Pricing Bank Stocks: The Contribution of Bank Examinations

A growing number of commentators advocate enhancing the role of market discipline in the banking industry. They argue that if private sector stakeholders can discourage excessive risk-taking and encourage safe banking practices through the pricing of bank securities, then the extensive regulatory framework currently in place may be unnecessarily burdensome. In the wake of recent studies concluding that 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. It addresses the concern that reducing regulatory oversight may adversely affect the market's ability to price bank securities effectively. Two recent papers provide evidence that market mechanisms can play a useful role in disciplining risk-taking by banks. Flannery and Sorescu (1996) show that prices of subordinated notes and debentures reflect specific risks of individual issuing banks, with asset quality and market leverage having significant effects on risk premia. Flannery, Kwan, and Nimalendran (1998) provide evidence suggesting that large banking firms are not overly difficult for market participants to value as compared with large nonbanking firms, and that market participants have rather good information about smaller banking firms in comparison to small nonbanking firms. Can we conclude from this evidence that market discipline could substitute for direct regulatory oversight? The supervisory process now produces a generous amount of information that the market may use in its assessments of banking institutions. Studies have shown that bank examinations often uncover useful information that market participants value but discover for themselves only with a lag