Using Market Information in Prudential Bank Supervision: A Review of the U.S. Empirical Evidence

Abstract

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.In principle, market and government supervision provide alternative devices for controlling (governing) any type of corporation. Most national governments have instituted nonmarket regulatory mechanisms for banking firrns, on the grounds that market-based mechanisms do not adequately discipline banks. But what evidence supports this assessment? Why must governments assure bank solvency, but not the solvency of other firms? Government oversight naturally displaces private efforts to evaluate and control financial firrns. Moreover, if the banking business changes over time-as it assuredly has in the past decade or twthe best combination of government and private supervision may change concurrently. This paper reviews and evaluates the growing empirical literature on private investors' abilities to assess the financial condition of banking firms. The evidence supports the proposition that market investors and analysts could reasonably provide a greater proportion of coxporate governance services for large, traded U.S. financial firms. (who first suggested this topic). Bart Danielsen provided research assistance. MARK 1. The United States has most severely limited the investment banking activities of commercial banks. U.S. banks are also entirely excluded from participating in nonfinancial commerce.2. U.S. banks may undertake many activities only through separate holding company affiliates, unlike the "universal bank" form of organization that is common in Europe. The Federal Reserve has long insisted that a BHC should serve as a "source of strength" for its subsidiary banks, and FIRREA formalized this requirement. With private corporate governance, individual firms could negotiate whether or not to eschew this limited liability protection for their banking subsidiaries.3. U.S. ownership restrictions preclude a firm from controlling both financial and commercial businesses. The market for corporate control in banking is consequently weaker than in other sectors of the economy (Prowse 1997; Gorton and Rosen 1995; Hubbard and Pallia 1995).4. Increased reliance on private assessments has been particularly important in the design of U.S. capital standards for market risk exposure. These standards use a bank' s own internal models to measure its risk exposure, on the grounds that a regulator cannot assess risk more accurately than the bankers themselves do.5. Gilbert ( 1990) and Berger ( 1991 ) evaluated the earlier parts of this literature, but many important institutional and regulatory changes have occurred since those reviews were undertaken. This content downloaded from 128.6.218.72 on Fri, 10 Apr 2015 16:19:52 UTC All use subject to JSTOR Terms and Conditions MARK J. FLANNERY : 275com...

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