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Market-based regulation and the informational content of prices

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Author Info
Philip Bond
Itay Goldstein
Edward S. Prescott

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Abstract

Various laws and policy proposals call for regulators to make use of the information reflected in market prices. We focus on a leading example of such a proposal, namely that bank supervision should make use of the market prices of traded bank securities. We study the theoretical underpinnings of this proposal in light of a key problem: if the regulator uses market prices, prices adjust to reflect this use and potentially become less revealing. We show that the feasibility of this proposal depends critically on the information gap between the market and the regulator. Thus, there is a strong complementarity between market information and the regulator's information, which suggests that regulators should not abandon other sources of information when learning from market prices. We demonstrate that the type of security being traded matters for the observed equilibrium outcome and discuss other policy measures that can increase the ability of regulators to make use of market information.

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Paper provided by Federal Reserve Bank of Richmond in its series Working Paper with number 06-12.

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Date of creation: 2006
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Handle: RePEc:fip:fedrwp:06-12

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Related research
Keywords: Markets ; Prices ; Banks and banking;

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  7. Khanna, Naveen & Slezak, Steve L & Bradley, Michael, 1994. "Insider Trading, Outside Search, and Resource Allocation: Why Firms and Society May Disagree on Insider Trading Restrictions," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 7(3), pages 575-608. [Downloadable!] (restricted)
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