July 24, 2016

Trading record shows top bankers knew trouble was coming before crash

Boing Boing

In a new working paper from the Center for Economic Policy Research, scholars look at the trading records of shareholders, directors and top executives of major financial institutions in the runup to the crash of 2007, and find that the sell-offs by the top five executives at a bank strongly correlated with that bank's losses in the crash, but that other stakeholders' trading do not correlate: in other words, the very top brass of banks knew that they were sitting on piles of worthless paper and sold before anyone else knew about it, and kept their shareholders, direct reports, and the board of directors in the dark.

The significance here is that after the crash, the standard line on the banks' risky behavior was that they simply didn't anticipate the consequences of their recklessness; this research suggests that they knew exactly what was coming, but that "explicit and implicit bank guarantees by states, such as deposit insurance, provision of central bank liquidity, and bail-outs make it rational for banks to take on excessive risk," the result of which is that "bank managements can escape from control of their shareowners and holders of bank debt."
The paper finds that the top executives’ ex-ante sale of their own bank shares predicts worse bank returns during the crisis; interestingly, effects are insignificant for independent directors’ and other officers’ sales of shares. That is, effects are substantially stronger for the insiders with the highest and best level of information, the top five executives. Moreover, the top five executives’ impact is stronger for banks with higher ex-ante exposure to the real estate bubble, where an increase of one standard deviation of insider sales is associated with a 13.33 percentage point drop in stock returns during the crisis period. Our results suggest that insiders understood the heavy risk-taking in their banks; they were not simply over-optimistic, and hence they sold more of their own shares before the crisis.

These results have not only implications for corporate finance or banking theory based on agency problems, but also for an understanding of financial crises and public policy – especially on the recent prudential policy measures across both sides of the Atlantic. Our evidence is consistent with agency problems in the banking industry being important for risk-taking. Accordingly, the recent policy initiatives to raise bank capital (including Basel III) or enforce macroprudential policies may be useful for limiting excessive bank risk-taking. If high risk-taking in banks were exclusively due to behavioral reasons, then some of the new prudential policies providing better incentives for bankers would not matter at all.
No less importantly, however, our results have policy implications for the regulation of insider trading in banks. Insiders’ ability to trade (selling shares of their own bank when they anticipate that their excessive risk-taking may lead to large losses) may exacerbate conflicts of interest between them and shareholders, bank creditors, and even the other employees of the bank who did not or could not see what was coming. Banning trading by bank insiders might reduce excessive risk-taking by banks and operate as a (partial) substitute for bank capital regulation or macroprudential policies. Whether a total ban on insider trading would be justified, however, requires further analysis, since that may have other effects that also need to be assessed.

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