
of the sample experiencing negative abnormal returns. Columns 6 through 9
present results for all other security issues (preferred stock, straight debt, convertible debt, and combinations).
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M. M. Cornett and H. Tehranian, Price reactions to voluntary/involuntary security issues
115
From table 4 it is evident that (for both voluntary and involuntary issues) the
larger the common stock issue relative to the book value of the bank’s assets
prior to the issue, the more negative the stock price reaction. For voluntary
issuances, the average abnormal return in the two-day announcement period is
- 0.43% (Z = - 0.18) for small common stock issuances and - 1.84%
(Z = - 2.86) for large common stock issuances. The difference, 1.41%, is
significant at the 0.10 level (Z-statistic for the difference in means is 1.73).For the
middle group, the portfolio abnormal return of - 2.16% is also significant
(Z = - 2.71). For small involuntary common stock issuances, the two-day
abnormal return is - 0.13% (Z = - 0.26), while for large involuntary common
stock issuances the abnormal return is - 1.62% (Z = - 2.44). The difference in
means, 1.49%, is not significant (Z-statistic = 1.64). For the middle group, the
abnormal portfolio return of - 0.30% is insignificant (Z = - 1.19). When we
compare voluntary and involuntary issues according to subsamples based on
relative size, the abnormal portfolio returns are not significantly different.
These results confirm Asquith and Mullins’ (1986) results (as well as others) by
documenting a negative relation between the relative size of the offering and the
associated stock price reaction. Interestingly, we also find that this negative
relation is not as strong for involuntary common stock issues as for issues
voluntarily undertaken by a bank’s management. It appears that the lack of
information associated with an involuntary issue is recognized by the market
and causes a less negative announcement-period stock price reaction. The
results for the voluntary and involuntary non-stock security issues are insignificant in virtually every case.
4.3. Results based on managerial ownership prior to the security issue
Table 5 reports portfolio abnormal returns for voluntary and involuntary
common stock issuances and all other security issuances grouped according
to managerial common stock ownership prior to the issue. It is evident from
table 5 that the announcement-period abnormal return for common stock
issuances is positively related to the level of managerial ownership prior to the
issue for both voluntary and involuntary issues. For the voluntary common
stock issues, managerial ownership of less than 5% prior to the issue produces
a portfolio abnormal return of - 2.92% (Z = - 5.30), while for managerial
ownership greater than 20% an abnormal return of 0.32% (Z = 0.84) is reported. The difference in mean returns,
3.24%, is significant (Z-statistic for the
. ._
difference in means is 2.93). The middle portfoiio (manageriai ownership between 5% and 20%) produces an insignificant abnormal return of - 0.38%.
For the involuntary common stock issuances, small managerial ownership
results in a significant negative portfolio abnormal return of - 1.60%
(Z= - 3.66), while the portfolio of large managerial ownership finds an insignificant abnormal return of 0.32% (Z = 0.26). The difference, 1.92%, is also
0
h
il
significant (Z = 2.27). Like the voluntary issues. the middle portfolio experiences
an insignificant abnormal return of - 0.12% (Z = - 0. IO). Again, when we
coInpare voluntary and involuntary issues according to subgroups based on
managerial ownership. the abnormal portfolio returns are not significantly
different.
The results presented in table 5 for common stock issuances coincide with the
theoretical work of Jensen and Meckling ( I9761 and Leland and Pyle ( 1977) by
confirming a positive rclationshlp between announcement-period abnormal
returns and managerial ownership prior to the issue. In addition, WC find that
while small managerial ownership elicits a significant negative stock price
reaction regardless of the voluntary or involuntary nature of the issue. the price
reaction associated with the involuntary issue is not as strong as that with the
voluntary issue. Although the dilierence in the two portfolio returns is insignifi=
cant, we huve some evidence that the dilution of ownership associated with the
involuntary issue causes the market reaction to the stock issuance tir be less
severe. As with the full sample, for issues of securities o!l., b than common stock
none of the portfolio returns reported in tablc 3 are slc,irificant.
One drawbac,k of the portfolio analysis examined above is that it does not
allow for any interdependencies between the variables. For example. an issue of
common stock :hat is small relative to the assets of the bank would have little
impact on ownership when managerial ownership is large prior to the issue. The
same issue. however. would have a relatively larger dilutive effect on ownership
when manager&r1 ownership is small. Accordingly, the stock price reaction to
a given size common stock issue may be I function of managerial ownership.
