Can the Stock Harket Tell Bank Supervisors Anything They Don't Already Know? - Brief Article

Economic & Financial Review, April, 2001 by Jeffery W. Gunther, Mark E. Levonian, Robert R. Moore

Stock prices provide useful predictive information, even after taking into account past rating information and information from the quarterly financial statements banking organizations file between inspections.

Various initiatives have been pursued in recent years to enlarge market forces' role in promoting a safe and sound financial system. Faced with dramatic increases in the size, scope, and complexity of banking organizations, policymakers have increasingly considered the possibility that the forces determining prices and quantities in the financial markets might be harnessed to supplement supervisory efforts aimed at maintaining safety and soundness.

A primary example of the increased emphasis on market forces is the comprehensive approach to capital adequacy recently developed by the Basel Committee on Banking Supervision. The new framework rests on three pillars--minimum capital requirements, supervisory review, and market discipline. By including market discipline, the committee recognizes that market forces can reinforce capital regulation and other efforts to promote safety and soundness.

Another example of the new emphasis is the Gramm-Leach-Bliley Act of 1999, which directed the Federal Reserve Board and the Treasury secretary to assess the appropriateness and value of requiring large depository institutions to issue subordinated debt. While the resulting study did not recommend the immediate establishment of such a requirement, the Board and the Treasury nevertheless concluded that the evidence supports use of subordinated debt both in supervisory monitoring and to encourage market discipline.(1)

This article considers only one of several avenues through which market forces might be used to support safety and soundness--the idea that investors' views on the financial condition and prospects of banking organizations can be distilled from stock prices and that such views can provide a useful supplement to supervisory assessments. Despite its intuitive appeal, insufficient analysis has been undertaken to document the empirical content of this basic idea. As a result, controversy remains over whether the financial markets can say anything about the health and prospects of financial institutions that supervisors do not already know.

Our empirical work uses supervisory ratings as a benchmark for banking organizations' financial safety and soundness, under the assumption that the results of supervisory inspections accurately reflect the financial condition of individual organizations. If after an inspection bank supervisors know everything about an organization's financial condition that investors know, and perhaps more, the question becomes whether market data can provide incremental information in the periods between inspections, beyond that offered by past inspection results and regularly reported data. It is important to note that the issue here is not which of these sources of information is better or more accurate. To be valuable, market indicators need not be superior to standard supervisory indicators. They just have to add a new perspective or dimension that helps provide a more complete picture of an institution's financial health, as Flannery (forthcoming) suggests. The tests reported in this article address this issue.

We find that a measure of financial viability based on stock prices helps predict the financial condition of individual banking organizations, as reflected in their supervisory ratings. Moreover, this measure provides useful information beyond that of past inspection results and quarterly financial statements. To the extent that these data are a reasonable proxy for the full set of information supervisors use between inspections, these findings indicate the financial markets can provide useful information to supplement supervisory assessments. The equity-market data give the right signals--or at least they are in broad agreement with subsequently assigned supervisory ratings--and they appear to contain new, or more timely, information not reflected by financing accounting statements.

EQUITY-BASED MARKET SIGNALS

The consensus of investors regarding individual organizations is reflected in market prices and price movements. The prices depend on future payoffs to investors and so are inherently forward-looking. With money at stake, investors have a strong incentive to collect valid information, evaluate it, and accurately assess the potential risks and rewards. At least in principle, a sense of what that assessment is can be extracted from the pricing of any risky claim on a bank or bank holding company.

In practice, the equity claims of an organization's owners have a number of advantages as a source of this type of information. Compared with other types of bank-related claims, markets for common shares are fairly liquid, so the quality of the price signals is reasonably high. Moreover, equity values are sensitive to changes in the condition of the issuing firm, making those changes easier to observe in share prices.