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Taking Market Data Seriously

September 1, 2001


Taking Market Data Seriously

The Minneapolis Fed has been calling for increased market discipline and greater use of market data in the bank supervision process for about 20 years. I think the timing and content of this conference, and its predecessor hosted by our co-sponsor, the Federal Reserve Bank of San Francisco, is right on target because we need to go beyond general policy discussions and good intentions, and address the practical advantages and problems raised by increased use of market data in supervision.

I assume supervisors will take Chairman Greenspan's concluding remarks—namely, that supervisory systems must increasingly rely on market discipline and data to avoid obsolescence—to heart. In my opinion, the chairman views favorably supervision of LCBOs (large complex banking organizations), and communications about such supervision, that include analysis of market data.

I would like to add some detail in support of the general sentiments of the chairman. In particular, I will explain why I think market data will be valuable to supervisors in their assessment of banking organizations, and I will offer specific suggestions for the use of such data. Finally, I will conclude with some thoughts on the future agenda in this area.

It seems that a fair number of supervisors think economists come to discussions of market data and banking supervisory issues with strong prior beliefs, namely that regulatory data and assessments are useless and market data tells us all we need to know. This straw man does not encompass my views. I firmly believe that both market and regulatory data contain valuable information, even though both are "noisy" and though assessments based on such data inevitably are imperfect. That is, the available data may not fully and accurately reflect the risk taking, and therefore potential difficulties, of a banking organization at any point in time.

For example, price signals from fixed-income instruments—subordinated debt issues, for example—reflect the supply and demand for particular bonds in addition to participants' views of risk. More generally, interpretation of movements in market prices and interest rate spreads is far from a trivial task. But on the other hand, supervisors may not fully appreciate the risk in a bank's derivative strategy or understand how poorly an organization is executing a merger. In short, relying exclusively on either supervisory or market data leaves some uncertainty in our assessment of financial condition.

The amount of uncertainty associated with regulatory assessments will vary over time and by institution. There is no reason to be defensive about this, given the inherent complexity and opaque nature of many banking activities as well as the probabilistic nature of risk. There is not an easy way to determine the chances of a "bad" outcome occurring in the myriad business activities of a large, complex banking organization.

I feel comfortable raising the specter of uncertainty with regard to Federal Reserve responsibilities because it occurs frequently in my job. The setting of monetary policy is characterized by doubt. No single set of data can inform monetary policymakers as to the correct action at Federal Open Market Committee meetings. In response, monetary policymakers review as much data as possible. Chairman Greenspan, as many of you have probably read, reviews a plethora of information on the economy to which he gives varying weights depending on the circumstances. The point is, we do not and should not throw information away, and this is particularly true when acquisition and analytical costs are reasonably low.

The logic for this broad approach is fairly straightforward. Each additional piece of relevant information we review may reduce the uncertainty that policymakers face. Greater certainty allows us to act sooner and be more precise in our response. I should stress one caveat: I do not advocate collecting information for its own sake. Rather, we review information that has a reasonable connection to our task, preferably a link validated by experience and empirical research.

The approach policymakers take toward monetary policy seems directly applicable to banking supervision. The more relevant information a supervisor has, the smaller the variation around the resulting risk assessment and the faster and more precise the supervisory response can be. I would think that supervisors, with their reliance on data and analysis, would be sympathetic to improving their assessments through additional, and potentially new, information.

Some skeptics of using market data in bank supervision point to the differences between the markets' and the supervisors' assessments as a justification for not taking market data seriously. But market data are well suited to complement regulatory assessments because of its particular attributes:

  • Market data are generated by a very large number of participants.

  • Market participants have their funds at risk of loss. A monetary incentive provides a perspective on risk taking that is difficult to replicate in a supervisory context.

  • Unlike accounting-based measures, market data are generated on a nearly continuous basis and to a considerable extent anticipates future performance and conditions.

  • Raw market prices are nearly free to supervisors. This characteristic seems particularly important given that supervisory resources are limited and are diminishing in comparison to the complexity of large banking organizations.

