Jason Schmidt - Financial Economist
Published September 1, 2001 | September 2001 issue
There are at least three types of institutions for which we believe market data will prove helpful in the short run: large complex banking organizations (LCBOs), institutions with publicly traded debt or equity that are not LCBOs, and institutions with a significant amount of nontraditional activities.
LCBOs. Market data might prove useful for LCBOs for three reasons. First, these institutions face the greatest level of scrutiny by market participants. These institutions have the most frequently traded debt and have widely held and frequently traded equity. Many LCBOs also provide relatively high levels of disclosure. Market participants thus should be able to generate high-quality signals regarding the condition of these banks. Second, these institutions rely on capital markets for funding and make sophisticated use of market data in their operations (for example, capital modeling). As a result, market prices heavily influence these institutions and they take such signals seriously. Finally, the complexity and scope of activities of these institutions make their supervision challenging. Supervisors should therefore welcome assistance from millions of market participants.
Two factors mitigate the benefits of using market data in the LCBO context. First, LCBO supervisors have constant access to nonpublic information on LCBOs and already make frequent assessments of their soundness. Market investors may therefore have less new information to add. Second, the complexity that makes understanding the institutions a supervisory challenge also applies to market participants.
NonLCBOs with market signals. LCBOs receive the highest level of scrutiny by both markets and supervisors. Further down the size and complexity spectrum, both the depth and the frequency of analysis begin to taper off. However, there appears to be a group of midsize institutions that are followed fairly closely by market participants, have debt or equity that trades fairly frequently, but are not under continuous supervision by the banking agencies. For these institutions, signals from the financial markets may add timely, fresh assessments to supplement the less frequent collection of supervisory information.
Nontraditional institutions. Banking organizations have increased their nontraditional activities over the last two decades, and financial modernization legislation could further encourage this trend. This shift could lead the Federal Reserve to supervise more firms that have relatively small amounts of their activity covered by traditional supervisory information and amenable to traditional analysis. The Federal Reserve and other banking regulators are responding by increasing their ability to analyze nontraditional activities. However, banking regulators could benefit by relying more on market data for such firms, leveraging the assessments of experienced market observers. Although changes in the banking business also present challenges for market participants, market data may provide summary measures of condition that are more robust to industry evolution.