To obtain additional insights into the price effects of the capital offerings by
banks. the following regression mode! is estimated for individual announcemefit-period stock returns:
SCAR, = us + u,CAP,
+ u2RLSZ,
+ u30WNER,
+ u4RATE,
where
SC-AR,
<‘AP,
R IS%,
= two-day (: = - 1 and I =
return for security offering
- bank’s total capital ratio
offering.
= size of the security off’ring
total iissets.
0) standardized r:umul;dtivr abnormal
i.
at the year-end prio, i&l the security
relative to the book value of the bank’s
II8
M.M.
Cornett
End If.
Tehranian,
Price reactions
to voluntary/involuntary
security issues
OWNERi = managerial ownership as listed on the proxy statement preceding
the security offering,
RATEi
= a dummy variable measuring the Moody’s bond rating at the issue
of debt (RATEi is zero if the rating was A3 or above, one if the
rating was BAA1 or below, and excluded if the debt was not rated
or if the security offering consisted of something other than debt),
RUNUPi = cumu!ative excess stock return over the 60 days prior to the
security offering, and
?‘ARi
= stock return variance over the 60 days prior to the security offering.
The first three independent variables in the regression (CAP, RLSZ, and
0 WNER) are those which were explored in the previous sections. By including
them in cross-sectional regressions we can identify their impact on abnormal
returns as well as any interdependencies which may exist. The last three
independent variables (RATE, RUNUP, and VAR) are variables which previous
research has found to affect announcement-period abnormal returns associated
with security issuances. Specifically, Eckbo (1986) finds a significant positive
relationship between an puncement-period abnormal returns and the debt
rating for convertible debt security offerings (i.e., the lower the rating, the more
negative the stock price reaction), and an insignificant relationship for straight
debt offerings. The differential results for convertible versus straight debt are
attributed to the equity-like characteristics of convertible debt. Asquith and
Mullins (1986) find that two-day mean excess returns for equity issues are
significantly and positively related to the eleven-month cumulative excess stock
return prior to the announcement of the equity issue. Thus, they claim that firms
sell stock following a period in which the stock outperforms the market. Finally,
Masulis and Korwar (1986) find a significant negative reiationship for utilities
between announcement-period abnormal returns and the stock return variance
prior to the issue, but no significant relationship for industrial firm equity issues.
They explain that ‘if a stock’s rate of return variance acts as a proxy for the
markets’ uncertainty about the value of the firm’s current assets, then according
to tk predictions of the Myers and Majluf (1984) adverse selection model, as
this uncertainty rises, so does the magnitude of the market negative reaction to
a given stock offering announcement’.
Table 6 presents the cross-section a! regression
_
results run separately for the
sample of voluntary (panel A) and involuntary (panel B) common stock issuances as well as for all other security issuances. The results in table 6 confirm
many of the results obtained from the portfoho analysis of the Freceding
sections.
The regressions using stock issuances produce significant negative reactions
in both the voluntary and involuntary case, but the relationship is qti!l slightly
stronger for voluntary stock issuances. Thus, there is evidence that the lack of an
informative signal associated with a forced capital injection is recognized by the
and 353 involuntary
+ o,RLSZi
+ UJOIVNERi
+ u~RATE,
+ a5RUNUPi
+ UhVARi
security issues by 176 banks between June 1983 and December 1989, based on type of security
offering (t-statistics are in parentheses).
6
a
us
0.026
(0.45)
0.101
(3.1s)h
- 0.032
( - 0.63)
0,041
(0.82)
- 0.096
( - 2.86)h
0.02 I
(0.32)
c3.046
(1.19)
0.063
(2.61)’
0.048
( I .36)
--
0.035
(2.10)’
0.033
I I S2)
issrrrs
0.04 1
(2.41)’
0.054
(2.14V
1.342
1.31)
- I.641
( - 1.52)
- 1.830
( - 2.35)’
(-
- 1.685
( - 1.71)
59
194
_
I77
61
N
-
2. I %
8.3%
._._._~_ .~~
2.6%
7.6*/u
RL
2.11
5.21
2.24
4.98
F-statistic
(1.15
0.02
__ _ ._~
0. I 3
0.03
Significance
of F
--
___
-
.‘~n issue i3 classilicd ;IS voluntary if the bank’s total capital ratio is above 7% prior to the issue and involuntary if the total capital is below 7”/0 prior to
the’ i,suc. These groupings ;irc based on the Fed’s classilications for adequately and inadequately capitalized banks.
hSignilicant at hcttcr llliill the 0.01 level.
