Do Institutional Investors Know Banks Better? Evidence From Institutional Trading Surrounding the 2008 Financial Crisis

Abstract

The catastrophic economic damage caused by the 2008 financial crisis was unprecedented and caught many market participants by surprise. It raises the question: To what extent do institutional investors play a monitoring role in the banking industry? In this article, we investigate this underresearched area and provide evidence that gray institutions (i.e., banks and insurance companies) have more information about banks’ risk exposure to securitization than independent institutions do (e.g., investment companies and public pension funds) as gray institutions shied away from banks holding more private-label mortgage-backed securities or issuing riskier securitization deals before the crisis. We also find that the trading of gray institutions before the crisis can predict high-exposure banks’ abnormal returns around the Lehman Bankruptcy and subsequent 1-year stock performance. The trades of gray institutions are also significant and positively related to such banks’ operating performance during the crisis period.