by John S. Jordan
May/June 1999

In the wake of recent studies concluding that financial markets effectively demand risk premia on noninsured bank securities, the debate has intensified over whether we should place greater reliance on markets and less reliance on direct regulatory oversight. This study contributes to the debate by investigating the interaction between the market's pricing of bank equity securities and the regulatory examination process during the early stages of New England's banking crisis in the late 1980s and early 1990s. It addresses the concern that reducing regulatory oversight may adversely affect the market's ability to price bank securities effectively. The author finds that the bank examination process contributed significantly to the market's understanding of financial problems at New England banks. Bank examiners appear to have uncovered problems that bank management was unwilling to disclose publicly, since accounting performance measures were significantly different in exam quarters that resulted in supervisory downgrades than they were in all other quarters. In addition, market participants appeared to find this information useful, driving down stock prices in the quarter after the exam, the period when the poor performance measures associated with the exam are generally disclosed. The author suggests caution in considering market discipline as a substitute for regulatory oversight; the results of his study suggest it should more appropriately be considered as a complement.

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