Using Market Information in Prudential Bank Supervision: A Review of the U.S. Empirical Evidence

In principle, market and government supervision provide alternative devices for controlling (governing) any type of corporation. Most national governments have instituted nonmarket regulatory mechanisms for banking firms, on the grounds that market-based mechanisms do not adequately discipline banks. But what evidence supports this assessment? Why must governments assure bank solvency, but not the solvency of other firms? Government oversight naturally displaces private efforts to evaluate and control financial firms. Moreover, if the banking business changes over time--as it assuredly has in the past decade or two--the best combination of government and private supervision may change concurrently. This paper reviews and evaluates the growing empirical literature on private investors' abilities to assess the financial condition of banking firms. The evidence supports the proposition that market investors and analysts could reasonably provide a greater proportion of corporate governance services for large, traded U.S. financial firms.