Economic research conducted over the last several years has shown
that market prices contain information on the riskiness of banking
organizations. (As a point of clarification, we use the terms bank
and banking organization to refer to both banks and bank holding
companies.) This finding effectively addresses claims that market
data offer no insight into bank risk taking.
But these findings taken on their own do not make a conclusive
case that bank supervisors, who must assess the condition of
banks, should begin relying on market data. As economists might
say: The findings are necessary but not sufficient. Bank supervisors
still must determine if and how they can use market signals,
given both their need for real-time, easy-to-interpret information
and the already established processes and techniques they use
In fact, obtaining high-quality market data that provide clear
signals to supervisors can be challenging. Moreover, the advantages
of augmenting the existing supervisory process with market data
do not appear overwhelming, at least as of today. That said,
we believe a comparison of benefits and costs justifies increased
incorporation of market data into supervisors' day-to-day work.
Specifically, supervisors could use such signals in three major
ways. Market information could be used to help assess the overall
condition of institutions, as well as the quality of loans and
capital. Market data also could facilitate supervisory responses
to institutional risk taking by reducing the uncertainty associated
with those responses and ensuring that actions are credible
and fair. Finally, supervisors could use market data to more
efficiently and effectively allocate scarce supervisory resources.
However, we believe that supervisors will need to look beyond
the usual data suspects and examine many sources, including
signals from equity markets.
We clearly believe that making more routine use of market
data in the supervisory process will have short-term benefits.
But increased knowledge of and experience with the data's strengths
and weaknesses offer the biggest potential return. Some of the
most significant concerns about the use of market information,
such as uncertainty of interpretation, may simply reflect a
lack of experience with the data. As a result, we make several
recommendations to encourage increased supervisory use of market
data. Other concerns require more applied research on the use
of market data, and we make suggestions for a future research
Arriving at the transition point from basic research
to practical use of market data
In the United States, federal and state authorities manage bank risk
taking through prudential supervision and regulation. Under this regime,
supervisors first assess the riskiness of banks. Part of this assessment
generally involves analysis of data from mandated financial reports as
well as sources specific to any given bank. This off-site data analysis
supplements the on-site supervisory reviews of loan quality, risk management
and other factors that take place on the physical premises of the bank.
Based on their assessment, supervisors may take necessary steps to ensure
that banks operate prudently.
This supervisory approach to banking stands out in an economy
that generally relies on market forces to determine how much
risk firms assume. Firms usually communicate their plans of
action to investors, who assess the riskiness of the firms'
proposals. These assessments influence the prices investors
demand for their funds as well as the restrictions they place
on the firm. Because most observers view this price-centric
system as successful, they naturally have called on bank supervisors
to make better use of market signals. After all, to some extent
market investors and supervisors seek similar outcomes: accurate
assessment of, and response to, bank risk taking.
However, before bank supervisors consider using market prices
as an input into their assessments, they must have confidence
that the prices set by bank creditors will vary in a reasonable
way with the riskiness of banking organizations. Market prices,
at a minimum, should signal greater risk for higher-risk institutions.
Prices set by bank creditors cannot simply be assumed to pass
this litmus test. Explicit government programs, such as deposit
insurance, and implicit guarantees that may lead some creditors
to perceive that they will be bailed out if a bank fails, can
distort prices. Indeed, such distortions partly justify prudential
supervision. The relatively high cost of evaluating opaque bank
assets adds to the challenge for market investors.
Despite the potential hurdles, bank research over the last
decade finds that creditors of banks produce market signals
that vary in the proper direction with the riskiness of banks.1 Market prices indicate a higher level of risk for banks that
are closer to failure, have riskier balance sheets and engage
in riskier activities; in addition, higher risk banks tend to
make less use of funds that are risk sensitive (that is, funds
whose cost will increase along with bank riskiness). Market
data thus contain information, not just "noise."
