The Effects of Large Bank Failures Upon Investors' Risk Cognizance in the Commercial Banking Industry

Abstract

The U. S. National Bank was declared bankrupt in October of 1973. Just a few days short of a year later the Franklin National Bank failed. These were the largest bank failures ever experienced in the United States and they occurred against a backdrop of extensive bank regulatory operations first to prevent them and then to reduce the effect of these failures upon bank depositors and the banking public. The objective of this study was to determine the effects of these two large bank failures upon the structural relationship of risk and return of equity investments in other large commercial banks. Using historical hindsight, it can be seen that these large bank failures were isolated and noncumulative, but it should be remembered that the investors in bank equities at that time did not know that these failures would not precipitate other bank failures. This worry or apprehension.should have.been reflected in the equity prices of other large bank stocks. Did these failures substantially affect the perceived risk of failure in other large commercial banks? Did these failures result in a substantial increase in the required rate of return on bank equity? Under the efficient markets hypothesis it is assumed that all current prices reflect all knowledge and thus equity prices should adjust quickly to the presence of new information contained in a bank failure. Therefore, in order to determine the influence of these banking failures upon the structural relationships of risk and return of bank equities, the market model was used to relate the weekly holding period returns on 19 large commercial bank common shares to the weekly holding period returns on the S & P 500 index over the past four and one half years.This study found that there was a lengthy period of structural stability when the realized returns on large bank stocks were compared with the realized returns on the market portfolio. Further, the study found that the U. S. National failure had no structural effect upon the relationships of risk cognizance and required return in that there were no resulting significiant changes in the parameters of the market model before and after the failure. On the other hand, the failure of the Franklin National had a significant structural effect upon risk cognizance. The perceived level of unsystematic risk significantly increased above that of a base period established before the Franklin failure. There was no structural change found in either the intercept term or the measure of systematic risk after the Franklin demise, only a change in unsystematic risk. The most significant change occurred just after the closing of the Franklin and subsided completely during the first and second quarter of 1975.