Excessive risk-taking by banks is widely blamed as a primary factor behind the financial meltdown of 2007-2008. Yet, not much work has been done on whether banks fundamentally changed their risk-taking behavior prior to the crisis, nor has much formal work been done on whether banks’ risk-taking was “excessive” in any way. In our paper, Risk-taking by Banks: What Did Banks Know and When Did We Know It?, which was recently made publicly available on SSRN, we tackle these questions head on and also examine possible motives for bank managers to have changed their risk-taking behavior in the years leading up to the crisis.
In the years 2000 to 2006, a preliminary examination of stock price volatility does not seem to support the idea that the financial markets deemed the level of risks assumed by banks to be excessive. But we document a remarkable compositional shift in the measures of risk-taking: bank’s systematic risk, measured by their equity betas, almost doubled while their idiosyncratic volatility came down significantly. This reduction in idiosyncratic risk is consistent with the increasing reliance on securitization to shed firm-specific risks. But the remarkable increase in betas clearly shows that bank assets were becoming increasingly similar in terms of their risk characteristics and that future bank performance was viewed as much more dependent on the performance of the macro-economy. Our results indeed indicate major changes in the nature of risk-taking by banks in the years preceding the crisis.read more