Financial market signals and banking supervision: are current practices consistent with research findings?

Abstract

The trend toward incorporating information derived from financial markets into the bank supervision process has gained momentum over the past several years. This in part reflects an evolution in the thinking about how private market information can contribute to the process. In light of the evolving view of the potential contributions of market information, this paper reviews the empirical evidence relevant to the usefulness of financial market information in the bank supervision process. This paper reviews the research on what information can be gleaned from the pricing of equity and debt securities issued by banking organizations. The weight of the research leaves little room for doubt that financial market signals reflect underlying bank risk and that market evaluations of the risk of individual banking organizations are strongly correlated with supervisory findings. The evidence on the extent to which market signals can augment the information set of bank supervisors is more subtle, but overall it demonstrates that financial market signals should play a role in the bank supervision process. 1.

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