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

CONCLUSION

Our results show an indicator of financial viability based on stock prices provides incremental information to bank supervisors during the periods between inspections, beyond the information contained in past supervisory ratings and the quarterly financial statements routinely used in the supervisory process. We see this finding as evidence that investors' views regarding the financial condition of individual banking organizations, as distilled from equity prices, provide a useful supplement to supervisory assessments. In essence, the markets give the right signals, and the information they provide is not redundant.

This interpretation of our results hinges on whether past rating information and quarterly accounting data together form a reasonable proxy for the extent of supervisory information between inspections. It is important to note that the supervisory information produced between inspections in some--and perhaps many--cases almost surely extends beyond the types of information included in our statistical models. This is especially true for the largest organizations, where a continuous on-site presence provides supervisors with more information about current conditions than is reflected in the past rating information and quarterly financial data we use as standard supervisory indicators. Based on these considerations, further work is needed to incorporate additional supervisory information into the analysis. Related to this work is the important issue of the extent to which supervisors systematically quantify any assessments formed between inspections.

An additional question is whether market data can provide incremental information, even when inspections are current. We have shown market information is useful in tracking financial conditions, as reflected in BOPEC ratings. But are BOPEC ratings a comprehensive indicator of organizations' financial condition? BOPEC ratings themselves may be only imperfect indicators of risk levels. One possible avenue for exploring this question would be further work along the lines of Berger, Davies, and Flannery (2000) that compares the ability of equity-market information and BOPEC ratings to predict additional indicators of financial condition, such as default.

NOTES

The authors would like to thank KMV LLC for providing the proprietary data this study uses. They also would like to acknowledge the helpful comments and suggestions of participants at the Conference on Using Market Data in Banking Supervision, May 2 and 3, 2001, sponsored by the Federal Reserve Bank of Minneapolis and the Federal Reserve Bank of San Francisco.

(1) See Board of Governors of the Federal Reserve System and U.S. Department of the Treasury (2000).

(2) For example, see Ronn and Verma (1986).

(3) The data we use to construct financial ratios are from quarterly financial reports, Consolidated Financial Statements for Bank Holding Companies (FR Y-9C), issued by the Federal Reserve Board. Insofar as these data are subject to revision, the values of our financial ratios may not reflect their assigned values when the data were first reported, since we do not have access to the original data.