Did US Banks learn any lessons from the 1998 crisis?

Bank officers are now saying we have learned some grave lessons from the 2007 crisis. We will try to never repeat the mistakes again etc. Should we believe them? Naah….Not one bit (some have forgotten lessons immediately)

In this amazing paper Rüdiger Fahlenbrach, Robert Prilmeier and Rene Stulz say nothing has changed. This time is the same as well.

They track banks performance in 1998 crisis (Russian debt crisis) when banks said the same things. They find banks which performed badly in 1998 have performed badly even now! The same story of banks having larger short-term finance and high leverage were the crisis banks then and are crisis banks now:

We investigate whether a bank’s performance during the 1998 crisis, which was viewed at the time as the most dramatic crisis since the Great Depression, predicts its performance during the recent financial crisis. One hypothesis is that a bank that has an especially poor experience in a crisis learns and adapts, so that it performs better in the next crisis. Another hypothesis is that a bank’s poor experience in a crisis is tied to aspects of its business model that are persistent, so that its past performance during one crisis forecasts poor performance during another crisis. We show that banks that performed worse during the 1998 crisis did so as well during the recent financial crisis. This effect is economically important. In particular, it is economically as important as the leverage of banks before the start of the crisis. The result cannot be attributed to banks having the same chief executive in both crises. Banks that relied more on short-term funding, had more leverage, and grew more are more likely to be banks that performed poorly in both crises.

They base their analysis based on two hypothesis — Learning hypothesis and business model hypothesis. Learning is based on the idea that executives learnt their lessons:

one hypothesis, the learning hypothesis, is that a bad experience in a crisis leads a bank to change its risk culture, to modify its business model, or to decrease its risk appetite so that it is less likely to face such an experience again. There is anecdotal evidence that executives claim they learned from the 1998 crisis. Lehman’s CEO was the same in 1998 and 2006. He is quoted as having said in 2008 that “We learned a ton in ‘98”. A recent book on AIG describes one Goldman Sachs executive as having “never silenced that desire to do something about the next 1998, about never being dependent on short-term funding again.”  The book goes on describing how that executive obtained authorization in 2004 for Goldman to lengthen the maturity of its funding. Credit Suisse performed relatively well during the recent crisis and one senior executive told one of the authors that the explanation is that they learned a lot from their difficulties in 1998.

The business model says nothing changes. What matters is money and business:

Another hypothesis, the business model hypothesis, is that the bank’s susceptibility to crises is the result of its business model and that it does not change its business model as a result of a crisis experience, either because it would not be profitable to do so or for other reasons. For instance, recent work by Adrian and Shin (2009) shows that broker-dealers increase their leverage in good times. Such an outcome may be the result of them having the best business opportunities during credit booms, but it also makes them more vulnerable if a credit boom is followed by a crisis. With this hypothesis, crisis exposure exhibits persistence, so that a bank’s experience in one crisis is a good predictor of its experience in a subsequent crisis.

What does research show?

We empirically test these two hypotheses against the null hypothesis that every crisis is unique, so that a bank’s past crisis experience does not offer information about its experience in a future crisis. We find evidence that is strongly supportive of the business model hypothesis. We show that the stock market performance of banks in the recent crisis is positively correlated with the performance of banks in the 1998 crisis. This result holds whether we include investment banks in the sample or not. Our key result is that for each percentage point of loss in the value of its equity in 1998, a bank lost an annualized 66 basis points during the financial crisis from July 2007 to December 2008. This result is highly significant statistically.

When we estimate a regression of the performance of banks during the financial crisis on their performance in 1998 as well as on characteristics of banks in 2006, we find that the return of banks in 1998 remains highly significant. For instance, the economic significance of the return of banks in 1998 in explaining the return of banks during the financial crisis is of the same order of magnitude as the economic significance of a bank’s leverage at the start of the crisis. Our results cannot be explained by differences in the exposure of banks to the stock market.

From the perspective of bank performance, the crisis of 1998 and the financial crisis are the same in the sense that banks that had a near-death experience in 1998 had it again during the financial crisis – except that during the financial crisis, the outcome was worse for the banks and the economy.

One could just look at banks  in 1998 and predict who would do worse in 2007:

An important question is whether poor performance in one crisis makes it more likely that an institution will fail in the next crisis. We find that banks that performed poorly in 1998 were more likely to fail in the recent financial crisis. The effect of bank performance in 1998 on the probability of failure is extremely strong. A one standard deviation lower return during the 1998 crisis is associated with a statistically highly significant 5 percentage points higher probability of failure during the credit crisis of 2007/2008. Relative to the average probability of failure of 7.5% for the sample banks, this represents an increase of 67% in failure probability. Again, this result holds whether we include or exclude investment banks in the sample.

They see other things.

  • Whether same CEOs in 1998 and 2007 were responsible? Not really.
  • Whether quick recovery from 1998 crisis led to higher risks in 2007? Not really
  • Common characteristics of poor performing banks – higher short-term finance and leverage

Superb stuff.

What should one expect? The authors don’t touch on this but same banks also end up getting bailed out and increase risks further. So the vicious cycle goes on and on….

In the next crisis, the policymakers could just look at this useful set of indicators the authors have developed…..

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