Why Did US Banks Fail? What Went Wrong at US Banks in the Run Up to the Financial Crisis

Abstract

This paper analyzes the differences between weak and strong US banks prior (2002-2006) to the financial crisis. We define strength as the ability to endure the crisis independently. Weak banks either went bankrupt, were acquired due to financial distress, or did not pass the stress test and needed government support. Strong banks, on the other hand, passed the stress test and repaid the government support as soon as they were eligible.The quality of formal governance, measured by CEO duality (CEO is also the chairman) and the rights of shareholders versus management, was slightly lower at strong banks. Weak banks were financed with more debt of which a larger portion short term, and less profitable than strong banks. The CEOs of weak banks were paid higher cash bonuses and more often raised in a low socio-economic environment than their counterparts at strong banks.Finally, we compare the buy-and-hold stock return of weak versus strong banks from January 2000 until February 2015. Weak banks outperformed strong ones in the run up to the crisis by 113%. Subsequently, weak banks lost 94% of their market value in the crisis and did not recover to pre-crisis levels afterwards. Strong banks lost 71% but did recover.