‘Slgnitic;lnt
:rt bcttcr than the 0.05 Icvel.
0.304
(0.78)
hw~hr~ifu,:1~
0.293
(0.64)
Prrrtci B:
(0.083
(2.X4)h
Ptrnd A: l~‘ohr~rc~r,~~iwmv”
(1.3
- 0 I24
( - 3.04T
u2
0.017
(1.16)
1’ 1
standardized
cumulative
abnormal
return, CAP = bank’s total capital ratio at year-end prior to the security offering,
RLSZ = six of security offering to the book value of the bank’s total assets, 0 WNER = managerial ownership, RATE = dummy variable measuring the
Mood!‘s bond r:lting (0 if rated A.?or better. 1 if BAA1 or worse, and excluded ifdebt was not rated or other than debt was issued), RUNUP
= cumulative
CYCCSSstock return over the 60 days prior to security issue, and VAR = stock return variance over the 60 days prior to security issue.
SCadR; = (10 + lI,CAPi
results for 238 voluntary
u hcrc SC.4 R = tNo-day
Regression
Table
security issues
market and causes a less negative announcement-period stock price reaction as
the size of the offer varies. As was found in the portfolio analysis, regressions
employing non-stock issuances produce insignificant coefficients on the relative
size variable for both voluntary and involuntary issues. Second, the abnormal
announcement-period return is positively and significantly related to managerial ownership prior to the common stock issues. In this case, however, the
relation is stronger for involuntary than for voluntary security issuances. Again,
regressions using non-stock issues produce no significant relation for this
variable.
Additionally, we find that for the involuntary common stock issues the
coefficient on the capital ratio is positive and significant. Thus, banks which are
relatively inadequately capitalized must issue more new capital, causing the
market to react unfavorably. The coefficient on CAP is insignificant for voluntary issues of common stock and all non-stock issues. Thus, the bank’s capital
ratio is unimportant to the market in reacting to the security issue when the
bank is operating in the adequate capital zone and when debt or preferred stock
is used. The significant coefficients on RATE imply that the rating on the debt
issues is unimportant for determining stock market reactions for both voluntary
and involuntary debt issues. The insignificant positive coefficients on RUNUP
for voluntary issues are consistent with those of Asquith and Mullins (1986).
A large stock price runup prior to the security issue is associated with less
negative announcement-period returns. Consistent with Myers and Majluf
(1984) banks time their voluntary security offerings to minimize the negative
impact on stock prices. The coefficient on RUNUP is insignificant for the
invoiuntary security issues of common stock, although (as reported in table 3)
the average runup was positive or involuntary security issues, suggesting that
rather than reflecting a timing consideration, the purpose of the security issue is
to meet capital standards. Finally, consistent with Masulis and Korwar (1986),
the involuntary, regulated capital injections (like utilities) demonstrate a negative relation between abnormal returns and preannouncement stock return
variance, while voluntary capital injections (like industrials) have an insignificant relation.
5. Conclusion
This paper examines issuances of capital by banks. Unlike security issuances
for nonfinancial firms, capital issuances by banks may be undertaken to meet
regulatory capital standards (we classify these as involuntary). Voluntary issues
of equity (i.e., those not needed to achieve capital standards) conform to Ross’
(1977) theoretical model which predicts that firms issue equity when future
prospects are poor. The negative information that equity issues signal to the
market results in a negative abnormal stock price reaction at the announcement.
M. M. Cornelt
and H. Tehranian.
Priw
rcuctions
to ~olu~~tar~~‘it~~~olunrar~ sccwriry issues
121
Involuntary issues, on the other hand, do not signal the bank’s prospects and,
therefore, are not expected to affect stock prices. Empirical tests of stock price
reactions associated with capital issuances by banks confirm that announcement-period abnormal returns associated with voluntary common stock issues
are significantly more negative than those for involuntary common stock
issuances. Furthermore, abnormal returns are negatively related to the relative
size of the stock issue and positively related to managerial ownership prior to
the issue. Issues of other types of securities appear to have no impact on
announcement-period abnormal returns.
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