Such research findings are necessary but not sufficient to
justify increased use of market data by supervisors. Supervisors
already have established processes to assess supervised institutions
with which they have extensive experience and comfort. Changing
those processes, through increased use of market data, is costly.
Part of the cost involves learning how market data can be used.
In addition, any switch in supervisory process will entail new
expenses such as developing and communicating new guidance.
Market data would also impose a cost if it led to inferior supervisory
assessments or actions.
Before increasing the use of market data in the supervisory
process, supervisory agencies should feel comfortable that the
benefits from increased use will outweigh these costs. Ideally,
supervisors would carry out this analysis with exact measures
of costs and benefits. Due to measurement challenges, supervisors
will only have a rough gauge as to costs and benefits. As a
result, we believe a case for increased use of market data could
rely on a finding of tangible benefits of increased use at very
low costs. Based on our analysis of the presentations and discussions
at the Federal Reserve conferences highlighted in the introduction
to this symposium, we argue that bank supervisors could gain
tangible benefits at low cost by using market data in:
- the assessment of bank condition;
- the supervisory response to bank condition; and
- the allocation of supervisory resources.
We discuss uses of market data in each of these three areas,
but first we briefly explain why practical use of market data
will likely rely on multiple types of signals from the market.
How multiple sources of market data
can facilitate practical use of market signals
A bank issues many types of financial claims in addition to insured deposits,
including equity, long-term and short-term bonds and notes, and uninsured
deposits. Embedded in the prices investors pay for these claimsor
equivalently, in the interest rates they demandare assessments of
the condition of the bank. Among these many types of claims, most recent
policy attention has focused on a single source of market data, spreads
on subordinated notes and debentures (SND), as providing the greatest
promise for enhancing the assessment of bank risk taking. (See "Market
Data Sources in More Detail" for a more detailed discussion of
SND and the other sources of market data mentioned below.)
We believe a focus on SND is too narrow, and that reviewing
multiple sources will maximize the benefit supervisors can receive
from market data. In part, this conclusion reflects current
limitations of SND spreads. Only a small number of banks issue
SND, although this does include many of the large and systemically
important ones. But, even many of the largest banks have a limited
amount of SND outstanding at any point in time. The SND issued
by one bank might differ in important wayssuch as the
time left to maturity on the issuefrom the SND issues
of other banks, making it difficult to compare a bank to its
peers using SND data. Finally, many SND issues do not trade
regularly in venues from which supervisors can dependably and
quickly obtain market prices.
Other sources of market data could be valuable additions to the information
There are now widely used models for obtaining risk assessments
from equity markets. Relative to SND, many banks issue stock
and this stock tends to trade in liquid markets. Vendors sell software
that generate easy-to-produce, timely equity-based risk assessments.
Senior debt could significantly augment data available from
Uninsured deposits may offer the only hope of obtaining market
prices for banks without traded SND or equity.
Quantity-based measures, such as changes in the proportion
of uninsured deposit funding, can provide signals as well.
Our point is not that these other types of data are better
than SND; they clearly are not perfect. For example, the equity-based
models are theoretically and computationally complex, and the
Federal Reserve does not have ready access to market prices
for uninsured deposits. But on balance, these limitations are
no more significant than those encountered with SND data. Thus,
looking beyond a single source appears likely to enhance supervisors'
ability to use market data.
Using market data to assess bank condition
There are three elements of supervisory processes where market data offer
bank supervisors a low-cost tool for assessing the riskiness of institutions.
First, market data, as an additional measure of overall condition, can
augment supervisors' assessment of the condition and riskiness of banking
organizations. Second, supervisors can incorporate market data into statistical
models used to forecast the future condition of banks. Finally, supervisors
could use market data in the analysis of a bank's loan quality and capital
Assimilation of market data into summary assessments
Bank supervisors review standard performance ratios on asset
quality, earnings and other aspects of bank performance, as
well as measures specific to the business of a supervised institution,
when assessing condition. Evaluations from on-site exams also
contribute significantly to these assessments. Supervisors use
all these pieces of information to come to conclusions about
components of bank soundness, including funding, capital adequacy
and risk management, as well as the overall condition and riskiness
of the institution. The judgmental nature of the existing process
could allow market data to be incorporated at a fairly low cost,
with minimal disruption.
