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MARKET DISCIPLINE OF FINANCIAL INSTITUTIONS AND THE CRISIS OF 2007-2008

Jill L. Wetmore

Saginaw Valley State University, USA

Chiaku Chukwuogor

Eastern Connecticut State University, USA

ABSTRACT

We determine if participation in risky mortgages by financial institutions (FIs) prior to and including the period of 2007-08 impacted systematic risk of their stocks which would affect the required rate of return. We examine the stocks of 59 banks and thrifts rated by American Banker having the largest amounts of first mortgages on their balance sheets as of December 31, 2006. A GARCH model is used to determine if systematic risk changes over the time studied. We find systematic risk increases each year during the entire period studied (2004-2008) for stock returns of thrifts and to a lesser extent for stock returns of regional banks. Stock returns of large banks show a decline in systematic risk during 2004 and 2006 and an increase in 2008. There is no significant change in systematic risk in 2005 and 2007. In the case of foreign bank stock returns, systematic risk declines during the years (2004-2005) and shows no significant change in 2006- 2008. This suggests that systematic risk is impacted for thrifts and regional banks prior to the crisis but not for large banks until the time of the crisis. In the case of foreign banks, there is no change in systematic risk in 2008 and a decline in 2004 and 2005.

Key Words: Financial institutions, banks, market discipline, risk

JEL Code: G21