Bank Litigation, Bank Performance and Operational Risk: Evidence from the Financial Crisis

Abstract

Deposit insurance is a put option that encourages excessive risk taking by banks. Excess litigation against a bank, a form of operational risk, is one indicator of risk because litigation often reflects a failure to maintain a strong system of internal control. We analyze five different measures of bank financial performance and a unique hand-collected data set on bank legal expense. Our results are consistent with the hypothesis that high legal expense predicts weak future bank performance. If investors had legal expense information on a regular basis there would be greater market discipline. Bank regulators should consider requiring consistent and comprehensive reporting of legal expense on regulatory reports to help identify institutions with excessive operational risk. Existing reporting creates unnecessary information asymmetries since investors are not as informed as they could be about operational risk, no doubt leading to mispricing of bank securities.