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

Equity-Market Data

To incorporate information from the equity market, the analysis includes the EDF credit measure for individual banking organizations, as constructed by KMV (EDF). As described above, EDF is an estimate of the probability a firm will default within the next year. As a measure of credit risk, EDF should be positively associated with problem BOPEC ratings; while BOPEC ratings are not explicit estimates of the probability of default or failure, we would expect institutions in relatively weak financial condition to have higher EDF values and higher (worse) BOPEC ratings. KMV generally releases data about two weeks after each month's end, so EDF is as of the end of the month falling two months prior to the month in which the corresponding inspection was opened.

Past Supervisory Assessments

To help predict BOPEC ratings for individual organizations, the analysis includes two variables reflecting supervisory assessments made prior to the opening of the current inspection. The first variable is the rating an organization received on its most recent prior inspection (BOPEC-1), which may be positively related to the organization's current rating. In addition, information is included from a separate bank exam process, which complements supervision at the organization level. Bank-level exam results can trigger changes in an organization's BOPEC rating. Ratings at the bank level range from 1 (best) to 5 (worst), similar to composite BOPEC ratings, and are referred to as CAMELS ratings. Composite CAMELS ratings are derived from the evaluation of six bank-level factors: capital adequacy (C), asset quality (A), management (M), earnings (E), liquidity (L), and sensitivity to market risk (S). The asset-weighted average of the composite ratings for an organization's bank subsidiary or subsidiaries (CAMELS) is included to capture supervisory information at the bank level. The variable CAMELS is based on the most recent bank exam (one-bank holding company) or exams (multibank holding company) closed prior to the month in which the corresponding holding company inspection was opened.

Financial Accounting Data

The analysis also controls for the potential predictive capacity of a number of indicators based on the quarterly reports banking organizations file with the Federal Reserve. One basic indicator is an organization's size. The log of total assets (SIZE) may reduce the chances of a substandard BOPEC rating if largeness provides financial strength, through either a greater ability to diversify risk or a closer relationship with the broader financial market.

The remaining nine variables are financial ratios that reflect various aspects of financial strategy and performance. The balance-sheet variables are scaled using total assets, and the income statement variables are expressed relative to average assets. Total equity capital (CAPITAL) and loan-loss reserves (RESERVES) serve as measures of capital adequacy. Each of these variables is expected to reduce the chances of a substandard BOPEC rating. Asset quality is measured using loans past due thirty to eighty-nine days (PAST-DUE 30), loans past due ninety or more days (PAST-DUE 90), and nonaccrual loans (NONACCRUAL). These variables are expected to raise the chances of a substandard BOPEC rating. Liquidity is measured using two variables: investment securities (SECURITIES) and certificates of deposit of $100,000 or more (LARGE CDs). SECURITIES should reduce the chances of a substandard rating, while the reverse is true for LARGE CDs. A reliance on this latter type of funding is often associated with aggressive banking strategies and frequently subjects an organization to added expenses. Finally, two income-statement variables are included to capture the effect of asset quality problems and other factors on profitability: loan-loss provisions (PROVISIONS), which should hurt BOPEC ratings, and net income (ROA), which should help the ratings. The financial ratios and SIZE are as of the quarter-end two months prior to the three-month period in which the corresponding holding company inspection was opened. The two-month lag used in the regressions compensates for lags in the submission and processing of financial statements.