Credibility gap: Investors don't believe managers' claims about bank assets

Government money needed not only to prop up banks, but to rebuild confidence, says MIT Sloan expert

CAMBRIDGE, Mass., March 10, 2009 — Even as governments keep pumping capital into their struggling financial sectors, confidence in banks will remain low until investors begin to believe what managers say about the value of assets in even strong institutions, according to an MIT Sloan School expert on capital markets.

“Our research supports the view that investors simply do not believe asset values being reported by these financial institutions, especially the assets with significant illiquidity and reporting reliability concerns,” says MIT Sloan Assistant Professor Jeffrey Ng. "Even when the banks report positive numbers, investors still have little confidence that these assets have any significant value. And as the economic crisis deepens, the market is discounting the value of the assets reported by these institutions more and more.”

The effect is a vicious cycle: even if a bank says it is doing relatively well, investors continue to doubt it, which means the bank remains mired in financial trouble, which means it may require additional assistance. “If banks have to write down their assets because the market doesn't believe their reported value, the ratio of equity to assets might become so low that it breaks regulatory requirements.”

For that reason, the government has little choice but to keep putting capital into the banks. “Better capitalized banks tend to have less of the confidence problem,” says Ng. “Our research finds that investors value banks with higher capital adequacy more than those with lower capital adequacy, suggesting that an infusion of capital could help increase confidence in the banks.”

What concerns Ng is that no one knows how much more assistance will be required to restore market confidence. For example, a recent article in Fortune magazine suggested that the bank bailout could cost as much as $4 trillion. “Though it does appear that putting money into the banks could eventually improve investor confidence, the situation is still not improving,” notes Ng. “Firms are reporting worse results than expected and nations all over the world are reporting worse GDPs than expected.”

Exacerbating the problem is that investors and the general public have lost faith not only in what managers say about assets, but in the managers themselves. “Every report of managers engaging in excesses further undermines public confidence and causes investors to further discount already vastly reduced valuations. The audience watching how the government responds is not just the banks and their shareholders, but the investor community and the broader public,” says Ng. "The government has little choice but to keep providing more support for the banks.”

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