Labor income accounts for about two thirds of national income in the U.S. and, since the seminal work of Mayers (1973), it has been assumed to play an important role in theoretical asset pricing. In studies such as Bodie, Merton, and Samuelson (1992), Danthine and Donaldson (2002), Qin (2002), Santos and Veronesi (2006) and Parlour and Walden (2010), risky labor income or more generally, human capital risk affects investors’ portfolio decisions, which in turn has general equilibrium asset pricing implications. Broadly, the theory suggests that the behavior of capital markets can only be understood together with labor markets. More specifically, the theory suggests that an important function of capital markets is to allow investors to hedge their labor income risk.
Since 1997, economists, policymakers, and journalists have talked about the “Asian flu.” It has generally been perceived that the adverse currency and stock market shock that first affected Thailand in July 1997 propagated across the world with little regard for economic fundamentals in the affected countries. Before the Asian flu, there was the 1994 Mexican “Tequila crisis,” and since then, the 1998 “Russian virus.” Emerging markets economic crises, in general, have been characterized as contagious. According to Webster’s dictionary, contagion is defined as “a disease that can be communicated rapidly through direct or indirect contact.” Emerging market economic crises have led to massive bailouts to quell contagion and have reduced support for free capital mobility. IMF deputy managing director Stanley Fischer rationalized the 1994 Mexican bailout in this way: “Of course, there was another justification: contagion effects. They were there and they were substantial.” Contagion has led Bhagwati (1998) and others to argue that “Capital flows are characterized, as the economic historian Charles Kindleberger of the Massachusetts Institute of Technology has famously noted, by panics and manias.” If markets work this way, it is not surprising that Stiglitz (1998) called for greater regulation of capital flows, arguing that “…developing countries are more vulnerable to vacillations in international flows than ever before.”
Even though this contagion connotes powerful images of economic and financial plagues, it is difficult to study scientifically. Evidence of this difficulty is that there is little agreement on even defining what financial contagion means. Since equity market valuations reflect future economic activity, much of recent research attempts to learn about contagion by investigating whether equity markets move more closely together in turbulent periods. There are considerable statistical difficulties involved in testing hypotheses of changes in correlations across quiet and turbulent periods and recent investigations of this issue find at best mixed results. Nevertheless, there does not seem to be strong evidence that stock returns in one country are more highly correlated with returns in other countries during crisis periods once one takes into account the fact that the conditional correlation of stock returns is higher during such periods even if the unconditional correlation is constant. A related literature demonstrates that, even though correlations change over time, it is difficult to explain changes in correlations.
There is a substantial literature examining performance after a banking merger. An offshoot of this is a second group of studies that look at the impact of bank mergers on operating costs and efficiency. The area of credit quality, hoerver, has received little attention. Credit quality is a key determinant of banking profitability. Weakness in this area can be disastrous. Southeast Bank in Florida failed in 1991 because of problems with its commercial real estate loan portfolio. Bank of America was sold to Nations Bank in 1997 primarily because of credit problems resulting from the acquisition of Security Pacific. Little attention, however, has been paid to the question of credit quality after a merger.
Credit quality can be difficult to manage and requires constant management attention to keep it under control. For this reason, it seems likely that quality could slip right after the merger as the two institutions are combined. However, in the long run, one would expect quality to return to its pre-merger level, or perhaps to improve a bit as the merged BHC combines the best practices of the buyer and target. This paper tests this hypothesis by looking at the changes in credit quality from pre-merger levels to the levels 1, 2, and 3 years after the merger. It also examines whether the combined institutions have credit ratios that differ from those of industry-wide BHCs in the year before the merger.