However, some bank supervisors have argued that lack of experience
would limit the use of market data in the assessment process.
Over the many years of working with traditional financial information,
managerial reports and on-site inspections, supervisors have
developed an intuition for the relationship between traditional
data and the condition of banks. Supervisors have not had the
time or experience to develop the same facility with market
data. Supervisors argue, for example, that it is difficult to
identify atypical market signals, thus limiting the benefits
of using market data in the short run. Analysts can address
the supervisory need, in part, by describing the distribution
of market data signals. For example, distributional analysis
can provide the average change in a market signal over recent
years, thereby providing supervisors with benchmarks for their
assessments (See "Interpreting Market
Data Signals" for reports of initial results from distributional
Off-site statistical models
While much of the assessment process relies on judgment, supervisors
also make use of empirical techniques such as statistical formulas
to forecast future supervisory ratings or to identify the probability
that a bank will fail. The Federal Reserve's econometric model
for forecasting bank failures relies on accounting variables
related to the asset quality, capital adequacy, liquidity and
earnings of a bank.2 A second model
estimates supervisory ratings for a bank and relies on similar
financial variables plus the most recent supervisory rating.
The output from these models deserves serious consideration;
for example, research shows that once an on-site supervisory
rating is more than six months old, supervisors would be better
off relying on the model than the rating to identify problem
These models provide an ideal method for determining if market
data would provide any additional benefit, given the existence
of supervisory ratings and financial data. Specifically, analysts
can add market data to these models and determine if this addition
improves the statistical accuracy of the model. Based on presentations
at the conference, such tests have found that market data, specifically
equity market data, could improve the forecasts of such models. 4
The addition of equity-based data improves measures of the
predictive capacity of the supervisory rating model by as much
as 5 percent to 10 percent (for cases where the bank is downgraded
to "unsatisfactory" condition). While these figures might appear
quite small, they do not represent the total informational power
of equity data but rather the marginal value of adding such
data to an existing model. The presentations did not investigate
the marginal power of adding traditional supervisory data to
a model that already included market data. As such, we do not
know whether the traditional supervisory variables in the model
would have similar marginal effects on forecast accuracy.
Statistical models would provide the greatest benefits for
the supervision of institutions where the supervisory rating
has the greatest chance of becoming stale. Many mid-size institutions
meet this description because they receive only annual on-site
examinations supplemented by off-site monitoring of traditional,
often backward-looking data. Market data could prove useful
even at larger institutions if they are not subject to continuous
Market assessments of condition could also prove useful for
banks engaged in nontraditional activities. Standard data sources
and analyses that were developed for institutions primarily
engaged in traditional banking may become less appropriate and
more difficult to interpret as the range of activities conducted
by banking organizations expands. See more detail on the types of institutions for which market data could
Asset quality and capital adequacy
The same market data used in assessing the overall condition
of a bank can also help assess the quality of a bank's loans
and the adequacy of its capital.
Asset quality. Firms that borrow from banks also
may issue equity and debt instruments. Supervisors can use the
signals from markets for these financial instruments to evaluate
the ability of borrowers to repay the bank. In particular, since
supervisors cannot review every loan made by a bank, market
assessments can provide a low-cost method for identifying the
loans that should receive the greatest level of supervisory
scrutiny. Supervisors might, for example, rank-order industries
by a market signal of risk. Borrowers in industries that appear
to be in the worst condition might receive additional supervisory
review. Indeed, over the last several years, a process along
these general lines has facilitated the supervisory review of
large, syndicated loans (loans of more than $20 million made
by one bank but sold to at least three others).
