Can the Equity Markets Help Predict Bank Failures - Literature review Example

Introduction Year 2007 onwards became few of the toughest years in the history of most of the developed countries owing to financial crisis which almost engulfed the whole world. The impacts of the crisis were not only felt on the financial sector but it also affected other sectors such as automobile, retail etc indicating the contagion effect of the crisis. What caused this crisis is an issue of significant importance however; question also arises as to whether such crises were predicted by different pieces of literature produced prior to the crisis' Tracing the history of bank failure and the subprime mortgage crisis, it will be evident that the era after 1970s resulted into the de-regulation of the economic system of the modern world which minimized the role of governments into the affairs of the markets. This however, also led to the fact that banks and other financial institutions started to take on more liberty due to this financial liberalization. The removal of restrictions on capital flows allowed banks to invest into cross border projects thus assuming more risks but also allowed them to indulge into banking practices which were more risky for the overall health of the financial institutions. The subprime mortgage market failure however, forced many experts including Prof. Susan M Wachter to conclude that the subprime mortgage failure will be much worse than the expectations held by most of the market participants. (Knowledge@Wharton). Evidence indicate that the literature comprehensively provided an insight into what may actually happen due to the lending policies adapted by the banks and other financial institutions and as such if such practices continue, it may be difficult for the financial system to sustain the increasing pressures from speculative activities in which banks and financial institutions have engaged themselves into. The flight towards a less regulated market also resulted into the increase activity in speculation which further resulted into the decline in the credit quality and institutional memory loss. The lack of rational analysis of the projects therefore resulted into the defaults which finally drained the liquidity of the firms. It was generally believed that the insolvencies of the banks are more threatening for the developing countries however, the current financial crisis and resulting insolvencies of banks like Lehman Brothers is an ample example of how the financial system of developed world can bear the heavy cost of bank insolvencies also. This paper will discuss some of the evidence and predictions that were presented in the literature published prior to the crises and will specially focus on literature published prior to 2003. Bank Failure Caprio G & Klingbiel D (1996) is of the view that the bank insolvencies have increased since 1970s and as such the losses are significant as compared to the losses that were incurred due to such bank insolvencies prior to such episodes. What is however, significant to note that such bank insolvencies clearly indicate the misallocation of resources as banks failed to identify and book profitable projects which can self generate the cash flows to repay the loans taken against them. (Caprio and Klingebiel). This analysis captures the real practices of the banks which continued in the 21st century also where banks continue to lend into those areas which were significantly more risky hence more deterimental to the overall health of the financial system. The lending into subprime mortgage market is just one example of imprudent lending practices adapted by the banks in order to achieve higher profitability targets with a very limited and short term horizon. What is also significant to understand that there was a systematic shift towards achieving the short term results as compared to ensuring long term insolvency of the banking institutions. Another analysis by Caprio G & Klingbiel D (1996) indicating that the worst affected of the crises would be Japan and other developing countries such as Argentine and Chile. (Caprio and Klingebiel). This study however, failed to take into account the fact that such incidences can also happen into the developed world despite the fact that they have put in place a more robust and efficient regulatory framework in place. What is also significant to understand that bad luck and bad banking policies are cited as reasons for the failure of the banks in developing countries only therefore what this analysis lacks is its extension into the financial markets of the developed world which proved more fragile as compared to the financial markets of the countries like Japan and Argentine' Basel Committee on Banking Supervision published a working paper in 2004 on the banking failures in the developed countries and included an analysis of the bank failures in countries like Japan, Norway, Spain, Sweden, Germany, UK and US. What is also significant to note that this research paper echoes the voice of many who advocated the cause of more regulatory changes to take place in such developed and mature economies owing to historical failure of the banks in such countries' Numerous studies were cited in the paper indicating the in-efficient management and imprudent lending policies of the banks in developed as well as mature countries often lead to the failure of the banks. (BIS) This working paper therefore provides a historical peep into the various banking crises that emerged into these developed countries and as such indicated the different factors which actually resulted into the failure of such banks. The evidence that is being reflected in this working paper also indicate as to how the central bankers in some cases acted pro-actively to manage the crisis by injecting liquidity into the market in a bid to achieve more stability into the system. What is also significant about this study is the fact that this study, as discussed above, provides a very critical review of the historical facts and figures which resulted into such bank failure. The current financial crisis are also the result of more or less same practices of the banks that led to the mass scale failure of the banks and their subsequent impact on the other sectors of the economy. Studies conducted by the Curry, Elmer & Fissel (2004) indicate that the different variables in stock markets such as equity prices, greater volatility as well as returns can provide effective insight into the bank failure. (Curry, Fissel and Elmer). However, to assess this claim and