Have Big Banks Gotten Safer?
ECONOMICS, 19 Sep 2016
Since the financial crisis, there have been major changes in the regulation of large financial institutions directed at reducing their risk. Measures of regulatory capital have substantially increased; leverage ratios have been reduced; and stress testing has sought to further assure safety by raising levels of capital and reducing risk taking. Standard financial theories would predict that such changes would lead to substantial declines in financial market measures of risk. For major institutions in the United States and around the world and midsized institutions in the United States, we test this proposition using information on stock price volatility, option-based estimates of future volatility, beta, credit default swaps, earnings-price ratios, and preferred stock yields. To our surprise, we find that financial market information provides little support for the view that major institutions are significantly safer than they were before the crisis and some support for the notion that risks have actually increased. This does not make a case against the regulatory approaches that have been pursued, but does caution against complacency.
We examine a number of possible explanations for our surprising findings. We conclude that financial markets may have underestimated risk prior to the crisis and that there may have been significant distortions in measures of regulatory capital. Yet we believe that the main reason for our findings is that regulatory measures that have increased safety have been offset by a dramatic decline in the franchise value of major financial institutions, caused at least in part by these new regulations. This decline in franchise value makes financial institutions more vulnerable to adverse shocks. We highlight that the ratio of the market value of common equity to assets on both a risk-adjusted and risk-unadjusted basis has declined significantly for most major institutions. Our findings, if validated by others, may have important implications for regulatory policy.
In “Have Big Banks Gotten Safer?” Harvard PhD candidate Natasha Sarin and Harvard Professor Lawrence H. Summers challenge a widely-held belief that major financial institutions in the United States and around the world are safer today than they were prior to the crisis because of regulatory changes made in the wake of the Great Recession.
In their paper, which has implications for future financial regulation and supervision and challenges the views of many officials and financial sector leaders who believe the system is safer now, Sarin and Summers examine a variety of market measures of risk—including stock price volatility, option-based estimates of future volatility, beta, credit default swaps, earnings-price ratios, and preferred stock yields.
Using extensive data on the largest financial institutions in the United States (Bank of America, Citigroup, Goldman Sachs, JP Morgan, Morgan Stanley, and Wells Fargo) and around the world and mid-sized institutions in the United States, Sarin and Summers find no evidence that markets regard banks as safer today than they were before the crisis, despite large decreases in leverage. In fact, measures of volatility and beta appear to be higher post-crisis than they were pre-crisis.
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This article originally appeared on Transcend Media Service (TMS) on 19 Sep 2016.
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