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Purnanandam, Amiyatosh
  Amiyatosh Purnanandam

From Russia, With Lessons

12/5/2007 --

New study shows that the current turmoil in the U.S. banking system is similar to the 1998 Russian debt crisis and that Fed intervention can get market back on track.

ANN ARBOR, Mich.—When a major banking crisis strikes—like the current subprime lending fiasco—firms are better off if they have what former Federal Reserve Chairman Alan Greenspan once called a "spare tire," i.e., access to other sources of financing in the public-debt market, says a professor at Michigan's Ross School of Business.

In a new study, Amiyatosh Purnanandam, assistant professor of finance at the Ross School, and colleague Sudheer Chava of Texas A&M University, contend that the health and lending capability of U.S. banks greatly affect the stock market performance of U.S. borrowers, and find that bank-dependent borrowers earn significantly lower returns than firms with access to the public-debt market during adverse financial events.

"This underperformance is magnified when bank-dependent borrowers have high-growth opportunities requiring more capital and/or little available collateral to offer lenders, or limited lending relationships, thereby giving them less financial flexibility to weather the storm," Purnanandam says.

By studying the Russian debt default in fall 1998—which resulted in a similar shock to the U.S. banking system¿Purnanandam and Chava suggest that intervention by the Federal Reserve potentially can restore the market to more normal functioning. While the Russian crisis, they say, had a disproportionately large impact on bank-dependent borrowers early on, these firms were quick to recover and actually outperformed other firms, once the crisis spread to the broader public-debt arena and the Fed infused liquidity into the banking sector.

"The current turmoil in the market is so similar in many ways to the Russian financial crisis," Purnanandam says. "Our research shows that, at least in 1998, the Fed was successful in bringing the market back on track by pumping liquidity."

Bank loans serve as the grease that keeps the wheels of business turning smoothly for firms that depend upon them as a sole source of financing, the researchers say. When these funds are constrained or cut off, as in the case of a major financial crisis, bank-dependent firms may be forced to make less than optimal investment and working-capital management decisions, which can in turn hurt their performance and lower their stock market price. In contrast, firms that have other sources of financing, multiple relationships with lenders and more capital for horse-trading are less likely to be affected by banking-sector woes.

The events of 1998—which began with the devaluation of Russian currency and the Russian government's announcement that it intended to default on its sovereign obligation, followed by suspension of ruble trading and concluding with the massive flight of capital from Brazil—resulted in a severe financial crisis in the United States.

Many U.S. banks had substantial exposure to these two countries and suffered significant losses and liquidity constraints. During the crisis, banking institutions made significantly higher charge-offs, cut their cash holdings and experienced a decrease in their liquid assets. The issuance and the amount of new bank loans plummeted by about a quarter in the post-crisis period. In contrast, at the beginning of the crisis, the public debt markets appeared to be functioning at relatively normal levels, with no obvious constraint on liquidity. Only later when the financial crisis spread throughout the U.S. economy did the availability of external credit become limited for all firms, bank-dependent or not.

In their study, Purnanandam and Chava use the Russian crisis to separate the effects of loan supply from loan demand, and to investigate the impact of the banking sector's deterioration on the returns of bank-dependent firms. They obtain financial data for 3,368 firms (excluding financials, utilities and those with exposure to crisis-affected regions) and utilize mathematical modeling to compare the returns across bank-dependent and nonbank-dependent firms over the 16-day event window.

Their results reveal that, on average, bank-dependent firms earned nearly 2 percent to 5 percent lower returns than public-debt financed firms, and that the more troubled the bank, the worse the borrower performed. The lower returns constituted a value loss in excess of 30 percent on an annualized basis, after controlling for the effects of size, leverage and growth opportunities. Overall, these findings reconfirm their theory that poor access to capital rather than poor credit quality was the key driver for the bank-loan borrowers' diminished performance.

However, conditions worsened, and firms in general faced a severe liquidity crisis. Even companies with access to the public-debt market were forced to draw on their banking lines of credit, thus exposing them to the same pressures as bank-dependent firms and eliminating the differential in returns between the two groups. But when the Fed twice moved to cut the Federal Funds target rate by 25 basis points, bank-dependent firms rebounded smartly, earning about 1 percent higher returns than the public-debt funded firms.

"These findings lend further support, in a reverse direction, to our key premise that the market value of bank-dependent firms depends significantly on the financial health of the banking sector and its ability to supply loans to borrowers," Purnanandam says.

Written by Claudia Capos

For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847,