Bank Risk and Analysts' Forecasts

Market discipline does not seem to have prevented banks to take excessive amounts of risk in the period preceding the financial crisis that began in summer 2007. This paper aims to explore the ability of financial analysts to perceive the risk taken by (listed) banks, and to investigate whether this ability deteriorated during the financial crisis. Using a sample of 36,343 analyst forecasts issued for 411 banks over the period 2003-2009, our findings indicate that analysts are subject to forecast errors and that these errors are not constant over time but tend to grow during the phases of market tension. The higher risk of banks during the crisis is neither immediately expected nor quickly built into analyst forecasts. In contrast, during the crisis, the dispersion in the forecast errors increases markedly and there is an increase in the correlation between forecast errors and risk. Excluding explanations based either on a poor systematic ability of the entire community of financial analysts to predict risk or on a distortion of their incentives (expectations management), these findings can be interpreted as indicative of a still insufficient ability of accounting data to provide adequate and timely estimates of the risk faced by issuers in the banking industry. This contributes to further emphasise the importance of pursuing a higher effectiveness in implementing the instructions of the Third Pillar of Basel 2 (i.e. strengthening the disclosure requirements of banks).