Confidence in the stability of the banking sector is crucial element for well-functioning financial markets. The fallout from the 2008 subprime crisis has led to decreased confidence in financial institutions. Indeed, 2008 saw old-fashioned bank runs with depositors lined up outside the doors of institutions like Indy Mac in the United States and Northern Rock in the United Kingdom hoping to withdraw their savings from those failing institutions. Speaking on the government’s response to the U.S. banking crisis in late February and early March of 1933, President Franklin Roosevelt stressed “there is an element in the readjustment of our financial system more important than currency, more important than gold, and that is the confidence of the people.” His words remain relevant today.
Increased confidence in the banking sector can promote recovery and increase the perceived credibility of post-crisis reforms. However, “crises leave citizens wary of entrusting their savings to the official banking sector. This diversion of savings is likely one of the great and unmeasured costs of banking crises” (Gerard Caprio, World Bank, 2005). Measuring the impact of a crisis on investor confidence is complicated by the fact the difficulty of disentangling whether financial decisions change due to decreased confidence or because of decreased wealth and income as a result of the crisis.
Despite the importance of investor confidence in determining the costs of a crisis and paths to recovery, it remains largely unstudied. We make progress in estimating the impact of crises on investor confidence, by examining the financial decisions of otherwise similar individuals who differ exogenously in their exposure to financial crises. Information on the investment behavior of immigrants in the U.S., together with measures of their exposure to systemic banking crises prior to migration, provides this opportunity. If episodes of financial instability have long-lasting effects on investor confidence, then individuals who have experienced a crisis may make different financial choices than otherwise similar individuals who have not lived through a crisis. In particular, reduced investor confidence may manifest itself in lower usage of U.S. financial institutions among individuals who have experienced a systemic banking crisis prior to arriving in the U.S.
Focusing on the investment behavior of individuals who have migrated to the U.S. offers distinct advantages for understanding investor confidence. First, by studying investment decisions in a common institutional, economic and financial environment, we minimize the potential impact of confounding cross country differences, including the success and credibility of post-crisis reforms. Examining investment decisions in the U.S. also helps to isolate factors that influence the demand for financial products rather than the supply, since the supply of financial services in the U.S. is likely to be independent of banking crises in other countries. In addition, because individuals from the same country vary in their exposure to crises, we can include country of origin fixed-effects in our empirical specifications. By doing this we hold constant country-level variation in economic, financial, institutional and cultural factors. Variability in the severity and the origins of financial crises allows us to explore how investor confidence is shaped by these features of crises as well.
In addition, the availability of detailed individual level data allows us to control for factors like income and wealth that are likely to influence financial choices and also be directly impacted by exposure to a systemic banking crisis. The availability of these data also permits an examination of how the impact of a crisis varies with individual characteristics, like education and years in the U.S. Finally, individuals who move to the U.S. are naturally aware that there are differences in the safety and soundness of U.S. financial institutions compared to those in their countries of origin. As a result, our estimates of how investor confidence is influenced by exposure to systemic banking crises may be conservative.
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