Julien Russell Brunet
RTGAM






August, 1998. The centre was not holding. Russia defaulted on its debt and scores of investors made large losses. Many sold securities to raise money and the prices of emerging market securities plunged. Stocks across the developed world followed. With security prices falling, investors' and financial firms' capital wore away. Volatility rose. Investors and institutions tried to curb their risk and moved towards safer and more liquid securities. Long-Term Capital Management went under. The market capitalization of both CitiGroup and Chase Manhattan decreased by roughly 50 per cent in the subsequent two months. In short, things went downhill quickly.

September, 2008. A different decade, a similar story. Investors lost big on securities that had been designed to be low risk. Then came the fire sales, the withdrawal of liquidity from the markets, and again the flight to quality. And two days after the historic bailout of American International Group Inc., these familiar phrases appeared in the pages of The Globe and Mail: "stock markets around the world tumbled," "skepticism heightened about the health of other financial institutions," "panicked investors sent global markets into a sickening nosedive," "a nation gripped by fear," "trading suspended, investors flee Russia," and "the most serious financial crisis since the Great Depression."

These trends are outlined in a recent working paper published by the National Bureau of Economic Research in Cambridge, MA, that investigates whether a bank's performance during the 1998 crisis predicts its performance during the recent financial crisis.

In the wake of the late-2000s recession, it wasn't uncommon to hear observers and members of the general public ask 'How could this happen again?' and the authors, professors in the United States and Switzerland, offer some insights. Entitled "This Time is the Same," the paper finds that "banks that did poorly during the crisis of 1998 again did poorly during the recent financial crisis."

In concrete terms, the papers shows that while some firms like Goldman Sachs and JPMorgan Chase learned from their experience in 1998, changed their business model, and performed relatively well in 2007 and 2008, others like Lehman Brothers, Bear Stearns, Countrywide Financial Corp., and CitiGroup did not learn or adapt and performed poorly once again.

According to Rudiger Fahlenbrach, the lead author in the study and a professor of finance at Ecole Polytechnique Federale de Lausanne in Switzerland, the case of Lehman Brothers is particularly instructive.

"Within two months, in 1998, they had lost 65 per cent of their market capitalization," he said. "One reasonable hypothesis is to say 'OK, this was very close to actually failing, so perhaps we should change something so that in the next crisis we don't have the same problem.' But they are a good example of a bank that has not changed enough."

"This is a very easy measure of banks that have crisis exposure," added Mr. Fahlenbrach. "You could look at those that survived and that did poorly in 2007 and 2008 and you would have pretty good candidates of those who would be doing poorly again in the next financial crisis, whenever that is."

Moving forward, Mr. Fahlenbrach said, the findings of the paper suggest banks need to be more tightly regulated or closely supervised.

"If you believe the results of our paper, then the self-regulation of the financial industry or the self-governance of banks looks failure-likely in the sense that they haven't learned from 1998, so why should they learn from 2007 and 2008?"