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

48 Pages Posted: 3 Jun 2010 Last revised: 18 Nov 2011

Sugato Bhattacharyya

University of Michigan, Stephen M. Ross School of Business

Amiyatosh K. Purnanandam

University of Michigan, Stephen M. Ross School of Business

Date Written: November 18, 2011

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 eff ectively to dramatic changes in the risk taking environment engendered by increased levels of securitization.

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

JEL Classification: G11, G12, G13, G14

Suggested Citation

Bhattacharyya, Sugato and Purnanandam, Amiyatosh K., Risk-Taking by Banks: What Did We Know and When Did We Know It? (November 18, 2011). AFA 2012 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1619472 or http://dx.doi.org/10.2139/ssrn.1619472

Sugato Bhattacharyya (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

University of Michigan
701 Tappan Street
Ann Arbor, MI 48109-1234
United States
734-763-9777 (Phone)
734-936-0274 (Fax)

Amiyatosh K. Purnanandam

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

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