Using Price Information as an Instrument of Market Discipline in Regulating Bank Risk

An important trend in bank regulation is greater reliance on market discipline. In particular, information impounded in securities prices is increasingly used to complement supervisory activities of regulators with limited resources. The goal of this paper is to analyze the theoretical foundations of market-based bank regulation. We find that price information only improves the efficiency of the regulator’s monitoring function if the banks’ risk-shifting incentives are not too large. Further, if the regulator cannot commit to an ex ante suboptimal auditing policy, market-based bank regulation can lead to more risk taking in equilibrium, increasing the expected payments by the deposit insurance agency. Finally, we show that the regulatory use of market information can decrease the investors’ incentives to acquire costly information, thereby reducing the informativeness of stock prices. ∗Please address correspondence to Günter Strobl, Kenan-Flagler Business School, University of North Carolina at Chapel Hill, McColl Building, C.B. 3490, Chapel Hill, NC 27599-3490. Email: [email protected] Bank regulators have embraced financial markets recently to improve the effectiveness of bank supervision. Feldman and Schmidt (2003) find that 40% of U.S. supervisory reports contain at least some reference to market data (mostly equity prices and market-based ratios). The idea seems simple: since markets are efficient in processing and aggregating information, bank regulators hope to gather information on the bank’s financial condition from market indicators that complements their knowledge derived from call reports and on-site bank inspections. In this paper, we analyze how the use of market information by regulators will change incentives for investors to acquire information and thus endogenize the information content of securities prices. Furthermore we examine the incentives for banks’ risk shifting and analyze the welfare effects of such a new regulatory approach. Im most developed economies banks are subject to government supervision partly to mitigate risk taking incentives that are introduced by deposit insurance schemes and to preserve financial stability of the banking system, which is of vital importance to the whole economy. A better assessment of a bank’s financial soundness enables the regulator to intervene in a timely fashion and may help avoid a collapse of the financial institution. Banks, however, have become increasingly complicated for regulators to evaluate. Large, multinational banks operate in many markets, under many jurisdictions, and often under the supervision of many national regulators. Complex derivatives and other structured securities are a potential source of substantial risks, but fit only poorly in traditional accounting-based rating schemes of bank regulators. Seeking ways to enhance the effectiveness of bank supervision, bank regulators are actively discussing incorporating information that is generated by financial markets into the regulatory process. One stream of discussion focuses on the value of market information for the off-site assessment of a financial institution’s health. Regulators in most countries have automated bank monitoring systems that periodically screen all banks. While most of them currently rely on call report data, recent research In the US, for example, the Federal Reserve uses its System for Estimating Examination Ratings (SEER) to regularly estimate a banks current regulatory rating and its probability of failure. Banks with sufficiently bad results are flagged for further review, possible leading to an on-site inspection. King, Nuxoll, and Yeager (2004) provide an overview of models used in the US and Sahajwala and Van den Bergh (2000) review off-site bank monitoring systems used in the US and in several G10 countries.