Once supervisors have decided which loans to review, they can
use the market assessment as part of their loan analysis. Using
market data in this way would fit well with current loan review
procedures that require supervisors to assimilate information
on the borrower and make subjective judgments. Many examiners
now carry software on their laptops that can generate market
signals derived from equity-based models, and so can use this
information during the loan review process at little or no marginal
Capital adequacy. Market data can assist in assessing
the capital adequacy for banks using economic capital models.
The Federal Reserve has encouraged banks to make increasing
use of economic capital models where appropriate. In the most
general terms, these models estimate the amount of capital a
bank must hold to withstand likely future losses some percent
of the time and over some period (such as one year). These capital
models require banks to determine the probability of default
on assets and the losses if defaults occur. Lack of institution-specific,
historical data has led banks to use market data in their modeling
efforts. For example, some banks use equity-based models to
determine the probability of default. Although bond data seem
to be used less often than equity-related data in capital modeling,
some banks also use the prices of defaulted bonds to estimate
default-related losses. Supervisors must have an in-depth understanding
and appreciation of market signals in order to evaluate and
assess the use of these models.
Using market data when devising supervisory action
Once supervisors make an assessment of the condition of a bank, they
must determine how they will respond. For institutions that pose few safety
and soundness concerns, the supervisory action plans will not require
much change for the bank. Alternatively, supervisors may demand that institutions
adjust their behavior, with the severity of the supervisory actions corresponding
to the assessment of risk. Market assessments can support the supervisory
response by reducing the uncertainty associated with supervisory actions,
facilitating communication between supervisors and institution management,
and providing an independent assessment to reinforce the legitimacy and
fairness of supervisory requests. These uses of market data appear consistent
with current processes, and thus should pose relatively little disruption
Reducing uncertainty. As noted by Minneapolis
Fed President Gary Stern, market assessments
of bank riskiness could speed supervisory actions by reducing
uncertainty about the appropriateness of the supervisory response.
Consider the case where supervisors and markets appear to draw
similar conclusions. For example, supervisors may come to an
initial decision to downgrade the supervisory rating of the
bank because asset quality, earnings and capital adequacy have
fallen; during that same period, debt spreads may have widened
relative to peer institutions. Market signals thus reaffirm
supervisory judgments, and supervisors could downgrade the bank
more promptly and with more confidence.
It might seem that conflicting signals between markets and
supervisors would increase uncertainty for supervisors. But
at least in principle, the more information a supervisor uses
in formulating assessments of bank condition and supervisory
response, the tighter the range of possible values their assessment
should take. When supervisors develop an initial assessment
of a bank's condition, they are in essence making a best estimate,
around which they always have some uncertainty. Market signals,
whatever they indicate, represent additional raw information.
And additional information, properly used, can almost always
improve initial estimates.
Flannery (2001) makes the point clearly. "Statistical theory
indicates that even an imprecise market assessment (forecast,
signal) of bank condition should complement standard supervisory
procedures, in the sense that a more accurate forecast can be
made using both sources of information than with either one
alone." Using both market and supervisory sources of data should
prove especially beneficial because the respective assessments
rely on different perspectives and calculations. Flannery goes
on to note that, "If market information could reduce the uncertainty
about a firm's true condition ... the market assessment [could]
convince supervisors to act sooner."5
Enhancing communication. Supervisory actions
should achieve the greatest effect when boards of directors
and managers of the regulated entities view them as well-founded.
We might expect institutions to engage in less resistance to
supervisory actions when supervisors can support their actions
with data the firm takes seriously and can communicate their
intent in terms the bank uses. Market data fill the bill in
both regards. Banks would have a difficult time rejecting the
validity of market data, especially if they incorporate such
data in their own business planning and processes, from funding
and compensation to business strategy and risk management.
Facilitate "fair" actions. In a democracy, society
as a whole must view supervisory actions as fair and legitimate;
capricious regulators eventually bear the consequences. Banks
can successfully challenge supervisory actions that are inconsistent
with regulatory powers or that arise from arbitrary decision-making.
Critics sometimes have charged that supervisory actions do not
treat all institutions fairly, with some institutions receiving
too light a response while others receive a harsh penalty.