validate it through the data after the publication of the paper is itself a significant exercise. However, what is also significant to note that the movements in the stock markets were relatively less volatile in recent years thus apparently not predicting any adverse movements in the stocks of banking firms and its impact on the future profitability of the firm. it is argued that the predicting of bank failure often result due to the huge negative information that is being circulated into the market and as such time period before the failure often result into significant losses for the banks on a consistent basis. The results of the various banks including Citibank etc were relatively healthy before the crisis hit and as such the profitability started to decline only when the crises started to emerge on large scale. Before the emergence of crisis, the results were relatively stable and returns were adequate also for the shareholders of these firms. The major theme of these studies was therefore to base the failure of the banks based on their performance in the equity markets and as such assumption was that those banks which were destined to fail were those banks which were not performing well in the equity markets for longer period of time. Few studies conducted during 1980s attempted to correlate the bank failure with the long term returns offered by the banks. These studies comprehensively predicted the bank failure based on the data appearing in the stock exchanges however, moving forward these studies may not have been fully able to predict current crisis owing to the reason that the data from 2003 onwards needs to be looked in order to comprehensively assess that these studies actually were sufficient enough to predict the bank failure and current financial crises. It is also significant to note that basing the failure of a bank based on its performance in the equity markets may not be entirely a plausible justification given the fact that before the recent financial crisis ratings of financial institutions like Lehman Brothers were really good showing the greater confidence of the investors in the going concern ability of the firm. What can also be assumed from this is the fact that dynamics of financial system have relatively changed in the recent past with greater financial innovation as well as use of technology in the markets. The new changes therefore may have resulted into the increasing complexity of the financial institutions as a whole which market may not have been to discount in its pricing of the same. As Philip Davis & Dilruba Karim argue that the recent subprime crises were unexpected as very few were able to predict it and its relative impact on the economy was relatively more severe than it was expected. (Davis and Karim). Thus markets were probably not ready or unaware of the potential impacts of the subprime mortgage crisis on the profitability as well as long term survival of these institutions. Thus markets therefore failed to discount such information into its pricing and prices of almost every firm that either collapsed or get affected remain relatively more stable prior to the crisis. Studies conducted by Robert Oshinsky and Virginia Olin (2005) also focused on the troubled banks and indicated that most of the banks that failed were those which were already troubled therefore their failure was relatively predictable. (Oshinsky and Olin). This study also fails to take into account the probability of the failure of more stable banks due to extreme external shocks as the high profile bank failure include Lehman Brothers, RBS, Citibank etc which, prior to crisis were considered as more stable and large banks with significant market presence and power. One argument that is further elaborated by Oshinky and Olin is the assumption that troubled banks tend to self correct themselves if regulations are favorable. Thus regulatory environment must have the ability and power to predict the behavior of troubled banks. Studies at Bank of England however, do indicate that a rapid increase in the loan growth as one of the leading causes of the future failure of the bank. This study attempted to draw the conclusions from the failure of the BCCI which was one of the leading banks of the world before it collapsed owing to its malpractices. Though this study also accounts for some of the factors such as low liquidity, low profitability as few of the indicators which may prove as deciding factors in determining the long term fate of the banks. (Logan). Lately there was also focus on the capital ratios as the predictors of the bank failure and as such three major classes or types of capital ratios were identified to determine the bank failure. (Estrella, Park and Peristiani). The leverage ratio as well as capital to gross revenue ratio was identified as two simple ratios with the power to determine the future of a bank. There was an attempt by Lehman Brothers especially during 2008 just before its collapse to raise new capital hence improves its capital by selling its non performing businesses. (The New York Times). This action therefore largely corroborate the argument made by Estrella, Park and Pertistiani that capital ratios are critical for the overall success of the firm and that te different regulatory regimes such as Basel II focused more on strengthenining the capital structure of the firm in order to make banks more flexible to absorb the losses incurring due to external shocks. In conclusion, it can easily be inferred that some of the studies provided indications of the failure of the banks. The indicators defined in such studies does predicted the current financial crises however, in more ambigious manner. What is surprising is the fact that most of these studies focused on troubled banks rather than more stronger banks to assess the impact of their failure on the banking system as a whole. Bibliography 1. Curry, Timothy J., Gary S Fissel and Peter J. Elmer. "Can the Equity Markets Help Predict Bank Failures'" FDIC Working Paper 04-3 (2004): 5-19. 2. Davis, E. Philip and Dilruba Karim. "Could early warning systems have helped to predict the sub-prime crisis'" October 2008. National Institute Economic Review,. 21 November 2009 . 3. Estrella, Arturo, Sangkyun Park and Stavros Peristiani. "Capital Ratios as Predictors of Bank Failure." FEDERAL RESERVE BANK OF NEW YORK. Economic Policy Review 2000: 33-52 . 4. Logan, Andrew. "The United Kingdom's small banks' crisis of the early 1990s: what were the leading indicators of failure'" 2001. Bank of England. 21 November 2009 Read More