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Do capital markets predict problems in large commercial banks?

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  • Katerina Simons
  • Stephen Cross
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    Abstract

    In the present climate of intense debate over deposit insurance reform, the nature and limits of market discipline become especially important. The widely accepted argument for greater reliance on market discipline is that it will restrain managerial risk-taking and reduce potential losses to the deposit insurance fund. Opponents of this view favor the traditional reliance on supervision by the bank regulatory agencies as the primary method to maintain the safety and soundness of the banking system and the integrity of the deposit insurance fund. ; This article attempts to shed some empirical light on the issue by studying the effectiveness of market discipline as it is exercised by bank stockholders. Residual analysis is used to test whether the market anticipates the bank’s downgrade to a problem bank status. The results show that shareholder returns fail to anticipate bank downgrades by examiners. These results cast serious doubt on the supposed advantages investors, and particularly uninsured depositors, would have over bank regulators in restraining risk-taking by banks and in monitoring their management.

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    File URL: http://www.bostonfed.org/economic/neer/neer1991/neer391d.pdf
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    Bibliographic Info

    Article provided by Federal Reserve Bank of Boston in its journal New England Economic Review.

    Volume (Year): (1991)
    Issue (Month): May ()
    Pages: 51-56

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    Handle: RePEc:fip:fedbne:y:1991:i:may:p:51-56

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    Related research

    Keywords: Bank supervision ; Bank failures;

    References

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    1. Pettway, Richard H & Sinkey, Joseph F, Jr, 1980. " Establishing On-Site Bank Examination Priorities: An Early-Warning System Using Accounting and Market Information," Journal of Finance, American Finance Association, vol. 35(1), pages 137-50, March.
    2. Fama, Eugene F, et al, 1969. "The Adjustment of Stock Prices to New Information," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 10(1), pages 1-21, February.
    3. Pettway, Richard H., 1980. "Potential Insolvency, Market Efficiency, and Bank Regulation of Large Commercial Banks," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(01), pages 219-236, March.
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    Cited by:
    1. Allen N. Berger & Sally M. Davies & Mark J. Flannery, 2000. "Comparing market and supervisory assessments of bank performance: who knows what when?," Proceedings, Federal Reserve Bank of Cleveland, pages 641-670.
    2. Kaen, Fred R. & Michalsen, Dag, 1997. "The effects of the Norwegian banking crisis on Norwegian equities," Journal of Multinational Financial Management, Elsevier, vol. 7(2), pages 83-111, June.
    3. D.T. Llewellyn, 2000. "Some Lessons for Bank Regulation from Recent Crises," DNB Staff Reports (discontinued) 51, Netherlands Central Bank.
    4. Allen N. Berger & Margaret K. Kyle & Joseph M. Scalise, 2001. "Did U.S. Bank Supervisors Get Tougher during the Credit Crunch? Did They Get Easier during the Banking Boom? Did It Matter to Bank Lending?," NBER Chapters, in: Prudential Supervision: What Works and What Doesn't, pages 301-356 National Bureau of Economic Research, Inc.
    5. Mark Flannery, 2001. "The Faces of “Market Discipline”," Journal of Financial Services Research, Springer, vol. 20(2), pages 107-119, October.
    6. repec:onb:oenbwp:y::i:48:b:1 is not listed on IDEAS
    7. Caprio, Gerard Jr. & Summers, Lawrence H., 1993. "Finance and its reform : beyond laissez-faire," Policy Research Working Paper Series 1171, The World Bank.
    8. Gropp, Reint & Richards, Anthony J., 2001. "Rating agency actions and the pricing of debt and equity of European banks: What can we infer about private sector monitoring of bank soundness?," Working Paper Series 0076, European Central Bank.
    9. Lee, Wai Sing & Kwok, Chuck C. Y., 2000. "Domestic and international practice of deposit insurance: a survey," Journal of Multinational Financial Management, Elsevier, vol. 10(1), pages 29-62, January.
    10. Allen N. Berger & Sally M. Davies, 1994. "The information content of bank examinations," Finance and Economics Discussion Series 94-20, Board of Governors of the Federal Reserve System (U.S.).
    11. Linda Allen & Julapa Jagtiani & James Moser, 2001. "Further Evidence on the Information Content of Bank Examination Ratings: A Study of BHC-to-FHC Conversion Applications," Journal of Financial Services Research, Springer, vol. 20(2), pages 213-232, October.
    12. John S. Jordan, 1999. "Pricing bank stocks: the contribution of bank examinations," New England Economic Review, Federal Reserve Bank of Boston, issue May, pages 39-53.
    13. Barry Eichengreen & Andrew K. Rose, 1998. "Staying Afloat When the Wind Shifts: External Factors and Emerging-Market Banking Crises," NBER Working Papers 6370, National Bureau of Economic Research, Inc.
    14. Joseph P. Hughes & Choon-Geol Moon & Robert DeYoung, 2000. "Efficient Risk-Taking and Regulatory Covenant Enforcement in a Deregulated Banking Industry," Departmental Working Papers 200007, Rutgers University, Department of Economics.
    15. Alicia García Herrero, 2005. "Determinants of the Venezuelan Banking Crisis of the Mid-1990s: An Event History Analysis," Economia Mexicana NUEVA EPOCA, , vol. 0(1), pages 71-115, January-J.
    16. Curry, Timothy J. & Elmer, Peter J. & Fissel, Gary S., 2007. "Equity market data, bank failures and market efficiency," Journal of Economics and Business, Elsevier, vol. 59(6), pages 536-559.
    17. Caprio, Gerard Jr., 1996. "Bank regulation : the case of the missing model," Policy Research Working Paper Series 1574, The World Bank.

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