Linking supervisory action to market signals offers a method
for reducing this impression. Linkage to a neutral measure could
help convince legal authorities and others that banking supervisors
have acted in a reasoned and fair manner. A formal link might
require supervisors to take a specified set of actions when
a market signal assumes a specified value (for example, three
times higher than peer average). A system of this sort already
links bank capital to supervisory action.6
But an additional advantage of linking market data to supervisory
action is the third-party nature of market assessments. Supervisors
can directly control bank capital levels by forcing a bank to
write down assets, but they cannot directly influence market
assessments of bank riskiness. Even without formal linkage between
market data and supervisory actions, supervisors could use such
data to support supervisory activities in legal venues. We do
not view market data in this context as a tool to prevent regulatory
forbearance, but rather as a backstop to confirm the legitimacy
of supervisory action. The market signal to trigger supervisory
action would have to be chosen to reflect this backstop role,
and trigger levels would be set to catch only banks in very
Using market data in allocating supervisory resources
So far we have largely limited our discussion to uses of market data
to assess risk and support supervisory action in institution-specific
cases. The data could also help regulatory agencies like the Federal Reserve
allocate their supervisory resources efficiently. Bank supervisors, aware
of the cost of devoting resources to supervision, have sought to economize
on those resources; for example, the Federal Reserve tailors its bank
examinations to those areas likely to pose the greatest risk (risk-focused
exams). Supervisors can use market data to directly advance their risk-focused
approach. As noted above, market data can help in asset reviews by freeing
up supervisors to spend the most time with the riskiest assets.
In the same vein, supervisors can use market data to rank-order
the riskiness of institutions. Those institutions posing the
highest level of risk would receive the greatest attention from
supervisors. Market signals are better suited to this purpose
than existing methods of supervisory assessment. Examination
reports are narrative and cannot be used to construct rankings.
Supervisory ratings are numerical but also are inadequate for
ranking. For example, supervisory ratings of bank holding companies
take on only five values, and only three are used with regularity,
making it difficult to adequately differentiate risk levels.
In addition, the rating numbers themselves have no inherent
meaning (they could just as easily be A through E instead of
1 through 5), making it difficult to quantify the relative condition
of institutions with different ratings.
Market measures can take on an infinite range of values and
thus can help differentiate between institutions. Moreover,
some market measures produce values that have meaningful interpretations.
For example, many models based on market data can provide an
estimate of the probability of failure; a 20 percent chance
of failure has a clear meaning relative to a 10 percent chance
of failure. Such rankings by market measures could thus supplement
current methods for allocating supervisory resources.
A lack of experience has slowed the transition
to practical use of market data
We believe there are benefits to adding analysis of market data to the
supervisory repertoire. However, this change to the status quo could take
some time unless concerted steps are taken. Supervisors have monitored
some market data, such as stock prices, for many years. But greater use
of market data along the lines discussed in this essay is akin to rolling
out a new product with which supervisors do not have significant experience.
Product adoption may be slowed by several factors related to this lack
Supervisors, as noted above, are not familiar with the properties
of market data. Although research that provides a better sense of
how to interpret market signals (for example, describing more completely
how to identify market signals that are sufficiently unusual to generate
concern) will help, supervisors may simply need additional hands-on
experience to achieve the intuition and comfort level they have with
more traditional supervisory data.
Supervisors in the field tend to rely on extensive guidance and
templates that assist them in assessing risk and devising a response
to that assessment. By and large, the guidelines and templates that
currently exist do not address or facilitate the use of market data
in the supervisory processes. More generally, there has not been specific
direction from senior supervisory staff encouraging explicit use of
market data in carrying out supervisors' jobs.
Supervisors normally review financial or managerial data linked
to specific components of an institution's condition. For example,
they review data on the performance of loans to determine the riskiness
of the loan portfolio. Outside of a small subset of fairly well-defined
events such as mergers, supervisors cannot currently link changes
in market data to specific activities or events. The risk premium
on a bank's bonds might increase, but to what aspect of a bank's business
is the market reacting? Absent that kind of interpretation, it is
difficult for supervisors to translate information into actions.
