Academic journal article Journal of Money, Credit & Banking

The Information Content of Bank Exam Ratings and Subordinated Debt Prices

Academic journal article Journal of Money, Credit & Banking

The Information Content of Bank Exam Ratings and Subordinated Debt Prices

Article excerpt

Do supervisory examinations of large commercial banking firms produce useful information not already reflected in market prices? To investigate this question, we apply a new research methodology to data on bank exam ratings and the subordinated debt risk spreads of their parent holding companies. We find that government exams do produce new, value-relevant information; that debenture prices do not immediately reflect this information; and that the market prices the likely regulatory actions implied by this information. These results have implications for market versus regulatory discipline at large banking firms, and for proposals to make subordinated debt mandatory for these firms.

WHILE MOST U.S. CORPORATIONS are scrutinized by private-sector monitors (ratings agencies, securities underwriters, bank lenders, etc.), commercial banks face the additional scrutiny of government inspectors. Approximately once every twelve to eighteen months, federal or state supervisors examine each U.S. commercial bank to assess its safety and soundness. At the close of each exam, the supervisor rates six dimensions of a bank's condition: its Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to market risk.(1) A composite CAMEL rating summarizes the supervisor's assessment of overall bank condition. CAMEL ratings reflect a combination of publicly available information (such as recent financial statements) and private information produced by bank examiners during their on-site investigation (such as the quality of individual loans). Supervisors report these ratings only to a few top officials at the bank, who may not reveal them to employees, customers, or financial market participants.

Relative to most other specialized monitors, bank supervisors have a greater capacity to act on the information they discover during their monitoring efforts. When the information they gather is extremely unfavorable, bank supervisors are empowered to ban certain bank activities, to dismiss upper-level bank managers, and even to close down the bank. These powers have been granted to government monitors based, at least in part, on the belief that outside stakeholders and private-sector monitors lack the information necessary to discipline the bank effectively. Therefore, it is important to know whether bank exam ratings contain value-relevant information that is unknown to market participants; for how long this information remains confidential; and how the market prices this information once it becomes publicly known.

Previous studies have compared bank exam ratings to various market assessments of bank condition (for example, bond ratings, equity prices, interest rates on uninsured CDs). This study evaluates whether examiner information is relevant to the risk premium on subordinated debt issued by banking firms. Subordinated debt spreads should closely reflect the factors that most concern bank regulators. While bank equity holders can in principle benefit from an increase in risk, subordinated-debt claims generally lose value when a bank becomes more likely to fail. Unlike previous studies, we decompose bank ratings into two components: the part correlated with public information, and the part that reflects the examiner's private assessment of bank condition. We apply a three-step research methodology to the CAMEL ratings of national bank subsidiaries of holding companies with traded debentures outstanding between 1989 and 1995. In the first step, we regress each bank's CAMEL rating on public financial data that were available at the time of the bank's most recent examination. The residuals from this (ordered logit) regression proxy for the private information known only to bank supervisors. This first step allows us to appropriately account for the discrete character of CAMEL ratings, and allows us great flexibility in decomposing different types of exam information. In the second step, we compute an option-adjusted risk premium for the subordinated debt of the parent holding companies of our sample banks. …

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