Academic journal article Journal of Money, Credit & Banking

The Value of a Government Monitor for U.S. Banking Firms

Academic journal article Journal of Money, Credit & Banking

The Value of a Government Monitor for U.S. Banking Firms

Article excerpt

Financial markets will allocate real resources efficiently only if investors can reliably infer the true value of firms' debt and equity securities. In an effort to resolve investor uncertainties efficiently, individual firms rationally incur costs to convey private managerial information to capital market participants, via audited financial statements, bond ratings, corporate advertising, meetings with stock analysts, and so forth. The commercial banking industry arguably has particularly severe informational asymmetries, given its specialization in funding assets which cannot readily be sold in public markets (see Berger, King and O'Brien 1991; O'Hara 1993). Banking firms also have a unique monitoring structure. Even while private rating agencies, stock and bond investors, and (uninsured) depositors seek to assess a bank's true condition and market value, the government undertakes an extensive program of on-site inspections and examinations.(1)

These examinations may affect book and market values in two important ways. Examiners collect information about the bank's business activities, complementing--or perhaps substituting for--private information collection. While the results of bank exams are confidential, examiners often require accounting disclosures which make at least some of their new information public. If examiners are considered credible evaluators, their investigations may improve the accuracy of accounting information. More accurate information may, in turn, raise the average examined firm's market value.

Examinations may also affect bank valuations through a regulatory channel. Examinations comprise one part of an overall regulatory process which is designed to assess and control the government's risk exposure resulting from its deposit insurance and lender of last resort activities. In this regard, examinations may lead to regulatory constraints which affect bank value. Moreover, if examinations are not random events, but rather targeted events partially triggered by private information about the bank's value, market values may be affected by the revelation that a bank is being examined. In short, examinations may either reduce risk and enhance the correlation between market and book values through the certification process or increase risk and weaken the correlation between market and book values by introducing regulatory risk. The net impact of these two effects is an empirical question whose answer is likely to vary over time and across banks.

Previous evaluations of examiners' ability to produce new information about bank values have yielded conflicting results. Cargill (1989) seeks to explain cross-sectional variation in large banks' uninsured CD rates during the mid-1980s. He reports that examiners' assessments of bank condition (CAMEL ratings) add no explanatory power to a regression that includes only publicly available financial information. More recently, Cole and Gunther (1998) find that CAMEL ratings predict bank failure rates more accurately than a probit model using financial information, but only if the CAMEL rating is less than six months old. Berger and Davies (1994) report that market values decline following examinations in which regulators lower their assessment of bank condition. They conclude that at least this subset of bank examinations generates information that was previously unavailable to public investors.(2)

This paper examines the impact of federal examinations on large U.S. banks' equity market values, in order to assess whether examinations add value to the market's supervisory process, and assess whether they introduce regulatory risk. Empirical evidence indicating that government examinations supplement private information sources about bank condition would have important implications for the appropriate design (reform) of financial sector regulation. Unfortunately, it has been difficult to compare market versus regulatory sources of information about banks' conditions because federal regulators are reluctant to provide data about any aspect of bank examinations. …

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