Enhancing Bank Transparency: Risk Ineffciency as a Market Disciplining Mechanism

This paper develops a stochastic frontier methodology to jointly test for market monitoring and influencing in a sample of US Bank Holding Companies over the period 1991-2008. First, we confirm the existence of market monitoring by linking stock market based risk measures to business model indicators and fundamental bank characteristics (in particular, constituents of the CAMEL rating). Second, we interpret the distance from the stochastic frontier as a measure of risk inefficiency relative to the best performing peers and show that the variance of this component is predominantly related to management discretion and opaqueness and less to business complexity. Finally, we find stronger evidence for the influencing channel of market discipline compared to most of the existing literature. Poorly performing banks will act faster to contain their risk and improve their performance in response to a deteriorating risk inefficiency score.