The Information Content of Bank Examinations

The role of information acquisition for bank regulators is important for the recognition and possible control of bank risk. This role is also consistent with the modern theory of banking under which banks hold a substantial amount of private information about their loan customers, and by implication, private information about their own conditions. The authors suggest that the main purpose of bank examinations is information acquisition. In order to maintain the safety and soundness of the banking system, regulators conduct regular on-site reviews of operations and determine a composite rating for the institution, known as its CAMEL rating. The authors test whether bank exams do in fact result in significant information acquisition. Their tests involve observation of how capital markets react around the times of examinations and whether these reactions are related to changes in examination ratings. They use event study methodology and track the cumulative abnormal returns on an institution's stock price before and after the examination relative to the predictions of a two-factor market model. Data are for institutions whose stocks were actively traded on major exchanges from 1985-1989 - a relatively stable regulatory regime. The question of whether bank examinations succeed in discovering substantial private information about loan quality and bank risk is crucial to answering policy questions regarding financial system reform. The modern theory of banking often rests on the assumption that are delegated monitors because of scale economies in information acquisition about borrowers. An extension of this theory might suggest that there are economies of scale in "monitoring the monitors". These economies of scale do not necessarily imply that government agencies should be the monitors. However, under the current federal safety net and deposit insurance regime, the federal government bears greater losses than do their creditors in the event of bank failure. One important consideration in choosing how much of the risk-bearing and associated monitoring responsibility should rest with government versus private sector agents depends upon the quality of the information available to the two groups. The authors' data suggest that regulatory examinations do generate valuable private information, although conceivable private sector firms could gain essentially the same or better information under a reformed regime. While CAMEL ratings and exam data are confidential, the authors suggest there are several ways information gathered in the process can be incorporated into capital market prices. One is that market prices react because insiders trade on information, although this would be illegal. Alternatively, the market may respond to information revealed in public documents released after an examination. The authors test for this possibility. The authors posit that there are at least three types of information effects that may be transmitted to the market from an examination - auditing, regulatory discipline, private information. They attempt to separate the effects of the three types by differentiating between examinations in which the CAMEL rating remained unchanged, improved, and worsened. The empirical results suggest that the net auditing effect is close to zero, and perhaps negative. They also find a relatively small regulatory disciple effect. The authors state that the data suggest that the private information effects of CAMEL downgrades in revealing unfavorable information about bank condition are substantial. Thus is consistent with some of the earlier studies of the combined effect and inconsistent with others. It also provides support for the concept of bank uniqueness - that banks hold private information about loan customers. The authors also find evidence that suggests that quarterly financial statements or the Call Report may be the conduits through which some of the examination information is revealed to the market.