Risk-Taking by Banks: What Did We Know and When Did We Know It?

Abstract:     
The composition of risks assumed by U. S. commercial banks underwent a dramatic transformation over the years leading up to the financial crisis: between 2000 and 2006 idiosyncratic risk dropped by almost half while systematic risk doubled. These patterns, more pronounced in banks with heavy involvement in residential mortgage lending and securitization, were accompanied by higher earnings per share performance. The stock market's response to these changes was, however, not uniformly enthusiastic. Banks heavily engaged in residential mortgage lending started exhibiting lower earnings response coefficients and had lower stock returns even prior to the crisis. Their managers, on the other hand, earned significant amounts through compensation plans heavily geared to short-term earnings. Our analysis provides strong support for the view that, even though financial markets were able to identify banks engaging in excessively risky lending activity long before the onset of the financial crisis, managerial compensation schemes failed to respond effectively to dramatic changes in the risk taking environment engendered by increased levels of securitization.

Number of Pages in PDF File: 48

Keywords: Sub-prime crisis, originate-to-distribute, screening, bank loans, risk-management, incentives

JEL Classification: G11, G12, G13, G14

working papers series