Did Information Intermediaries See the Warning Signals of the Banking Crisis from Leading Indicators in Bankss Financial Statements?

Abstract

In this paper we address two important questions that emerged in the aftermath of the recent banking crisis. First, did the financial statements of the bank holding companies provide an early warning of their impending distress? Second, whether the actions of four key financial intermediaries (short sellers, equity analysts, Standard Poor’s credit ratings and auditors) were sensitive to the information in the banks’ financial statements about their increasing risk and their approaching distress? We find a significant cross-sectional association between the banks’ 2006 4Q financials and bank failures over 2008-2010 suggesting that the financial statements reflected at least some of the increased risk of bank distress in advance. The mean abnormal short interest in our sample of banks spikes from 0.66% in March 2005 to 2.4% in March 2007. This increase in short interest is also accompanied by a sharp increase over time in the cross-sectional association between short interest and leading financial statement indicators. In contrast, we observe neither a meaningful change in analysts’ recommendations, Standard and Poor’s credit ratings and audit fees nor an increased sensitivity of these actions to financial indicators of bank distress over this time period. Overall, our results suggest that actions of short sellers likely provided an early warning of banks’ upcoming distress prior to 2008 crisis.