When the December issue of the Journal of Finance landed on my desk, it was almost like Christmas had come early. Among the articles was an interesting examination of banks which failed (or were rescued) during the recent financial crisis (for a non-pay-wall working paper version see here). The authors set out to ask a simple question: how well does the performance of individual banks in 1998 predict their performance in the recent crisis?
Recall in 1998 Russia defaulted on some of its debts. It was generally believed (erroneously) that nuclear powers did not default. Market participants did not take the news well, with a resulting flight to quality and spike in lending spreads. Then Treasury Secretary Robert Rubin called it “the worst financial crisis in the last 50 years” (sounds a little familiar).
While the authors find that other factors, such as leverage and reliance on short-term funding, were significant predictors of failure, 1998 performance predicted well which banks got in trouble this past crisis. This effect is likely capturing a variety of bank specific characteristics, such a firm culture, risk tolerance and management style.
One of the central debates about financial crises is to what extent are shocks contagious, like a disease that spreads from one bank to another, or rather do shocks, such as recessions, separate weak firms from strong firms? If the former then broad-based Geithner-Bernanke style rescues might be appropriate. If however failures are limited to weak firms, then rescues keep these weak firms, with their dysfunctional cultures around.
The results of this paper suggest to me the importance of allowing firms to fail, rather than resorting to bailouts. One of the fundamental problems of our current bank regulatory regime is that it is subject to its own flawed theory of intelligent design. If only enlightened regulators are given sufficient power, they can design the best system. I believe reality is quite different. Only by allowing the evolutionary sorting of banks, and their firm cultures, can we improve the stability and efficiency of our financial system.