Supervisor and Market Analysts: What Should Research be Seeking?

Abstract

This article is primarily directed towards examining the desirability of incorporating market signals in the process of supervision of commercial banks by regulators and insurers. But the ideas developed here can also be applied to the general problem of using market information to assess the solvency and safety of any financial or non-financial institution.

Market prices and yields of securities anticipate actions by regulators, central banks, and other players due to the fact that such actions may materially influence the risk and the expected return associated with investment decisions pertaining to those securities. It is well known that the yield curve of government securities such as T-bills, T-notes and T-bonds reflect the market's consensus regarding the actions that the Federal reserve may take as they pertain to the valuation of such securities. The extent to which the market has already “discounted” the future actions of the central bank will no doubt play a role in the way in which the central bank may think about its actions, its actual effect and how it relates to its intended effects.

The extent to which market prices can provide useful guides depends on the underlying market structure and the practices in the industry.

While markets may do “lot of the hard work” in aggregating and incorporating future actions, the task of supervision and regulation can never be put on “automatic pilot.” Ideally, supervisory policies should effectively combine the market signals with initiatives that serve to maintain the safety and the soundness of the underlying markets. I will begin by exploring the extent to which equity prices may be used as a signal of bank credit risk. I will then explore the advantages and disadvantages of using subordinated debt securities to derive a market signal.