How might financial market information be used for supervisory purposes?

Bank supervisory monitoring, both on-site and off-site, generates a wealth of information with which to judge the safety and soundness of banks and bank holding companies (BHCs). For BHCs with publicly traded securities, the monitoring efforts of investors generate additional information that may complement the supervisory information set. In this paper, we address three public policy questions related to how supervisors might use this financial market information. First, can financial markets detect changes in BHC risk characteristics? To address this question, we summarize the academic literature on the topic and present our own empirical results using BHC stock returns and bond spreads. We find that securities prices signal changes in supervisory ratings of BHC condition up to a year prior to their assignment. Second, do securities prices provide information that complements supervisory information? Using forecasts generated by an off-site monitoring model developed by Krainer and Lopez (2001), we find that securities prices do improve forecasts of supervisory ratings changes, although the improvement is not statistically significant. Third, what is an appropriate level of accuracy to demand of financial market signals and off-site monitoring models more generally? We examine this question by studying the model's ratio of correct forecasts to incorrect forecasts.