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Market-based regulation and the informational content of prices

  • Philip Bond
  • Itay Goldstein
  • Edward S. Prescott

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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  1. 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, Society for Financial Studies, vol. 7(3), pages 575-608.
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  7. Douglas D. Evanoff & Larry D. Wall, 2000. "Subordinated debt as bank capital: a proposal for regulatory reform," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q II, pages 40-53.
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  11. James Dow & Itay Goldstein & Alexander Guembel, 2005. "Commitment to Overinvest and Price Informativeness," OFRC Working Papers Series 2005fe18, Oxford Financial Research Centre.
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  13. Itay Goldstein & Alexander Guembel, 2008. "Manipulation and the Allocational Role of Prices," Review of Economic Studies, Oxford University Press, vol. 75(1), pages 133-164.
  14. DeYoung, Robert, et al, 2001. "The Information Content of Bank Exam Ratings and Subordinated Debt Prices," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(4), pages 900-925, November.
  15. Hulya Eraslan & Philip Bond, 2008. "Information Based Trade," 2008 Meeting Papers 1012, Society for Economic Dynamics.
  16. Antoine Faure-Grimaud, 2002. "Using Stock Price Information to Regulate Firms," Review of Economic Studies, Oxford University Press, vol. 69(1), pages 169-190.
  17. Roll, Richard, 1984. "Orange Juice and Weather," American Economic Review, American Economic Association, vol. 74(5), pages 861-80, December.
  18. Stephen Morris & Hyun Song Shin, 2005. "Central Bank Transparency and the Signal Value of Prices," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 36(2), pages 1-66.
  19. Faure-Grimaud, Antoine, 2002. "Using Stock Price Information to Regulate Firms," Review of Economic Studies, Wiley Blackwell, vol. 69(1), pages 169-90, January.
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