Bank Performance in 1998 Explains Performance during the Recent Crisis
The stock market performance of a bank in the recent crisis is positively correlated with the performance of that same bank in the 1998 crisis.
When Russia defaulted on its debt in 1998, a number of investors worldwide experienced large losses. Many were forced to sell securities across markets, and as security prices fell, the capital of investors and financial firms was eroded. Further, market volatility increased. These developments taken together led investors and financial institutions to reduce their risk. Hedge funds were severely battered, and within two months the market capitalization of banks like CitiGroup and Chase Manhattan fell by approximately 50 percent.
The meltdown that started in 2007 has since replaced that of 1998 as "the biggest financial crisis of the last 50 years." In This Time Is the Same: Using Bank Performance in 1998 to Explain Bank Performance During the Recent Financial Crisis (NBER Working Paper No. 17038), authors Rudiger Fahlenbrach, Robert Prilmeier, and Rene Stulz demonstrate that U.S. banks that performed poorly during the 1998 financial crisis did so again during the most recent financial crisis, even if the banks underwent mergers or were under new leadership.
They explain that the "learning hypothesis" holds 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. The "business model hypothesis" says that the bank's susceptibility to crises is instead the result of its business model, and that it does not change its business model (or culture) as a result of a crisis, perhaps because it is too costly to do so, or for other reasons. Fahlenbrach, Prilmeier, and Stulz test these two hypotheses against the alternative view that every crisis is unique, meaning that a bank's past crisis experience does not offer information about its experience in a future crisis.
Examining data on some 347 banks, they find support for the business model hypothesis, in that the stock market performance of a bank in the recent crisis is positively correlated with the performance of that same bank in the 1998 crisis. Their key result is that for each percentage point of equity value lost in 1998, a bank lost an annualized 66 basis points of equity value during the financial crisis from July 2007 to December 2008.
When the authors relate the performance of banks during the recent financial crisis to their performance in 1998, as well as their characteristics in 2006, they find that the banks' 1998 return retains its explanatory power. The return of banks in 1998 does as well in explaining their return during the recent financial crisis as the bank's leverage at the start of the crisis. The effect of bank performance in 1998 on the probability of failure is similarly strong. A single standard deviation lower return during the 1998 crisis is associated with a statistically significant 5-percentage-points higher probability of failure during the credit crisis of 2007-8. These results cannot be explained by differences in the exposure of banks to the stock market.
Fahlenbrach, Prilmeier, and Stulz caution that by their very nature, crises are unexpected. "We cannot exclude that banks learned from 1998 and chose to take less risk on the asset side," they write, "but as they invested in less risky assets, those assets turned out to perform unexpectedly poorly in the recent crisis. There is no good way to assess comprehensively the ex ante risk of the assets banks invest in, so that there is no good way to exclude the possibility that banks that suffered more from 1998 chose to invest more safely. However, our evidence shows that the banks that performed poorly in both crises had more risky funding, higher leverage, and greater growth than other banks before the crises. Hence, our evidence does suggest that banks did not change fundamental aspects of their business strategy as a result of their performance in the 1998 crisis."