Following the financial crisis, regulators, academics, and practitioners investigated the factors that contributed to the systemic failure of the financial system. An important dimension of systemic risk that was identified is the correlated movements in market prices among banks during market downturns, known as “tail-risk” contagion. This increased tail-risk co-movement can make raising capital more difficult precisely when banks need capital the most, exacerbating systemic risk, increasing banks’ cost of capital, and contributing to a liquidity crunch.
While initial regulation called for higher capital adequacy requirements and periodic stress testing, more recent reforms have focused on the role of market participants in disciplining and monitoring banks (BIS 2015). Though academic literature has shown that institutional investors may serve as an important governance mechanism to mitigate excessive risk taking (e.g. Shleifer and Vishny 1986, 1997), we provide evidence that they may actually undermine the stability of financial institutions. Due to their large trades and correlated funding and trading, institutional investors may act as a transmission mechanism through which systemic risk can propagate.
How might institutional ownership exacerbate tail-risk co-movement? First, institutional investors typically hold larger portfolios of stocks than individuals or insiders. Stocks within a portfolio will necessarily be connected via the trading of the portfolio manager. For example, an adverse price movement in one banking stock may trigger sales in other banking stocks if managers seek to sell an underperforming sector. Moreover, negative fund performance may lead to redemptions which may also trigger sales within the portfolio. Second, certain types of institutions may be trading based on correlated stock characteristics or style preferences. Studies have shown that investors have a tendency to group assets in categories and then allocate funds on the level of these categories, treating all securities within a particular group as indistinguishable (e.g. Sun 2015). For example, a poor performing banking stock may lead investors to question the health of the banking sector and sell their positions. Third, during market contractions, it’s common to see funding liquidity dry up, and given that institutions tend to draw from a common pool of capital, this may prompt correlated selling among institutional investors, consistent with Shleifer and Vishny’s (1992) asset fire-sale model. Finally, program trading and stop-loss mechanisms at asset managers may also contribute to increased tail-risk co-movement, given that severe price drops may automatically trigger selling without adequate analysis of fundamentals. For example, the influence of these types of mechanisms was evident in the “flash crash” of 2010. Based on the above evidence, we argue that the degree of institutional ownership within banking stocks may exacerbate tail-risk co-movement and thus propagate systemic risk.
To test this prediction, we examine the co-dependence of equity returns between a bank and the banking system (e.g. Acharya et al. 2017). We use two measures commonly found in the academic literature: (1) Marginal Expected Shortfall (“MES”), which is the correlation between an individual bank’s returns and the returns of the banking sector on days when it is performing poorly; and (2) the number of overlapping days between an individual bank’s poor performance and poor performance of the banking sector.
Our analysis reveals four main findings. First, consistent with institutional ownership (“IO”) behaving as a transmission mechanism, we find that higher levels of IO are positively associated with banks’ future tail risk co-movement. Consistent with institutional owners experiencing common adverse funding-liquidity shocks during market downturns, our results are significantly exacerbated during market contractions. Moreover, our results are stronger within banks with heightened capital needs, showing that IO exacerbates tail-risk precisely when banks are most vulnerable. While banks with shared ownership are four to five times more likely to propagate systemic risk relative to banks that do not share any overlapping institutional investors. However, increased IO still adversely relates to tail risk co-movement even among banks without any common overlap in IO.
Second, we find that active institutional owners—i.e., those with high portfolio turnover—tend to drive the relation between IO and systemic risk. This finding makes sense given that active managers tend to have more volatile capital flows that could trigger immediate buying or selling of portfolio securities. Moreover, large active traders are likely to also engage in algorithmic or program trading, which may exacerbate tail risk. Notably, we find that “dedicated” institutional investors—i.e., those with large stakes with relatively low turnover – play no role in the transmission of systemic risk. In fact, these institutional investors may actually mitigate systemic risk. Put simply, more active institutional owners facilitate greater tail risk co-movement, while those with longer-term investment horizons and thus greater incentives to monitor (i.e. dedicated investors) may have a stabilizing effect on systemic risk, in line with regulator thinking.
Third, we find the positive relation between IO and systemic risk proxies is limited to banks with more dispersed ownership, where the incentive to monitor is low. In contrast, among banks with more concentrated IO we find no discernible relation to systemic risk. These results are consistent with the notion that once many institutional owners purchase a stock, dispersed ownership reduces the individual incentive to monitor and leads to free-rider problems (i.e. each investor relies on others to undertake costly monitoring activities). Moreover, given the large number of stocks institutional investors tend to hold and their relatively short-term orientation, there is less incentive for them to monitor individual firms, since they will simply exit their positions at the first sign of poor performance (e.g. Manconi et al. 2012).
Finally, we find that the relation between institutional owners and systemic risk is primarily driven by those banks with lower quality disclosures. This is consistent with the notion that greater bank disclosures will help reduce uncertainty regarding the bank’s underlying economic activities and may decrease both the correlation across institutional investors’ trades as well as the correlation of trades within an institution’s portfolio. This finding provides some support for the enhanced disclosure requirements of Basel III and the arguments that higher quality disclosures can mitigate systemic risk concerns (e.g., Bushman and Williams 2015).
Our findings inform the recent call from the Financial Stability Oversight Council (FSOC) for more research to understand how asset managers could transmit risks across financial markets. FSOC is considering whether large institutional investors should be subject to enhanced prudential standards and supervision under Dodd-Frank. Our findings also resonate with the recent concerns of the IMF regarding the extent to which investment funds pose risks to financial stability. We highlight a potential risk with the recent strategy of regulators who have called for institutional investors to play a larger role in the monitoring of banks, and speaks more broadly to the academic literature that tends to assume the benefits of institutional ownership without adequate consideration of the potential costs.
ACHARYA, V.V.; L.H. PEDERSEN; T. PHILIPPON; AND M. RICHARDSON. “Measuring Systemic Risk” Review of Financial Studies, 30 (2017): 2-47.
BUSHMAN, R.M., AND C.D. WILLIAMS. “Delayed Expected Loss Recognition and the Risk Profile of Banks.” Journal of Accounting Research 53 (2015): 511–554.
FINANCIAL STABILITY OVERSIGHT COUNCIL. “Implementation of the alternative investment fund managers directive” Financial Services Authority Consultation Paper CP 12/32 (November 2012).
MANCONI, A.; M. MASSA; AND A. YASUDA. “The role of institutional investors in propagating the crisis of 2007-2008” Journal of Financial Economics 104 (2012): 491-518.
SHLEIFER, A., AND R. VISHNY. “Large shareholders and corporate control.” Journal of Political Economy 94 (1986): 461-488.
SHLEIFER, A., AND R.VISHNY. “Liquidation Vales and Debt Capacity: A Market Equilibrium Approach” Journal of Finance, 47 (1992): 1343-1366.
SHLEIFER, A., AND R. VISHNY. “A survey of corporate governance”. Journal of Finance 52 (1997): 737-783.
SUN, Z. “Institutional Clientele and Comovement.” Working Paper (May 15, 2015). Available at: https://ssrn.com/abstract=1332201.
This post comes to us from professors Emmanuel T. De George at the University of Miami, Nayana Reiter at the University of Toronto, Christina Synn at the University of North Carolina at Chapel Hill, and Christopher D. Williams at the University of Michigan. It is based on their recent article “Institutional Ownership and the Propagation of Systemic Risk among Banks” available here.