In their own words
Conference calls show how CEOs would deal with upcoming crises
By Andrew Chunwon Yi
With the threat of European nations’ fiscal troubles wreaking havoc on financial markets around the world today, we are still reeling from the aftermath of the financial crisis of 2007 which inflicted tremendous economic damages to the world economy and ushered in enormous corporate and political changes in many countries.
It is widely established that the financial crisis of 2007 took everyone by surprise. The top leaders of the financial world, regulators, academics and the general public alike, largely failed to anticipate the onset of the crisis.
Alan Greenspan, the former Chairman of the Federal Reserve, once commented that “we will never be able to anticipate all discontinuities in the financial market” and “cannot hope to anticipate the specifics of future crises with any degree of confidence.”
After the market crumbled, Charles Prince, the former CEO of Citigroup, testified before the Financial Crisis Inquiry Commission that “everyone, including our risk managers, government regulators, other banks and CDO structures, all believed that these securities held virtually no risk.”
So, apparently no one saw it coming. However, recent studies my colleagues and I conducted tell a completely different story.
Using data on U.S. banking firms during the period of 2001 through 2008, we examined the transcripts of all US banks’ quarterly earnings conference calls. These conference calls are typically conducted by firms’ top management teams, including CEOs, CFOs and other members of top management, shortly after firms’ quarterly earnings releases. The conference calls provide an opportunity for the management team to discuss the firm’ performance and its outlook with stock analysts and other investors.
These conference calls show that the banks varied widely in the timing of their recognition of the impending crisis. As early as 2005 and 2006, some banks expressed concerns over the subprime mortgage markets and took actions to reduce their exposure to toxic assets while others were still jumping in to grab a share of the lucrative securities markets.
It turns out that some banks including J.P. Morgan and Wells Fargo that recognized the crisis earlier than others took corrective actions, made strategic changes, and as a consequence remained resilient against the disaster even when the vast majority of the industry suffered enormous economic damages.
In fact, banks that tended to recognize the subprime crisis earliest undertook the greatest changes during the period of turbulence, and the firm’s speed of crisis recognition was positively related to its profitability during the crisis period. Naturally, we have to ask: why are some firms able to recognize crises earlier than others?
Borrowing a page from cognitive psychologists, we turned to the words top managers have used. We analyzed the contents of the conference call transcripts, and examined how the cognition of top management teams influenced how fast a bank recognized the crisis.
The result is striking: the banks whose managers were relatively more forward looking and externally oriented recognized the subprime threat early. Furthermore, the banks with managers who exhibited overly optimistic and overconfident tendencies and commitment to the status quo were either late to recognize the threat or did not sense the crisis at all.
Banks with top managers who showed greater positive tones and used more optimistic languages in the conference calls turned out to be exactly those banks that took greater risks and ended up receiving U.S. government bailouts.
The finding corroborates some of the speculative causes of the financial turmoil. One view is that strategic myopia led managers, investors and analysts to focus excessively on short-term performance and ignore long-term implications.
Top executives paid attention to key performance metrics and expectations and often felt compelled to react with strategies that bolster short-term profits at the expense of long-term firm stability. Perhaps such “short-termism” behavior prompted another famous quote by Charles Prince: “When the music stops, in terms of liquidity, things will be complicated. But, as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Indeed, our research does provide support for this short-termism hypothesis: banks whose executives were less focused on the future and more committed to the status quo were less likely to recognize the subprime crisis.
Ironically, but perhaps not surprisingly, the financial markets reacted more positively upon banks’ earnings announcements when they were accompanied by more positive and optimistic words by banks’ top management in the period leading up to the financial crisis. We all got fooled perhaps. So, next time when you hear some warm and soothing words from top management, watch out. The next crisis may be just around the corner.
Andrew Chunwon Yi is an assistant professor of finance at Sungkyunkwan Graduate School of Business (SKK GSB). The column has been co-authored by Profs. CJ song and Theresa Cho, and Daniel Mack collaborated on the studies mentioned in the column.