Run on the Bank and the Dangers of Information Cascade in the Markets
Lehman brothers, one of the most reputable firms on Wall Street, declared Chapter 11 on September 15, 2008 in the biggest bankruptcy filing in US history. How did such a massive organization with great client relations and excellent fundamentals fail so quickly? The answer can be explained in one of the most dangerous real-life applications of an information cascade: a bank run.
The US stock markets operates as a simple supply and demand market; investors and traders would typically sell stocks that they think are overvalued, driving the stock price down. On the other hand, if a stock is perceived as undervalued players in the market would buy it, driving the price up. For the most part, stock prices represent the intrinsic value of companies over their entire lifetimes, which is why although the equity markets are very volatile, very few companies “go under” in a short period of time.
Lehman Brothers announced a massive asset write-down as a result of sub-prime mortgages. For Lehman’s management team and the majority of institutional investors (who understand how to value a company), this wasn’t a major problem (in fact, many institutions actually injected capital into Lehman in order to keep the company afloat, a major sign of confidence in the fundamentals of the investment bank). However, individual investors began to sell shares of Lehman stock as they feared their equity was in danger.
This started off an information cascade effect commonly known in financial services as a “bank run” or a “run on the bank”. More and more investors, seeing the stock price falling as a result of other investors unloading shares, decide to sell shares themselves based not on intrinsic valuation but on the general panic of the market. This eventually led to a massive drop in Lehman Brothers’s stock price over a very short period of time, eventually forcing the operationally-sound company to the point of insolvency and bankruptcy. The bank run was clearly due to investor panic and not the actual solvency of Lehman, but the end result is that significant drop in the share price actually forced the bank to default.
Lehman’s failure illustrates the danger of information cascades in the financial markets. Individual stock investors made decisions not on the fundamentals of Lehman Brothers, but on the general movement of the market. What resulted was the largest bankruptcy in US history and the further descent of the US economy into recession. Sometimes following the herd isn’t the best idea – this is certainly the case in financial markets.
http://time.com/money/3330793/lessons-from-lehman-brothers-collapse/