I would think that market data would be of value whether or not they confirm supervisory assessments. Imagine a case where a supervisor believes an institution is becoming less risky but still has some doubts. At the same time, the trends in market data suggest that market participants believe the institution is posing less risk as well. To the degree that a separate, independent source confirmed the supervisory assessment, I would assume that the supervisor would become at least a little more confident of his view.

But what about the case where the two signals are at odds? Even here, uncertainty eventually may be reduced. Consider, for example, a case in which market data indicate a change in the condition of a banking organization—a deterioration, say—while regulatory assessments reflect no such change. Reliance on the supervisory assessment may lead to claims that markets "overreacted." Such conclusions are simply erroneous and are akin to judging a treacherous activity "safe" because you survived improbable odds. It could very well be that the supervisor underreacted. At the very least, market information should encourage the supervisor to take a second, close look.

There are several venues where supervisors can make effective use of market data, including assessments across institutions. The Federal Reserve has increased its efforts to allocate limited supervisory resources across districts and institutions. Those institutions posing the greatest risk would presumably receive the greatest attention. Market signals are a natural complement to regulatory data in making these relative comparisons. Because relative comparisons eliminate general market noise and benefit from forward-looking data, cross-institution comparison could represent a potentially effective use of market data.

Descriptive statistics based on market data also offer supervisors alternative methods for assessing the overall condition of the banking industry. For example, supervisors can look at the mean or median market-based measure of risk for the LCBO group to determine the current condition of these institutions and how it has changed over time.

Credit quality is another area where market data could enhance supervision. Traditional asset quality ratios have well-known failings, such as their backward-looking nature. Banks' internal ratings can be more forward-looking, but comparing ratings across institutions is a challenge. Supervisory ratings of asset quality and asset classification offer a potentially good source of information but also suffer from a lack of timeliness. Market data, in contrast, is forward-looking, timely and could facilitate comparison across institutions for at least part of the organizations' portfolios (for example, exposures to publicly traded firms).

The bottom line of my talk is that supervisors should include market data as input into assessments of regulated institutions. In cases where market data confirm supervisors' original view, I would expect faster supervisory response. As noted, market data could also act as an excellent "check" on supervisors' views and actions. And I think we know that actions of supervisors, in particular, are subject to second-guessing, particularly after the "forbearance" periods of previous banking crises. Because of forbearance, some influential observers of banking policy argue that market data, with its highly visible and public nature, would make an ideal tool to accelerate, if not force, regulatory action. Links between prompt corrective action (PCA) and some market measures are advocated, for example, in order to preclude forbearance.

One might be tempted to dismiss such PCA reforms as uninformed and unlikely to become law, but the original PCA proposals often provoked the same reaction. Rather than dismiss such proposals, it seems prudent for supervisors to proactively monitor and, where appropriate, respond to market signals, or at least be in a position to explain why such reactions did not occur.

Market data could also be of value in discussions with bank management, particularly when markets and supervisors take a dimmer view of the institution than its leaders. The third-party, objective nature of market assessments reduces the ability of an institution to characterize supervisors' assessments as off base or isolated. Moreover, banking organizations behave in many ways that suggest market prices provide information. It would be difficult for these institutions to later dismiss market data as noise.

This conference will conclude by establishing an agenda for future work in the market data arena, so let me add my thoughts. We will leave here with a continuing need to determine what data we should monitor, how we should obtain the data, how we should analyze the data to distill its risk assessments and how we should interpret changes in market signals.

Many declarations that call for greater use of market information stop at requiring additional disclosure. Now is an opportune time for policymakers to go further and articulate in detail their expectations for use of market data by supervisors.

In that vein, I would expect progress toward clarity and direction from the appropriate senior management throughout the Federal Reserve System. Such direction could lead to incorporation of market data into formal supervisory guidance and processes. The benefits of market data seem real enough and the costs of increased use low enough to justify a higher priority to the study and use of market data even with the data's flaws and with our limited knowledge.