Supervisors' experience is based on analysis of information not
generally available to the public. An emphasis on such private information
and in-house analysis leads many supervisors to be at least somewhat
skeptical of the benefits of market assessments. After all, from the
supervisory perspective, market participants must rely on inferior
data to come to their conclusions. This information disadvantage may
be offset in other wayssuch as the large number of market participants
and the resources they are able to devote to analysisthat make
market information valuable, but these offsetting factors tend to
be subtle and hard to demonstrate.
Recommendations for transitioning to
practical use of market data
Our recommendations in response to the concerns noted above fall into
two categories: those that involve supervisory policies and procedures,
and those that suggest an applied research agenda to respond to supervisors'
questions about the data.
Changes to supervisory processes. Supervisory
agencies could directly address some of the key concerns that
have slowed the transition to practical use of market data.
First, policymakers and senior bank supervision staff should
describe their expectations for use of market data in the supervisory
process in greater detail. Part of the confusion as to expectations
comes from the use of similar terms with dissimilar meanings.
In particular, some policymakers have called for "increased
use of market assessments" in supervision or "increased market
discipline," but appear primarily to be encouraging increased
disclosure by banks rather than supervisory uses of data of
the type we have been discussing. Clarification could help prevent
a disconnect between practice and policy statements.
Second, and related to the first point, the supervisory agencies
should move beyond statements of policy to practical guidance
for staff. Promulgation of more formal supervisory guidance
could provide field-level supervisors with needed direction;
the lack of official guidance makes it difficult for supervisors
who do not have significant experience with market data to use
it effectively. In addition, guidance would emphasize leadership
Third, supervisors could offer training to staff on use of
market data. Training offers another vehicle for gaining experience
with market data and could supplement what supervisors learn
from making use of market data. Supervisors at Federal Reserve
conferences identified training as a high priority.
Additional applied research. Supervisors have
raised a number of questions that would require additional research
to answer. One of the most repeated queries concerns the relative
merits of the various data sources. Does one source provide
a signal deserving greater weight in analysis? Carrying out
such analysis for the limited number of signals would require additional data collection. In addition, supervisors
want confirmation that the more sophisticated market-based signals,
such as those derived from equity prices using relatively complex
models, outperform simpler market signals such as raw stock
prices or price-to-book ratios, which supervisors feel are more
A second request from supervisors reflects the need to filter
out those aspects of market signals that do not relate to the
riskiness of institutions. Stock prices rise and fall for many
reasons, not all of which reflect changes in a bank's condition.
Debt spreads reflect more than just default risk; for example,
changes in liquidity affect the spreads on bank-issued SND.
Research that provides techniques to more keenly focus on the
relevant supervisory content of market signals would yield big
benefits for practical supervisory use.
A third, and similar, strand of remarks from supervisors focuses
on the link between market signals and the specific operations
of a bank. Ultimately, supervisors with concerns about an institution
must ask the bank to do something. Supervisors would prefer
to link market signals to specific bank activities so that they
can tailor their analysis and response. Additional research
could help make these links.
What's the right speed for the transition?
The case for making the transition to greater use of market data seems
clear, but how quickly should bank supervisors make that transition? The
research evidence that market data have informational content has grown
over the last several years, but our understanding of market data remains
incomplete. Initial practical experiments by Federal Reserve analysts
have given them a much greater appreciation for the challenges involved
in making greater use of market data. We have already noted some of these
in our discussion above. There have also been bugs in presentations of
market data, in calculations of measures of risk based on market data
and in interpretations of changes in market data. Anyone involved in the
rollout of a new process will not find these imperfections surprising.
