Using Bank Performance in 1998 to Explain Bank Performance During the Recent Financial Crisis

Rudiger Fahlenbrach, Robert Prilmeier and I have made available a paper on SSRN titled This Time Is the Same: Using Bank Performance in 1998 to Explain Bank Performance During the Recent Financial Crisis. In this paper, we show that banks that performed poorly during the Russian crisis of 1998 also performed poorly during the recent financial crisis.

Russia defaulted on its domestic debt on August 17, 1998. This event started a dramatic chain reaction. As Thomas Friedman from the New York Times put it, “the entire global economic system as we know it almost went into meltdown.” The Russian crisis was described as the biggest crisis since the Great Depression. The financial crisis that started in 2007 would eventually be described as the biggest financial crisis of the last 50 years, supplanting the crisis of 1998 for that designation.

The similarity between the crisis of 1998 and the recent financial crisis raises the question of how a bank’s experience in one crisis is related to its experience in another crisis. In our recent paper, we examine this question.

If an organization and its executives perform poorly in a crisis, it could be that they learn to do things differently and consequently cope better with the next crisis. Further and perhaps more importantly, an unexpected adverse event could lead an institution to assess payoff probabilities differently or to reduce its risk appetite. Therefore, 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. 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. 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.

Our paper empirically tests 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 and economically: 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!

What could then explain such a systematic crisis exposure? We find that the persistence is not due to the banks that have the same top executive in both crises. It is not due either to the broker-dealers, as it exists when we restrict the sample to commercial banks. We analyze characteristics of banks that performed poorly in both 1998 and 2007/2008, and compare them to characteristics of other banks that performed better. The results of this exercise suggest that the correlation between returns during the 1998 financial crisis and the recent financial crisis is at least partly due to a business model that relies on higher leverage, more short-term funding, a larger proprietary trading desk, and stronger asset growth during the boom preceding a crisis.

Overall, our results show that financial institutions that are negatively affected in a crisis do not appear to subsequently alter the business model or to become more cautious regarding their risk culture. Consequently, the performance in one crisis has strong predictive power for a crisis which starts almost a decade later.

The full paper is available for download here.