In this paper we examine insider trading around the failure of banks. Between 1980 and 1994, 1,617 banks failed in the United States. This number constitutes 9.14 percent of all U.S. chartered banks. On a total asset basis, the failed banks held 8.98 percent of the total banking system assets (FDIC, 1997). While no geographic area of the United States was immune from the failures, some were hit harder than others. Nearly 60 percent of the failures occurred in 5 states: Texas, Oklahoma, California, Kansas and Louisiana (FDIC, 1997). Despite the economic significance of these bank failures, to date no paper has examined insider trading behavior around bank failures. We examine insider trading around four largest commercial bank failures that took place in the 1980's. The four failures that are examined are Continental Illinois National Bank and Trust Company, First City Bancorp., First Republic Bank and Mbank.
Given the lack of evidence regarding insider trading for banks and other financial institutions, we will discuss the empirical literature on insider trading behavior in non-financial firms. These studies have attempted to answer three important questions: (1) Is insider trading beneficial to capital markets? (2) Do insiders earn excess returns?, and (3) What kind of trading patterns do insiders exhibit relative to significant corporate news announcements? While all of these issues are interesting, our focus is on answering the third question for the banking industry.
Elliott, Morse and Richardson (1984) found evidence that insiders with private information purchased stock in their firms before value increasing announcements and sold stock before value decreasing information releases. Oppenheimer and Dielman (1988) examined insider trading patterns during the twelve months prior to announcements of dividend resumption (omission) and possible abnormal returns associated with such insider trading. They found evidence suggesting that insiders engaged in extensive net buying (selling) activity prior to dividend resumption announcements (omission). However, these pre-announcement insiders purchases failed to consistently earn excess returns, while pre-announcement insider sales enabled the insider to avoid negative abnormal returns. Furthermore, officers (high-information insiders) were found to earn larger profits than all insiders considered as a broad group.
The literature relating to non-financial firms indicates that the announcements of voluntary liquidations tend to benefit stockholders, whereas the announcement of filing for bankruptcy reduces equity prices. On that basis, Eysell (1991) hypothesized that the announcement of voluntary liquidations would be associated with an increase in insider purchases and that announcements concerning bankruptcy filings would lead to increased insider sales. As expected, when he empirically tested these hypotheses he found that corporate insiders were in fact heavy purchasers prior to liquidation announcements and during the period when the value of firms' stock kept rising. Furthermore, as expected, insiders of firms that eventually filed for bankruptcy were heavy net sellers. Additionally, those with the greatest access to information (high-information insiders) were found to be the heaviest purchasers before liquidation announcements and the heaviest sellers before bankruptcy announcements. These findings indicate that insider trading is prevalent in a manner consistent with the exploitation of private information. In a recent article, Hu and Noe (2001) derive the conditions which allow insiders to trade on their on their own behalf and in a manner which increases shareholder wealth.
Karpoff and Lee (1991) examined the insider trading patterns before new equity offerings. The authors found that insiders are net sellers of their firms' common stock prior to the announcements of new common stock and convertible debt issues. On that basis, they concluded that penalties for illegal insider trading did not deter insiders from using their superior information. Teal (1993) examined insider holdings, as opposed to insider trading, around the failure of savings and loan associations (S&Ls) during the period from June 1977 to March 1991. Teal argues that managers maintain a dual role. In the management role, the manager strives to maximize the value of his salary. In the shareholder role the manager strives to maximize his equity value. He suggests that these objectives often conflict, and consequently, we should expect managers with higher shareholdings to act on behalf of shareholders in general by assuming greater risk in order to increase the value of the deposit insurance option. Consistent with this, he found evidence that the insiders of S&Ls which subsequently failed owned 23.1% of the outstanding equity, compared to only 11.0% for S&Ls that did not fail. Bank failure announcements are generally found to have a negative effect on the stock prices of the failing banks as well as other commercial banks. For example, using weekly data Swary (1986) found that all banks experienced a 3% decline in the value of their common stock in reaction to the Continental Illinois failure. In a similar fashion, Lamy and Thompson (1986) show that all banks experienced a 1% decline in stock value in reaction to the Penn Central failure.
In this paper we examine insider trading around the failure of financial institutions. We examine insider trading around four major bank failures that took place in the 1980's. We begin by discussing the theory related to bank contagion and insider trading. We continue by proposing testable hypotheses and discussing the data and methodology. Next, the test results are presented followed by concluding comments.
THEORY RELATED TO BANK CONTAGION AND INSIDER TRADING
Banks are unique in that a significant proportion of their liabilities are payable at par on demand or at very short maturities. To meet these deposit withdrawals the bank may have to quickly liquidate assets at current market value. While banks are required to hold a small percentage of reserves against transaction or demand deposits, these reserves are not sufficient to meet a massive withdrawal of deposits. To help protect again such a "bank run" the FDIC insures bank deposits up to $100,000. This deposit guarantee, plus the fact that historically the FDIC charged a flat-rate insurance premium regardless of bank risk, encouraged banks to assume increased levels of risk. This moral hazard condition has been well documented in the literature (Kane, 1986). In effect, bank management has been encouraged to take excessive risks which, if successful, benefits bank shareholders as well as bank management. If the risky investments are unsuccessful and the solvency of the bank should be in jeopardy, the FDIC and tax payers will ultimately bare the financial burden. In addition, to prevent a massive run on the banking system, the Federal Reserve and the FDIC instituted a "too-big-to-fail" doctrine which lead to the protection of all liability holders at Continental Illinois banks regardless of amount or type of deposit or indebtedness. The argument put forth at that time was that, should Continental Bank fail, hundreds of other banks with correspondent banking relationship with Continental might also fail. This could then lead to widespread panic or contagion within the banking system that could eventually migrate to non-bank financial institutions. The size of the FDIC insurance fund was felt to be inadequate to deal with such a massive bank run.
Aharony and Swary (1983) make a distinction between pure or industry-specific contagion and firm or bank specific contagion. With industry-specific contagion the market has difficulty differentiating between individual banks and views the banking industry as more or less homogeneous. Given the difficulty that the market has in evaluating the quality of bank assets, in particular private loan contracts, problems at one bank are viewed as a likely problem for all banks and may illicit an irrational response toward the entire industry. With bank-specific contagion an adverse event at one bank is seen as being indicative of problems at other banks which share common characteristics, such as similar types of loan exposures or common product lines. In this case the market reaction is rational in the sense that bank performance is correlated to a common set of industry or macro economic variables. Industry-specific contagion is viewed as being more damaging than bank-specific contagion as it potentially impacts all banks, rather than shifting deposits and loans within the system from weak to healthy institutions. Furthermore, as Kaufman (1994) points out, the news may not be all bad since the failure of a major bank may significantly benefit its competitors. This was certainly the case for First Chicago Bank, the primary competitor of Continental Bank. In reviewing the evidence surrounding a number of major bank failures, Kaufman concludes that bank-specific rather than industry-specific contagion is...