Banks have difficulty adapting in crisis: study

May 18, 2011 By Sarah Perrin

( -- Can the financial sector regulate itself? A study carried out by EPFL’s Swiss Finance Institute, involving 350 American institutions, shows that those that perform poorly in times of crisis will also be adversely affected the next time. The choice of the starting business model seems to be crucial.

Do the banks implement changes that would enable them to better confront turbulence in the markets? Not really, according to a study by EPFL’s Swiss Finance Institute, recently published in the journal Social Science Research Network.

The researchers analyzed the performance and data of 350 American banks between the two most recent important financial crises: involving the Russian debt of 1998 and then the subprime crisis of 2007-2008. A sample of this study concerns both large and small institutions, and includes investment banks, savings banks, and commercial banks.

“Those which had performed poorly during the first crisis were also adversely affected during the second”, notes Rüdiger Fahlenbrach, Tenure Track Assistant Professor at the College of Management of Technology, who, with his team, looked into the reasons behind these results.

They noticed in particular that the Managing Director in charge at the time had very little influence on the performance of these companies. Neither does it depend on the nature of the two crises, both called “the most serious crisis of the last 50 years”, but caused by very different phenomena. In 1998, Russia was not able to meet its debts, which created a chain reaction, with investors registering big losses and trying to get rid of their shares quickly. In 2007, the crisis was essentially caused by a poor estimation of the risks associated with mortgage debts and the over-estimation of the value of certain investments (mortgage-backed securities).

Risk-taking in re-financing doesn’t pay

“Contrary to popular belief, small institutions are often less affected by crises – it’s the big banks that are worst affected”, Rüdiger Fahlenbrach points out. “The determining factor is in fact the business model chosen at the beginning.”

According to this expert, the methods used by banks to finance their debts – which are very difficult to sell off or to re-finance in times of crisis – is crucial. The study confirms that the institutions that use these methods in the short-term, and that have only limited capital, will perform less well in the event of a crisis. Those that opt for aggressive growth and excessive risk are also among the more fragile institutions. One reason why these companies are reluctant to change their model is that it serves them well when the markets are booming.

The message of the research – based on experimental work and empirical data – is to have more capital and less financing in the short term. Rüdiger Fahlenbrach is now attempting to disseminate these ideas through the publication of his article and by participating in various international conferences.

Explore further: Mortgage crisis: Blame the bank?

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0.9 / 5 (51) May 18, 2011
The idea that banks should self regulate is ludicrous. Even Adam Smith thought banks should be regulated.
5 / 5 (2) May 18, 2011
I agree.
I also the think the real problem is much deeper and much more pervasive than this article assumes. Clearly the dodgy companies lack prudence. They probably have a bunch of mid level "can-do" yes men who are good at ticking boxes to indicate "prudential guidelines adhered to" on demand but I don't think any of these organisations has yet truly understood the real challenges of the 21 Century.

Economists and capitalist big-men don't like to be accused of being ideologically driven yet the situation is actually worse than mere ideology. Money is the modern form of God [2nd 'Person' of the capitalist Trinity] and it is considered holy to assess everything in terms of purported monetary value. The fatal flaw in this process is that other, deeper, values are ignored and disparaged.

Fact is there are two other 'bottom lines' of equal importance: the social cost, and the environmental cost.
not rated yet May 18, 2011
It says that banks that take more risk and agressively expand are more fragile.

and this is generally true throughout the business and economic world.

While risk and expansion are certainly acceptable for new industries, our economies are very much centralized on the banking and stock systems - if we didn't have them, all economies would be magnitudes smaller, because banking and stock systems facilitate economies beyond the very local.

Quite simply, the banking system should no be allowed to operate the same as a grease shop, where the impact of failure is small. They should be required to be responsible.

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