But pushing a new product out the door before it achieves a certain state
of readiness can cause irreparable damage to its reputation. Indeed, some
claims made on behalf of market data, such as an ability to routinely
identify weak institutions that supervisors incorrectly deem healthy,
seem overstated and unsupported. Does prudence dictate that the Federal
Reserve should increase its understanding of market data before asking
supervisors to make more use of it?
We recommend moving forward quickly in the near term, even
with our less-than-perfect understanding because increased use
of market data in the short run appears to pass basic cost-benefit
tests. The costs of using market data in the ways and for the
objectives we have suggested seem very, very low. It is relatively
cheap to acquire and process the information with many types
of market data available in electronic form from well-known
sources. A small, coordinated staff could, and to some degree
has, managed data acquisition, analysis and distribution for
the entire Federal Reserve System. And although the benefits
may be difficult to quantify fully, they appear real and substantial.
Our conclusions are consistent with the limited empirical research
on this topic, which finds that supervisors have valuable and
unique insight into bank condition, but that market data provide
additional valuable information.7
Perhaps the more compelling reason to move forward quickly
rather than cautiously is to improve bank supervisors' understanding
of market data. Only through the limited monitoring of market
data done to date have flaws been exposed, additional analyses
conducted and remedies devised. In short, the Federal Reserve
has gained most of its knowledge about the data from using it.
We doubt that a hiatus from practical use would improve our
understanding or address the major stumbling block, the limited
experience bank supervisors have with market data. Indeed, assessing
and responding to bank risk taking involves more art than science,
implying a certain futility in waiting for a precise answer
as to how supervisors incorporate market and supervisory data
into their decisions. Using market data in the low-cost and
minimally disruptive ways suggested here is the most straightforward
way to address concerns related to the lack of experience.
1 For summaries of this research see Federal Reserve System Study
Group on Subordinated Notes and Debentures, Using Subordinated
Debt as an Instrument of Market Discipline, Board of Governors
Staff Study 172, December 1999; and Mark Flannery, "Using Market
Information in Prudential Bank Supervision: A Review of the U.S.
Empirical Evidence," Journal of Money, Credit and Banking (August 1998, Part I),
2 A discussion of
the Federal Reserve's model is found in Rebel Cole, Barbara Cornyn
and Jeffrey Gunther, "FIMS: A New Monitoring System for Banking
Institutions," Federal Reserve Bulletin January 1995, pp.
3 Rebel Cole and
Jeffrey Gunther, "Predicting Bank Failures: A Comparison of On-
and Off-Site Monitoring Systems," Journal of Financial Services
4 Research shows that bond ratings and equity measures better predict
bank performance variables than all but the most recently issued
supervisory ratings. See Allen Berger, Sally Davies and Mark Flannery,
"Comparing Market and Regulatory Assessments of Bank Performance:
Who Knows What When?" Journal of Money, Credit and Banking,
Vol. 32., No. 3, August 2000, Part 2, pp. 641-670. Subordinated
debt spreads predict supervisory rating changes better than some,
but not all, measures of bank capital. See Douglas Evanoff and
Larry Wall, "Sub-Debt Spreads as Bank Risk Measures," Federal
Reserve Bank of Atlanta, Working Paper 2001-11, May 2001.
5 Flannery, M. J.
(2001) "The Faces of 'Market Discipline,'" Journal of Financial
Services Research, forthcoming.
6 The regulatory
regime called "prompt corrective action" groups banks into five
categories ranging from "well capitalized" to "critically undercapitalized"
based on the amount of capital they hold. Banks face tougher regulatory
requirements as they fall into groups defined by lower levels
7 For examples, see
Robert DeYoung, Mark Flannery, William Lang and Sorin Sorescu, "The Information
Content of Bank Exam Ratings and Subordinated Debt Prices," Journal
of Money, Credit and Banking, forthcoming; and Allen Berger, Sally
Davies and Mark Flannery, "Comparing Market and Regulatory Assessments
of Bank Performance: Who Knows What When?" Journal of Money, Credit
and Banking, Vol. 32, No. 3, August 2000, Part 2, pp. 641-670.